Trendline Trading Strategy (Backtest)
Last Updated on November 27, 2022
One interesting thing about technical analysis is that there are many tools you can use to analyze the market. One of the most powerful and versatile but underutilized tools in trading is the trendline. You can use it to do almost anything you want and can create a trading strategy around it. Do you want to know about the trendline trading strategy?
A trendline trading strategy can come in the form of breakouts, price bounces, and reversal strategies. Trendlines can also be used as a reference support or resistance level for stop losses or to trail profits.
A trendline is a diagonal line drawn through a chart to show the trend in price. The slope of the trendline shows the direction of the trend: an upward slope implies an uptrend, a downward slope implies a downtrend, while a horizontal slope implies a range-bond market.
In this post, we take a look at the trendline trading strategy. We end the article with a backtest.
What is a trendline trading strategy?
In technical analysis of financial markets, a trendline is a diagonal line drawn through a chart to show the trend in price. The slope of the trendline shows the direction of the trend: if the line has an upward slope, the trend is up (an uptrend), and if the line has a downward slope, there is a downtrend. When the slope is flat, the trend is horizontal, and in that case, we say that the market is moving sideways or is range-bound.
As you know, the price moves in swings, creating swing highs and swing lows. When the price is rising, it creates a series of higher swing lows and higher swing highs. Likewise, when the price is declining, it creates a series of lower swing highs and lower swing lows. An up-trendline is drawn across the rising swing lows, while a down-trendline is drawn across the descending swing highs. In a range-bound market, the line is drawn across both the swing highs and swing lows to delineate the boundaries of the range.
“All” technical traders and analysts use trendlines to understand the behavior of the price. But trendlines are more important to chartists and price action traders who depend on them to delineate price patterns and analyze the price action.
A trendline trading strategy is a way of trading that relies on the use of trendlines. This can come in many forms, including breakouts, price bounces, and reversal strategies. Trendlines can also be used as a reference support or resistance level for stop losses or to trail profits.
Examples and a list of trendline trading strategies
There are different trendline trading strategies available to traders. Here are some of the more common ones:
- Trend-following strategies: These are strategies used by price action trend followers. One example is the use trendline or local support/resistance level breakout to spot the emergence of a new trend and then use a trendline to delineate the new trend and trail profit.
- Trendline bounce swing trading strategy: This is a pullback reversal swing trading strategy. The trader waits for the price to retrace to a trendline and bounce off and then enters a trade in the direction of the trend. The entry trigger may be a reversal candlestick pattern, such as the hammer or engulfing pattern. Profit is taken at the next resistance level.
- Counter-trendline breakout strategy: In this strategy, a short trendline drawn across a pullback is used to know when to enter a trade in the direction of the trend. The breakout of the counter-trendline is a signal to place a trade.
- Price channel strategy: This is a swing trading strategy whereby a trader wants to trade the individual price swings within a price channel (a price channel is created by applying a trendline across both the swing lows and swing highs). The price bouncing off the trendlines creates trade setups. A reversal candlestick pattern may be used as a trade entry trigger.
- Trend reversal breakout strategy: Here, the trader looks for a breakout of the main trendline to suspect a trend reversal. There can be false breakouts, so the trader needs more confirmation that the trend has changed. This can come in the form of a lower swing high after a breakout below an uptrend line.
Is trendline good for trading?
Yes, the trendline might be very good for trading, especially if you are a price action trader, but we recommend backtesting your trading ideas. Apart from the patterns created by the price movement, the two key tools you need for analyzing price action are the trendlines and support and resistance levels. You need the trendline to show the direction of the trend and the price swings. In addition, you need to use trendlines to delineate some chart patterns, such as wedges, triangles, and flags/pennants.
The best strategies can be found in our….
Backtested trading strategies
Even those who trade with indicators often combine their indicators with trendlines. Apart from showing them the direction of the trend, the trendline can also serve as dynamic support or resistance levels that can guide where they look for trade setups and place their stop loss orders, as well as how they trail their profits.
Is a trendline strategy profitable?
Yes, when used correctly, a trendline strategy can be very profitable. Many profitable discretionary traders trade based on price action and trendline is a key tool for their analysis. There are different strategies that use trendlines. One of them is swing trading price bounce from around a trendline. It is a sort of mean-reversion strategy where the price tries to trade back to its mean after moving far away from it.
One problem with trendline strategies is that they are difficult to code into trading algos and, as such, difficult to quantify. However, they can still be traded systematically and they can be very profitable when executed well. What makes a strategy profitable is how well it is executed and the risk management strategies in place.
Which timeframe is best for trendline trading?
Trendline trading may work well in any timeframe if executed correctly because the price can form a trend in any timeframe. However, for a day trader, the H1 timeframe may offer the best trend to work with. For a swing trader, the daily timeframe is the best timeframe to look for a trend and search for trade setups. A position trader may work with the daily and weekly timeframes. So, the timeframe a trader uses for trendline trading depends on the trading style.
However, the only way to know the best timeframe for the specific strategy you want to trade and the markets you want to trade is through backtesting. It is when you backtest your strategy that you can find the right timeframe to trade it on.
How do you master a trendline?
As with any other thing in life, practice makes perfect. You have to practice how to draw a trendline until you master it. To draw an uptrend line, you have to find the lowest point from where the trend starts to rise. Connect that with the next swing low and extend to the end of the chart. You can draw your trendline across the lows of the wicks or across the close/open prices.
Similarly, to draw an uptrend line, you have to find the highest point from where the trend starts to descend. Connect that with the next lower swing high and extend to the end of the chart. You can draw your trendline across the highs of the wicks or across the close/open prices.
Mastering a trendline trading strategy depends on how good the strategy is and how well you implement it. If possible, convert it to a trading algorithm and automate your trading so that you remove emotions from your trading.
How accurate are trendlines?
Trendlines can be relatively accurate when drawn correctly, connecting the right price swings. Depending on the stage of the trend, you aim to connect as many swing points as possible. In a newly emerging trend, you can just connect the two corresponding swing points. But in a long-lasting trend with many swing points, you should aim to connect as many swing points as possible, as that would show you the prevailing trend.
The good thing about a well-drawn trendline is that you will know when the trendline is broken for a new trend to emerge. You can see when it is breached and taken out of play. However, like every other thing in trading, nothing lasts forever; an accurate trendline would still experience a false breakout which may make you want to redraw it but that may not be necessary.
How do you read a trendline?
The first thing is to be sure that the trendline is correctly applied. Once that is established, the key things to look out for are the slope and how the price reacts around the trend line. An up-sloping trendline indicates an uptrend. The steeper the slope, the higher the momentum of the uptrend. In the same way, a down-sloping trendline indicates a downtrend, and the steeper the slope, the higher the momentum of the downtrend.
You should observe how the price reacts around the trendline. In an uptrend, the trendline should serve as a rising support level, so when the price pulls back to it, it is expected to bounce off with a new impulse wave to the upside. But it is not uncommon for the price to fall below the trendline a little before rising again, creating a false breakout.
In a downtrend, the trendline acts as a descending support line, and the price will often decline whenever a rally hits the trendline. On some occasions, the price may pierce the trendline and create a false breakout before falling down harder.
How do you draw a trendline?
First of all, identify the trend you want to apply the trendline. Is it an emerging trend or an established one? If it is an established uptrend, draw a line across its rising swing lows, starting from the lowest swing low from where the trend started. You should aim to catch as many swing lows as possible. You can draw your trendline across the lows of the wicks or across the close/open prices.
Do the same for an established downtrend using the swing highs and starting from the highest swing high from where the downtrend started. You can draw your trendline across the highs of the wicks or across the close/open prices.
For a newly emerging uptrend, connect the first two swing lows, starting from the lower one and extending the line across the chart to the right end. As usual, you can connect the lows of the wicks or the close/open prices. Do the same for a newly emerging downtrend, using the first two swing highs. You can draw your trendline across the highs of the wicks or across the close/open prices.
How do I know if my trendline is broken?
The first thing is to be sure you have a good trendline. If you do, then knowing when it is broken is easy. What you look for is a price close beyond the trendline. That is, for an uptrend line, a price close below the trendline is a sign that the trendline has been broken. A spike below the trendline without the price closing below it is not considered a breakout.
Similarly, for a downtrend line, the price must close above it before you consider it broken. A spike above it without the price closing above the trendline is not a breakout.
However, note that in any case, the price can close beyond the trendline and within a few trading sessions, get back within it. In that case, we call it a false breakout — a breakout that failed to progress.
What is a trendline breakout strategy?
A trendline breakout strategy is a trading method that uses the breakout of a trendline to determine a potential trade setup. Depending on whether the trendline is a main trendline or a counter-trendline, it could be a trend reversal strategy or a trend continuation.
The breakout of the main trendline signals a potential trend reversal. But you should wait for further confirmation, such as a higher swing low following a downtrend line breakout before you assume a trend reversal is on the cards. On the other hand, the breakout of a counter-trendline shows that the price is about to continue moving in the direction of the trend and it is a common trade entry trigger when trading the reversal of a pullback.
What happens when a trendline is broken?
When the main trendline is broken, the trend may be about to change direction. If an uptrend line is broken, the price may be about to head downward. Similarly, if a downtrend line is broken, a bullish reversal may be on the cards. But the breakout alone is not enough to confirm a change in trend.
What often happens is that the price will come back to retest the trendline and the level will change polarity. That is, if a rising trendline is broken, that trendline becomes a resistance for the price when it comes back to retest it. Likewise, once a falling trendline is broken, that trendline becomes a support for the price during a retest.
Why do we use trendlines?
There are many reasons traders draw trendlines. One of them is to show the direction of the trend. It is easier to trade in the direction of the trend — the trend is your friend. For beginners, it is often advisable to trend only along with the trend, and there is no clearer way to show the trend than with a trendline.
Apart from showing the trend, trendlines are also used to indicate potential support and resistance levels where price setups are likely to occur. Price action traders often use trendlines to delineate chart patterns which they use to find trading opportunities. Some traders also use trendlines as a reference for their stop loss and trailing stops.
Types of trendlines in technical analysis
Based on the direction of the slope, a trendline can be an uptrend line if it is sloping upward, a downtrend line if it is sloping downward, or a horizontal trendline if it is flat without any slope.
You can also classify trendlines based on the usage: the main trendline or the counter-trendline. The main trendline shows the direction of the main trend, while a counter-trendline is used to know when a pullback is over, and the price is about to start moving again in the trend direction.
What is a trendline in a graph?
Generally, in a time series graph, a trendline is a line superimposed on a chart to reveal the overall direction of the data. For example, trendlines can be drawn for Scatter Charts, Bar Charts, Column Charts, and Line Charts.
A similar thing is done with the price chart, which is also a time series graph represented with unique graphs — such as the candlestick chart and so on. In price charts, trendlines help to show the direction of the price.
What are some trendline indicators?
Ordinarily, you draw the trendline manually. But there are some custom indicators that can spot the most exact trend and automatically plots the trendline on the chart. Depending on your trading platform, you can find free indicators online or you can code one yourself or pay someone to do it for you. It will relieve you of the need to spot and manually draw the trendlines yourself.
Trendline trading strategy backtest
The biggest problem with trendlines is that they mostly use hindsight bias. They are easy to spot after the fact. Second, we tend to imagine trends when there are few. Because of this, we are skeptical toward any trendline trading strategy unless we have a proper backtest with trading rules supporting the claim.
We would like to prove our point with a backtest, but as you might imagine it’s very difficult to code a trendline trading strategy.
Unfortunately, we are not able to make a meaningful backtest. Because this is a very subjective pattern, we are not able to jot down what is needed. It’s simply too many rules that are needed for a historical test and it would take a lot of time.
Because of the lack of objectivity, we believe traders are better off NOT trading on classical chart patterns. Why spend time on something that is mostly based on subjectivity and not any objective standards based on historical data? How do you know a pattern is profitable if you have not backtested it and found any statistical advantage or a trading edge?
Backtesting or a data-driven trading approach is no sure thing, but at least you have an idea that something has worked in the past – you have historical performance and strategy performance statistics. If it has not worked in the past, you can skip it immediately. If you know how to backtest with historical data you can develop a portfolio of trading strategies pretty fast. There is no best trading strategy because you need many to smooth returns.
(If you are new to backtesting and statistical testing and it looks like a daunting task, you might be interested in our backtesting course.)