Although Moving Averages offer an excellent means for determining the trend in the market, their lag and lack of precision makes it difficult to trade them in an optimal fashion. Trendline Analysis allows us to more effectively trade the market by clearly defining levels of support and resistance. This is particularly true when combined with an analysis of trends in the Open Interest. These analysis techniques may be applied to any time frame and are useful in developing a long-term “top down” form of market analysis. We’ll go into greater detail on “top down” techniques in another article.
Conventional wisdom holds that Trendline support is found at levels where buyers have consistently entered the market in greater numbers than sellers. Trendline resistance levels are those that have managed to consistently attract sellers over buyers. A Trendline is drawn by simply “connecting the dots”. More specifically, connecting the lows below or highs above the market with a straight line and then extending that line into the future by continuing to the right hand margin of your chart. You will find a Trendline drawn off five high or low points much more resilient to penetration by the market than a Trendline drawn off just two points. Also, you will notice that a market trend tends to accelerate as it develops. For instance, you will be able to draw several Trendlines under a rising market with the slopes of each Trendline increasing as they move forward in time.
Old support often turns into new resistance. This is largely because traders who got long at previous support levels will own their position under water if the support level is broken. Therefore, every time they have a chance to break even when the market pulls back to its old support level they will attempt to sell their longs. Thus, the weak longs are putting a cap on the subsequent rallies.
Open Interest represents the total number of net open positions in the market. Open Interest is not the total number positions held overnight by all traders, just half of them. Increasing Open Interest is regarded as a sign of confidence in the trend as traders commit an increasing amount of capital to the market. Decreasing Open Interest is indicative of a lack of confidence in the current trend. Traders are liquidating their positions. Therefore, a rising market with decreasing Open Interest may actually be a bearish scenario. You can anticipate a decrease in Open Interest when a market retraces after a prolonged rally.
Your optimal bullish scenario for establishing a long position would be to see a series of increasingly steeper Trendlines, drawn on three of more points, combined with rising open interest.