INVESTING: How to use trend lines to help divine market direction

There is a simple and often-underestimated tool used by technical analysts that even the most timestrapped investor can profit from.

The trend line is an old utility technicians have believed in for centuries. Everyone has heard the term, “The trend is your friend.” In order to visualize the trend, all you have to do is get a chart of any stock or index, and start drawing lines connecting highs or lows of prices. Hold the page back a little, and you can see the trend.

You can easily see how prices tend to move along that trend for long periods. Here’s a simple trading strategy: Every time the price moves back to the trend line, you buy. I know it sounds too easy, but you would be amazed how often it works.

Along with providing a quick way to see where support can come into play, trend lines serve another, perhaps more important, role to the investor. If a price falls through the trend line, this serves as a warning of a coming change. If the break comes on large volume and the result is a close at least 1 percent below the trend line, something different could be coming down the pike.

I’m getting worked up about trend lines now because they are coming into play after the stock market’s pounding of the past week. There are strong areas of the market that did not fall through their support lines, but there was one telling occurrence: The NASDAQ 100, which is the 100 largest stocks on the NASDAQ exchange, fell below a trend line going back more than a year. This is something we have been looking for the last few months, and it will have enormous influence over your portfolio for the next few quarters.

The Dow Jones industrial average may still fulfill what some say is destiny and hit a new all-time high before the end of this quarter. But if there is one thing that has become painfully clear since the beginning of 2006, it is that any further rally will take fewer and fewer stocks with it. Are you going to roll the dice in the hopes you are holding one of the lucky few?

A common attribute of the trend line break is the ability of the market to trade back to the trend line soon after it falls below. This is called a retest of prior support, and it needs to be closely watched.

If, for example, the NASDAQ 100 goes back up to the former trend line and moves powerfully through it, the up trend could well be re-established. In most cases, however, the market gets back to the line, then falls horribly below it, sometimes in dramatic fashion.

Speaking of drama, a tremendous amount of weakness has built up in the overall market, pretty much under cover because of the amazing job the Dow Jones has done masking the deterioration. This weakness does not mean the market is going to crash soon, but it raises the probability that a real train wreck could happen soon. And successful investing is all about turning the probabilities in your favor.