Trendline Penetrations, Adjustments, and Price Targets
Sometimes trendlines have to be adjusted in accordance with a stock’s change in angle of ascent. If a steep rising trendline is broken, a slower rising trendline may have to be drawn. If the original trendline is rising too slowly, a newer steeper trendline may have to be drawn. If the price action is too far away from a rising trendline, the trendline is of little use (though it does show potential downside risk). Generally, it is a good idea to continue tracing all trendlines in case they are needed in the future. If the stock does not return to the trendline but keeps accelerating away from it, then a curvilinear trendline (moving average) may be more appropriate. No indicator works well all the time. That’s why it’s good to have more than one. Steep trendline penetrations often call for trendline adjustments and they do have price implications. That is, you can estimate the extent of the decline that is in progress..
It is difficult for a stock to maintain the high level of momentum needed to sustain a trendline rising at a very steep angle of ascent for very long. The stock will lose momentum and the trendline will be violated. The steeper a rising trendline, for example, the sooner it is likely to be violated, even if the stock only goes sideways too long and there is no significant decline in the price. Violations of very steep trendlines occur so frequently and so expectedly that no particular significance should be attributed to such an event other than that the stock may simply be taking a short “breather” before resuming its uptrend. Steep-angle trendline penetrations usually occur without signifying a change in general trend. That is, after the short corrective move, the stock resumes its previous upward trend. These short counter-trends or minor corrections are of major importance only to the short-term swing trader.
However, the short correction resulting in the penetration may be the first step in the stock’s attempt to adjust its angle of ascent to a more moderate and more sustainable rate. Therefore the pullback low may shortly qualify as a low point for trendline construction purposes. If the stock recovers to the approximate level it was at before the decline, then the low can be used to draw a new trendline with the more moderate angle of ascent. All of the foregoing comments would simply be reversed for declining trendlines.
There are retracement implications associated with the breaking of steep trendlines. For example, traders at stockdisciplines.com may make use of the fact that the amount of decline that can be expected after the trendline penetration can be estimated by observing the stock’s behavior just before the penetration. Here is how they might do that. Draw a vertical line starting at the highest point reached by the stock before the decline leading to the penetration. The vertical line should intersect the trendline. Calculate the distance from the high point reached to the point where the vertical line intersects the trendline. That is the distance that the stock is likely to decline below the point where the stock penetrates the trendline. If at the stock’s peak it is $4 above the trendline, then it will likely decline $4 below the point where the stock penetrates the trendline. If the stock drops significantly below your calculated target price, we are talking about a price reversal. In that case your target price will act as overhead resistance if the stock tries to return to its higher price levels. For example, assume the stock reaches a high price of $50 when the trendline is at $45. In that case, if the trendline is penetrated at $52, then your likely target price is $47. However, if the stock declines to $40, then on an attempted recovery to its previous price levels, the stock will have to overcome resistance that will be at the $47 level.
Steep trendline penetrations are to be expected. No stock can sustain for very long the level of momentum necessary to maintain the steep angle of ascent. When there is a penetration, the decline is usually minor and relatively predictable in extent. As the angle of ascent becomes more moderate, the importance of a penetration increases.