Trend lines are an important instrument to make sense of market movements and predict the future direction of a price.
A trend consists of three points:
In a bullish trend, every new top creates a new point 2; the following bottom a new point 3. In a downtrend the roles are reversed. New bottoms create new point 2s, and new tops create point 3s. An uptrend could look something like this:
Now, imagine being a trader somewhere in the middle of this trend. As you can see, the price does not move in a straight line, and it does not even have a constant momentum. Even if you know the market is an uptrend right now, it is hard to make a prediction based on this knowledge.
Which direction will the market move in right now? How far will it move? Candlesticks can help you to answer these questions, but they are far more effective when you combine them with other instruments to predict the direction the price will move in. One of these instruments is trend lines.
Two of the most important questions any trader has about a trend are: “Where does the reversal end?”, and: “How long will the movement to point 2 keep going?” At first sight, these questions are hard to answer and even harder to predict.
To make things easier, let’s think about how the price of an asset is created. The only factor determining the price of an asset is the relationship of supply and demand – this is important to understand. If demand is higher than supply, prices will rise. If demand is lower than supply, prices will fall.
In an uptrend, demand exceeds supply. Still, after the price has moved up for a while, everybody willing to buy has bought into the asset. Even if there are the best reasons to buy this asset, everybody else is simply not interest in buying. Maybe they don’t know these good reasons, maybe they are already invested in a different asset, or maybe they don’t have any money. Whatever the reasons may be, at this moment supply will exceed demand and prices will start to fall again.
After a while, the falling prices will make the asset more attractive to investors again. Some of the traders that couldn’t buy before will have sold their other investments and are now ready to buy this asset. Others might simply get their monthly paycheck and are now looking to invest it. All of these events make demand rise again. After it exceeds supply, prices will turn around, start to rise again and continue the trend.
For a trader, it is important to understand that these events happen periodically. Although you will never know the exact reason for these periods, you can understand them when you look at a price chart. When you draw a line connecting all the point 2s in a chart you can find the trend line the current trend is following. This line significantly helps you understand what the market is currently doing, and what it will do in the near future.
Is the price approaching a trend line, you know it will likely turn around soon. This knowledge helps you to make successful trades and avoid bad ones. Similarly, if the trend is far from a trend line, you know that the correction still has some room left, and can invest in this prediction.
As you can see in the picture above, a trend has more than one trend line. It has a main trend line, in this picture the long red line, but regularly leaves this line to create steeper sub-trends, as indicated by the shorter red line. These sub-trends, again, have their own sub trends, in this picture the white trends.
Eventually, each sub-trend will end. Then the price will move back to the trend line of the next superior trend, either with another sub-trend in the opposite direction, or with a period of sideways movement. To recognize such periods, there are a number of large candlestick formations that can help you.