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Ask The Trader
Wednesday, April 04, 2001

Fan Principle

What are some more advanced uses of trendlines? I understand the basics behind support and resistance but would like to take these concepts further.

For those of you that are trendline traders I have another method for you to put in your trading toolbox. It's called the fan principle and as we shall soon find out, it is a way to use multiple trendlines to analyze tests of support and resistance.

As a stock is stuck in a downtrend, it often tests its downtrend line that is constructed by connecting the relative highs (line #1). When it finally does break this downtrend line, the stock often creates a new relative high before falling back to test the previous downtrend line that should now act as support. Once the stock makes a new relative high, a new trendline can be drawn and the process repeats itself (line #2).

Although in the above example Cummings did not come back to test its line #2, we can see that the stock did create a new relative high around $38 and came back to test its line #3 just this week. The important thing to remember with the fan principle is that the breaking of the third line is your valid trend reversal signal. In charting, as in life, the third time is usually a charm. Just also remember that after the breaking of the third line, the stock will generally come back to test support before heading higher.

In the above illustration of the fan principal, I gave an example of a stock that is coming of a bottom. Please note that this charting technique can be just as easily applied to stocks that are topping. In the case of analyzing the reversal of an up trend, you would use up trendlines instead of downtrend lines as the basis of your analysis. In analyzing whether a stock has topped, it is the breaking of the third up trendline that confirms the new downtrend.

While this analysis works best on weekly charts due to the smoothing of the price data, the fan principle can also be used in your analysis of daily and in some cases even 60 or 30 minute charts.

Good Luck and Have a Profitable Trading Day

Craig Seidler
Assistant Editor

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