In many cases, the optimal buy point is at new highs. For investors waiting to pounce on a stock, waiting for that new high can seem like forever. Trend lines, however, offer a way to find earlier buy points with acceptable risk.
Trend lines are drawn on stock charts to identify significant changes in price behavior. They can reveal bullish and bearish shifts in a stock or index. When properly used on base patterns, you can pinpoint entries that let you buy ahead of the buy points.
So, how do you draw a proper trend line? You’ll need two tools: a stock chart and a straight ruler.
Start with stocks forming proper bases such as flat bases, cups and saucer patterns. In all such formations, the highest price at the start of the base is what determines the buy point. Now, take your ruler and see if you can connect a straight line over the highs that appear during the base-building period.
There should be a minimum of three price highs that connect your trend line. The more price highs the line touches, the better your trend line is. If you subscribe to MarketSmith, you can draw a trend line by pressing the Control key and dragging your mouse.
Here’s how this strategy worked with the chart of JetBlue (JBLU). The stock was still working its way through a long bottoming process last December, when it started to form a consolidation. Although it resembled a cup-with-handle base, it didn’t conform to the model because the handle was too low in the pattern.
That made it an ideal choice for using a trend line. That line began with the start of the base at 16.35 (1) and touched highs at 16.03, slightly poking above that price bar, (2) and 15.70 (3). That met the requirement for at least three highs touching the line.
The way the trend line extends will determine the buy point. In the JetBlue example, the line crossed the 15.50 price. (4) That’s where you buy shares, and in this case it’s 6% cheaper than the 16.45 normal buy point.
The discount airline’s stock surged as much as 42% from the trend line buy point, a period that saw travel stocks bounce back as the coronavirus pandemic began to fade in the U.S.
Investors can opt to buy a smaller amount of shares using the trend line than with a normal breakout. As you would with any breakout, a trend line breakout should come in heavy volume. If the relative strength line is at or near new highs, all the better.
In a cup with handle or a double bottom with handle, investors may also draw a trend line over the handle area. It may be difficult to draw a proper trend line that touches three highs, so exercise care.
IBD’s online course on Advanced Buying Strategies includes a detailed discussion on the use of trend lines.
Juan Carlos Arancibia is the Markets Editor of IBD and oversees our market coverage. Follow him at @IBD_jarancibia
YOU MIGHT ALSO LIKE: