This is a guest article by Jack Schwager taken from an extract from his book A Complete Guide to the Futures Market - find out more here.
Trend lines and channels are useful, but their importance is often overstated.
It is easy to overestimate the reliability of trendlines when they are drawn with the benefit of hindsight.
A consideration that is frequently overlooked is that trend lines often need to be redrawn as a bull or bear market is extended. Thus, although the penetration of a trend line will sometimes offer an early warning signal of a trend reversal, it is also common that such a development will merely require a redrawing of the trend line.
For example, Figure 1 shows an uptrend line connecting the November and December 2012 lows in the Russell 2000 Mini futures. Prices remained above this line until February 2013, when prices closed below it, signaling an end to this move.
Figure 1: Uptrend Line: Russell 2000 Mini Continuous Futures
Figure 2 extends Figure 1 by two months and shows that the February penetration of the original (dashed) trend line was a pullback that preceded a rally to a higher high. Prices remained above the revised (solid) trend line connecting the November and February lows until early April, at which point the market posted a more significant correction.
Figure 2: Uptrend Line Redefined: Russell 2000 Mini Continuous Futures
Figure 3, however, shows the larger uptrend extended for almost another year, prompting three additional revisions to the uptrend line, each of which was necessitated by a closing penetration of the preceding trend line.
Figure 3: Uptrend Line Redefined: Russell 2000 Mini Continuous Futures
Figure 4 provides a similar example for a downtrend. The initial downtrend line connecting the December 2014 and March 2015 highs (gray dotted line) was penetrated to the upside in June, but after a few weeks of sideways price action, the market resumed its decline.
The revised trend line (thicker dashed line) connecting the December 2014 and June 2015 highs extended until November 2015, when prices again pushed higher—enough to require a third revision to the downtrend line (solid line), but not enough to end the longer-term downtrend.
Figure 4: Downtrend Line Redefined: Oat Continuous Futures
The preceding examples are meant to drive home the point that the penetration of trend lines is more the rule than the exception. The simple fact is that trend lines tend to be penetrated, sometimes repeatedly, during their evolution, which is equivalent to saying that trend lines are frequently redefined as they extend.
The important implications of this observation are that trend lines work much better in hindsight than in real time, and that penetrations of trend lines often prove to be false signals.
Identifying false trend line breakouts
As we saw in the previous section, trend lines are particularly prone to false breakouts. Such false breakouts, however, can be used as signals for trading in the direction opposite to the breakout. In fact, in my opinion, false trend line breakout signals are considerably more reliable than conventional trend line breakout signals.
In the case of a downtrend, a false trend line breakout would be confirmed if the market closed below the trend line a specified number of times (e.g., two, three) following an upside breakout. Similarly, in the case of an uptrend, a false trend line breakout would be confirmed if the market closed above the trend line a specified number of times following a downside breakout.
Figure 5 provides an example of a false breakout of an uptrend line in 10-year T-note futures. The September downside breakout of the uptrend line was soon followed by a break above the line. The indicated failure signal is based on an assumed requirement of two closes above the line for confirmation.
Figure 5: False Breakout of uptrend line: 10-year T-Note Continuous Futures
Figure 6 provides a similar example in the E-mini Nasdaq100 futures.
It is quite possible for a chart to yield multiple successive false trend breakout signals in the process of a trend line being redefined.
Figure 6 False breakout of uptrend line: E-Mini Nasdaq Continuous Futures
In Figure 7, the initial upside penetration of the prevailing downtrend line occurred in mid-March. Prices quickly retreated back below the line, with the indicated failure signal assumed to be triggered by the second close below the line.
Another false breakout occurred about a month later based on the redefined trend line using the March relative high. Prices retreated below this downtrend line several days later, yielding another false trend breakout signal.
Figure 7: Multiple False Breakouts of Downtrend Lines: Euro Continuous Futures
By Jack Schwager
Jack Schwager is an industry expert in futures & hedge funds, perhaps best known for his best-selling series of interviews with the greatest hedge fund managers of the last three decades, which includes Market Wizards ,The New Market Wizardsand Stock Market Wizards.
Schwager was also a partner at London-based hedge fund advisory firm Fortune Group and has 22 years experience as Director of Futures research for some of Wall Street’s leading firms, most recently Prudential Securities.
He is now the co-founder of FundSeeder, a platform designed to find undiscovered trading talent worldwide & connect unknown successful traders with investment capital.
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