Getting Friendly with Trends: Drawing and Applying Trendlines

From falling and rising hemlines in fashion, to falling rates of poverty and rising life expectancies around the world, trends are everywhere. When it comes to stock prices, it seems no matter what the economy is doing, or whether the Fed will or won’t hike interest rates, you can always find some stocks that are rising, falling, or doing a whole lot of nothing.

With stocks, the word “trend” refers to the prevailing direction of price movements. There are generally three ways prices go: up, down, or sideways. Uptrends can be defined as a series of higher lows and higher highs in price over time. Conversely, downtrends can be defined as a series of lower highs and lower lows in price over time. Sideways trends are roughly equal highs and lows over time.

One quick and easy way to determine the trend of a stock is by looking at a chart of historical prices. For instance, figure 1 shows an uptrend in the Utilities Select Sector Index ($IXU) since the beginning of 2016.

Using Trend Analysis to Support Decision Making

Looking at historical prices on a chart and identifying a trend in highs and lows is a relatively straightforward task. But there’s a problem: those prices are in the past and don’t guarantee anything about the future.

Drawing trendlines is a way of extrapolating historical trends visually on a chart. For an uptrend, investors might use the series of higher lows to draw a trendline. Figure 2 shows a trendline based on the series of higher lows in $IXU.

As you can see, $IXU recently dropped to test its trendline near 500. If it drops below the trendline, it could signal a longer-term change in trend. That’s because the series of higher lows would be broken, and a new series of lower lows could unfold.

Some investors might set a stop-loss slightly below a trendline, thinking that if price carves out a lower low, then it might have further to fall. Of course, there’s no guarantee that $IXU will keep falling even if it does break below its trendline. Sometimes markets bounce back.

Other investors might buy a put option to protect against potential further declines if $IXU breaks below its trendline. A put option gives the buyer the right, but not the obligation, to sell typically 100 shares of stock at a predetermined price and by a specific date. A put option can hedge against declines in stock prices, but only after accounting for the cost of the option and transaction costs.

Whether you decide to take action when a market breaks a trendline or not, identifying trends in stocks you own is a good way to stay on top of your investments. Drawing trendlines can keep you informed about the price action unfolding in your investments, and may even support your decision making.