How to determine the "Quality" of trendlines

As you may already know, Screenulator detects chart patterns and trendline patterns among tens of thousands of stocks every day, and it also automatically draws uptrending and downtrending lines for every stock chart. Many subscribers ask me then how do you use all this information to determine buy and sell signals? How do you choose from so many screener qualifiers?

There are two ways to use screenulator to increase your profitability:

1. If you are already interested in a particular stock - either it is a stock you have been tracking for a long time, or read it on a news, or some friends told you about. Now you want to look at the trendlines generated by screenulator to verify your buying or selling thesis. In this case, you have to be aware that not all trendlines are equally important, because your trading time frame and strength of trendlines differ (more on this later). And sometimes, computer can miss trendline human eyes are better detecting - especially a previously broken trendline being retested. In this case you should be modifying the chart with a pencil and ruler.

2. A more powerful approach to using Screenulator is by looking at its screening results to discover new trading opportunities. Because Screenulator has so many screeners, I will use "Near support bottomline alert" as an example for simplicity. In a typical bull market correction / pullback scenario, the number of uptrending stocks pulling back to near its support level increases. When you look at this screener, there are more than 100 qualifiers. How do you choose which stocks to trade so as to maximize the profit? The answer is choose the ones with
    (1) the best "quality" trendlines,
    (2) steep slope (% price increase per day) of the trendline
    (3) and pick at least 3 stocks to trade to diversify.

(2) and (3) are are easy to understand. But what does it mean by "quality" trendlines? This "quality" used to come to me and some people naturally, so it was not well defined concept, rather an art of shape selection. However, I have spent the last 3 months running simulations in attempt to gain better understand of what separates good trendlines from bad ones. I have come to the following conclusion.

- Uniform distance between pivot points Distances between bottom points and top points should be uniformed spaced. While they do not have to exactly equal, but the more regular intervals between up and down cycles of a stock indicate underying cyclical nature of the stock, therefore more predictable the pattern will hold true in the near future.

The equal distances between pivots also make trendlines better defined in a sense that once it is breached, it cannot be redrawn with a lower sloped one. This allows you to have a very tight stoploss in case of breach. The reason will become apperant if you read the following section.

- Avoid "big gaps" and "big heads" If the most recent gap (distance between the most recent pivot and the previous one) is overwhelmingly large (50% of overall trendline length or more) and the height of the peak between these two pivots are very high, then it is a bad trendline. These trendlines tend to get broken and unpredictable. The reason is the downward cycle of the big head usually marks short term downtrend line, often not shown in the chart, therefore forming a "wedge pattern" with short topline, and VERY long bottom line. When the two trends clashes - down and up, it usually results in very volatile actions with unpredictable breakouts or sharp falls. While you can use the "wedge" pattern to your advantage if you had other informations to help you decide the trades.

Also stocks with "big gap" and "big head" trendlines usually have much larger margin or error when the trendline is drawn - because the slightest change in angle of the trendline drawn from the distant past can result in very larger price variation in the present. So if you were to "buy" near its bottom support, stoploss cannot be easily triggered because often a new trendline with flatter slope can be drawn and still look valid on the chart. This exposes you to greater drawdowns if market turns bearish. However, the stock may someday recover and you can still end in profits, it is not a pleasant wait while the money locked in could have been used to generate profits in better trades.


Some of Examples of big gap, big head:

PRTA (Prothena Corp). has been following a consistent trendlines since late 2013 to the first quarter of 2014, until recent breach. Refer to chart 1: point A, B, C, D, E all marked a very good and reliable bottom buying opportunities, because all the peaks between these points are pretty uniform and gaps between them are relatively even as well. Between C and D there was a longer gap, which is why there was some hesitation to go up at point D, but it eventually did. However, after point E, the next peak P reached $50 from ($26 at E), which is $24 jump, compared to average $5 - $10 range in the previous peaks. When the prices came back down to F, the trendline is broken. chart 1:


MELI (Mercadolibre, Inc.)
Refer to chart 2:
This is a very long bottom line spanning over 2 years, and reached bottom on Feb 2, 2014.
However, because the last peak and gap was extremely long, it forms a big head shape, leading to break down.



In chart 3 below, you can see a top down-trendline forming after point D.
Even though it is much shorter than the bottom line, it still spans 4 months, which is why the bottom line is hard to hold its ground.


Examples of good quality trendlines:

ZBRA (Zebra technologies)
Chart 4 shows 2013-9-17 detection of bottom line. All the previous bottom points are uniformly spaced, and peaks are also uniformed high.


Chart 5 shows current (2014-5-9) chart of ZBRA.
Not only did the original bottom line hold, but it formed an even steeper bottom line.


GLOG (Gaslog)
Chart 6 shows uniformed spaced bottoms forming support line:


Chart 7 show currently, it formed an even steeper uptrending support line:







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