Qualified And Disqualified Td Lines

Practically all traders are trend followers. It is not uncommon for these traders to draw trendlines to establish the probable trend of the market. Unfortunately, there exists no widely accepted method or industry standard for the construction of these trendlines. Consequently, five different traders may draw five completely different trendlines on the same price chart. To confront this inconsistency, we developed an objective means of drawing trendlines, called TD Lines. This trading methodology can be effectively applied to price activity across a variety of markets and various time frames. By applying TD Line breakouts to underlying securities, a trader can then extrapolate from these breakouts that the options for these securities will likely behave similarly. While this approach is a legitimate means of trading options in a trend-following fashion, we have developed rules and other indicators that are designed specifically for evaluating contratrend option trading opportunities.

One of the biggest problems with trendlines is that while they may be useful in establishing points of market price resistance and support when drawn properly, they are often constructed arbitrarily and therefore they are unreliable and difficult to reproduce. The selection of these lines is many times a function of a trader's bias, current trading positioh, or market outlook. We developed TD Lines to overcome these shortcomings and to introduce a degree of objectivity and consistency to trendline construction. In order to draw a trendline, one must connect two price points. For most traders, it is second nature to refer to the left-hand side of a chart to select a price point and then work their way to the right to connect to another more recent subjectively selected price point. It concerns us that this process is random and arbitrary. The price activity at the left-hand side of a chart is part of trading history. It makes more sense to rely upon more recent market activity for the selection of price points. Figuratively speaking, we do just that since TD Line price points (TD Points) are selected from the right side of the chart to the left side of the chart. We do not mean to imply that we draw our TD Lines from right to left, rather we simply review price activity from the right side of the chart to the left to identify TD Points and then to select the two most recent price reference points to draw our TD Line.

The first step in drawing a TD Line is to identify the two most recent TD Points. A Level One TD Point Lew is a price low which is immediately preceded by one higher price bar low and immediately succeeded by one higher price bar low— in other words, it is a low that is surrounded by higher lows. Conversely, a Level One TD Point High is a price high which is immediately preceded by one lower price bar high and immediately succeeded by one lower price bar high—in other words, it is a high that is surrounded by lower highs. Once these objective points are identified, they can be connected to create a Level One TD Line. The distinction between Level One and higher-level TD Points and TD Lines is related to how many consecutive price bars immediately to the left and immediately to the right of the TD Point are required. For purposes of this discussion, we always refer to Level One which is the most basic.

A TD Demand Line is an upward-sloping trendline and a TD Supply Line is a downward-sloping trendline. To create a TD Demand Line, we connect the two most recent TD Point Lows. Because a TD Demand Line is upward-sloping, these TD Point Lows must be ascending, meaning the more recent TD Point Low is higher than the previous TD Point Low. Once a more recent TD Point Low is formed, a new TD Demand Line is drawn and becomes active. If the previous TD Demand Line was exceeded to the downside, the TD Line remains on the chart and a new TD Demand Line is added; if the previous line was not exceeded, the TD Demand Line is simply redrawn. To draw a TD Supply Line, we connect the two most recent TD Point Highs. Because a TD Supply Line is downward-sloping these TD Point Highs must be descending, meaning the more recent TD Point High is lower than the previous TD Point High. Once a more recent TD Point High is formed, a new TD Supply Line is drawn and becomes active. If the previous TD Supply Line was exceeded to the upside, the TD Line remains on the chart and a new TD Supply Line is added; if the previous line was not exceeded, the TD Supply Line is simply redrawn.

Figure 7.1 of Merck (MRK) illustrates both an up-sloping TD Demand Line and a down-sloping TD Supply Line. The two most recent TD Points at that time which were connected to construct these TD Lines are identified with asterisks (*). Figures 7.2, 7.3, and 7.4 are all qualified TD Line trades. In almost every case, a validated breakout above a TD Supply Line or a validated breakout below a TD Demand Line was followed by a continuation of the trend. The horizontal lines identified on the chart are a series of TD Line breakout projections, which we will discuss later in the chapter. While we could trade these qualified TD Line breakouts, and would do so if we were trading on a small time frame, we prefer to trade longer-term disqualified TD Line breakouts—by longer-term, we mean that we look for disqualified breakout trades primarily on daily price charts, although any large intraday time frame can be utilized.

Even beginning trendline traders can recite instances when they drew a trend-line, witnessed a perceived price breakout, and entered a trade intraday only to see the breakout fail and price reverse. Naturally, a trader's emotions elevate once price breaks out above or below a trendline. Unfortunately, it is just those instances in which a trader is most convinced that a breakout is genuine and warrants intraday entry that they fail. Just like other traders, we suffered with this affliction of buying and selling failed breakouts. Consequently, many years ago we examined the trading activity prior to a valid intraday breakout versus an invalid intraday breakout. This exercise highlighted a list of four important breakout qualifiers, any one of which would validate intrabar entry.*

Like other trendline approaches, TD Lines are trend-following in nature. However, by introducing qualifiers, one has an innovative way of trading breakouts above or below these levels. TD Lines can be either qualified or disqualified. Qualified TD Lines are treated as any other type of trendline and any intrabar price breakout is valid, suggesting that price will continue to move in the direction of the breakout. On the other hand, if a disqualified TD Line breakout occurs, an intrabar price breakout in the direction of the trend is invalid. Instead of trading with the

* By intrabar, we mean that trading takes place at some point during that price bar's time interval, such as intraday or intraminute, and so forth.

FIGURE 7.1 The two most recent TD Points (identified by asterisks) are connected'to create TD Lines. The ascending TD Line is called a TD Demand Line and connects consecutively higher TD Point Lows, and the descending TD Line is called a TD Supply Line and connects consecutively lower TD Point Highs.

TDLin

TD Supply Line

TD Demand Line

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