Trendlines are one of the most simple and perhaps the most fundamental tool in technical analysis. The significance of a trendline is determined by how many times it has been successfully tested and the length it has been intact.
The more times a trendline is successfully tested, the more confidence traders will have in that trendline in terms of support or resistance. Likewise, the penetration of such a trendline is considered more important than the breaching of a line that has developed over less time.
Once a trendline is broken, its role as support or resistance changes. Generally speaking you want to long (buy) bullish trendline support and short (sell) bearish trendline resistance, as the saying goes “the trend is your friend“.
If you are unfamiliar with the concept of trendlines, take a moment to review the Trendline TA Crash Course. This short read will help you better understand how to draw and trade using trendlines.
The fan principle is a technique that expands on the use of trendlines by drawing lines at various angles as a price trend starts to ascend or decline. Each line in the series leads back a central point, which gives the pattern the fanning effect.
As each trendline is broken, the next line in the series will act as support or resistance. The previously broken line will also act as support or resistance, this pattern can be drawn in downtrends or uptrends.
The fan principle is useful in identifying trend reversals because they actually gauge the speed of a trend based on their angle. As a general rule of thumb, a 45 degree angle is considered a healthy trend, anything greater or less than 45 degrees can be considered to be a unsustainably strong or weakling trend.
Rule of Three
Most important of all, the breaking of three trendlines is considered a valid trend reversal. Many traders will buy the third breakout of a fan pattern with a stop loss traditionally set below the first trendline in the series.
A more aggressive stop loss strategy would involve a series of small orders at each trendline, this will result in fewer losses if the reversal fails and it will avoid exiting your entire position in the event of a simple retest of a previous trendline.
Gann Fan Lines
Named after legendary commodity trader, W.D. Gann, these trendlines are drawn from prominent tops or bottoms at specific angles. The most important Gann line is drawn at a 45 degree angle from a peak or trough.
Additional lines are drawn at various angles along the trend, ranging from 15 degrees to 75 degrees. Gann lines are designed to provide support during downward corrections or resistance along an accelerating trend. It’s possible to draw as many as nine different Gann lines.
Each Gann angle divides time and price into proportionate parts. As stated previously, the most important Gann angle is the 1×1 (or the 45° angle). According to Gann, the 1×1 angle represents one unit of price for one unit of time, making it a perfect 45° which ascends 1 point every 1 day.
There are additional important angles such as the 2×1 (moving up two points per day), the 3×1, the 4×1, the 8×1, and the 16×1. All of these different Gann angle lines combine to create the Gann Fan.
Fibonacci Fan Lines
The fan line principle can also be used in the same manner with Fibonacci numbers. In this technique, trendlines are drawn at angles that coincide with the Fibonacci sequence, with the most prominent being 38.2% and 61.8%.
Fibonacci Fan lines may also include angles at 23.6% 50% and 78.6%. Each angle is derived from a central trend line (the 1) that is drawn from the highest to lowest point in the current trend.
Fan Line Pitfalls
The fan principle may be considered somewhat controversial among technical analysts. Like with any technical tool, fan lines should be used along with other indicators to find confluence to identify a high probability outcome.
Generally speaking, when one fan line is broken, prices will tend to fall to the next lower line (in an uptrend, opposite in downtrend). The main problem with fan lines is that they are not usually as strong as horizontal lines or longer term trend lines, meaning if one line is broken, price could drop two or three levels down.