Bad signals, commonly called “whipsaws,” can be eliminated when a trader uses time and price filters to try and isolate valid trendline penetrations. Whether he is day trading, swing trading or options trading, the trader knows the general rules is: a close beyond the trendline is more significant than an intraday penetration. The 3% penetration criteria is a price filter used mainly for the breaking of a long term trendline. The rule states the trendline must be broken, on a closing basis, by 3%. Keep in mind, this rule doesn’t apply to some markets, such as interest rate markets.
Let’s say some longer-term traders, as in swing or options, were watching an uptrend on a trade of Google (GOOG). The price breaks the up trendline at $380 and closes 3% below the trendline at $368. While a $12 trendline penetration may be important to these traders, it wouldn’t be appropriate for day trading. A 1% criterion is a better choice for this short-term trading. The percent rule is just one form of price filtering. There is a tradeoff when using any type of price filter. If the filter is too small, it’s not useful in reducing whipsaws. If the filter is too big, then the initial move required to see a valid sign may be missed. A trader needs to decide which type of filter is best for degree of trend he is following, and to make allowances for the differences in markets.
If a trendline is broken by some predetermined price increment or percentage, the trader may decide to use a time filter instead of a price filter. The most common time filter is the 2-day rule. This means a valid breaking of a trendline would require that the the trade closes beyond the trendline for two successive days. Looking at an uptrend, the up trendline would need to close under the trendline two days in a row. In a downtrend, the prices would need to close above the trendline two days in a row.
The 2-day rule and the 1-3% rule may also be applied to important support and resistance levels as well as major trendlines.
Once a trendline is established by the third valid point, and the trend continues in the original direction, the trendline becomes a tool with many uses. There are two basic concepts of a trend:
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A trend in motion tend to remain in motion
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Once a trendline determines the slope or rate of speed of a trend, the trend
usually maintains that slope
The trendline can be used by the Day trader or Options trader to determine the extreme in corrective phases or when a trend is changing.
In an uptrend, a trader’s intent is to buy in the dips. So an up trendline can serve as a support boundary which can be used as a buying area indication. When the corrective dip comes close to or touches the trendline, it’s time to buy.
Once a trendline is violated, it can no longer be used to determine buying and selling areas. Most likely, the breaking of a trendline is a warning the trend is changing and calls for a liquidation of all positions in the direction of the previous trend. Note in the drawing below of an uptrend, dips located at points 5 and 7 would be excellent opportunities to buy additional long positions. However, at point 9 when the trendline is severely broken, it is time to liquidate your long positions.
The opposite is depicted in the drawing below of a downtrend. A trader participating in swing trading would see points 5 and 7 as excellent indicators to sell. Then when the trendline is broken at point 9, it is evident of an upside trend reversal.
How do we determine the significance of a trendline? This is a twofold answer. First of all, the longer the trendline has been intact the greater the significance. For example, a trendline which has been intact for 3 months is much more significant than one intact for 3 weeks or even 3 days. Secondly, significance is also measured by the number of times the trendline has been tested. Looking at a trendline that has been touched 8 times would create more confidence than one that has been touched only 3 times. The more significant the trendline, the more confidence it inspires and the more impact its penetration has on a trader’s decision to liquidate his positions.
