► Introduction

This article is a continuation of "Profit from Trend Lines' Confluence". In the previous article, we talked about how to profit from trend lines' confluence. We learned to draw trend lines and mark an area around two trend lines' confluence point. Then, we just wait for price to test the confluence area and enter a trade.

In this article we will take a closer look at trend lines. I would like to suggest a better way to draw trend lines. This lets us draw trend lines more correctly. It also helps us find more trend lines and confluence points on a chart. Therefore, the number of potential trades increases too.

Also, I have done some back tests on Daily charts. I tried to test different aspects of this strategy: the confluence area, test candle, trade rules etc. I wanted to see if any of them can be improved. I hope the conclusions will help us make this strategy more precise and profitable.

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► Old Rule For Drawing Trend Lines

In the previous article, we drew trend lines by simply connecting candles' lows for an up trend, or candles' highs for a down trend. The problem with this approach is that the trend line must go through the exact high or low. For example, let us review the following EUR/USD chart:

We clearly see that price moved down significantly. Price was around 1.3700 at the start of February. It reached much lower, to around 1.2750, on March 27th. Now, let's try to draw a down trend line, using the old rule of connecting exact candles' tops:

We can connect the first two points (first two red arrows). However, the trend line cuts through a candle's wick at the third point (third red arrow, crossed-out). Therefore, this trend line is not valid according to the old rule.

Let us try again, connecting two other candles:

Here we see the same problem again: we can connect the first two points (first two red arrows). However, when we try to connect a third point, the trend line cuts through a candle's wick (third red arrow, crossed-out). So this trend line is not valid according to the old rule.

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► New Rules For Drawing Trend Lines

Now, let us try to be a little more flexible. Here is the new rule: the trend line can cut through a wick of a candle. The difference between the candle's edge (high or low) and the trend line must be 50 pips or less.

So, here is the trend line, according to the new rule:

Here is the third point of the trend line, zoomed-in:

It is nice to see that price actually confirms the trend line! We have another connected point shortly afterwards. I have marked it with a black rectangle:

It is interesting to see that the trend line doesn't touch the candle's high, but is very close to it. This suggests another new rule: the trend line can come very close to a candle without touching it. The difference between the candle's edge (high or low) and the trend line must be 25 pips or less.

So, here is the fourth connected point of the trend line, zoomed-in:

Price continued to confirm the trend line. Three more points are connected afterwards. I have marked them with a black rectangle:

We can draw a trend line connecting 7 points with the new rules, instead of not being able to draw any trend line with the old rules! Price is clearly moving downwards, so it seems elementary that we should be able to draw some down trend line. This reinforces the logic beyond the new rules.

If there are several ways to draw a trend line, we try to connect as many candles as possible! In other words, the drawing of the trend line, in a manner that connects the most candles, is the "correct" way to draw the trend line.

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► EUR/USD Back Test

I have back-tested the strategy on the EUR/USD Daily chart, using the new rules. The test period is May 21ts, 2012 till May 21ts, 2013:

I have marked all trend lines on the chart. Up trend lines appear in blue color. Down trend lines appear in black color:

Red arrows appear at lower highs, that are connected by the down trend lines:

Green arrows appear at higher lows, that are connected by up trend lines:

Red arrows mark short trades (selling):

Here is a summary of the test results:
• Number Of Trend Lines: 15 (8 down trend lines, 7 up trend lines)
• Number Of Winning Trades: 4
• Number Of Losing Trades: 3
• Average Winning Trade: 97.75 pips
• Average Losing Trade: 79.17 pips
• Total Pips Gained: 147 pips
• Equity Gain: +6%
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► Back Test Conclusions

Here are my conclusions from analyzing the back test results:
• The strategy seems to work well.
• The Test Area and Test Candle rules filter out bad entries. We enter mostly good trades, after good price confirmation.
• Only enter trades that offer 1:1 risk:reward ratio or higher.
• The Take Profit rule needs to be changed. The strategy tells us to take profit on the next trend line. However, this is clearly not the best option. Taking profit on the next support or resistance level will work much better.

According to the current rule, take profit should be at the next trend line. So, we should take profit at the level marked with a red circle and line, near 1.3090:

A much better take profit is the previous high (resistance), around 1.3200. Taking profit there brings 110 pips more in profits!

• If there are two setups, one following the other at nearby levels, always trade the first setup only. Why? Well, usually the first setup is at a better price. Also, the fact that there is a second setup means that price retraced back and went against the trade.

For example, here are the last two short trades (selling), zoomed-in:

We should have entered just the first trade (at the higher red arrow) and not the second (at the lower red arrow). The first trade was profitable, but the second trade was a loss. Price just retraced back, hit the stop loss, before resuming the original down movement.

Here is the second trade, zoomed-in. The green candle, pointed on with a black arrow, hit the stop loss:

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► GBP/USD Back Test

I have also back-tested the strategy on the GBP/USD Daily chart. I used the conclusions from the EUR/USD back-test (see above). The test period is March 12th, 2012 till June 11th, 2013:

Up trend lines appear in blue color:

Green arrows appear at higher lows, that are connected by up trend lines:

Down trend lines appear in black color:

Red arrows appear at lower highs, that are connected by the down trend lines:

Here are all the trend lines:

Here is a summary of the test results:
• Number Of Trend Lines: 14 (6 down trend lines, 8 up trend lines)
• Number Of Winning Trades: 4
• Number Of Losing Trades: 1
• Average Winning Trade: 96.75 pips
• Average Losing Trade: -42 pips
• Total Pips Gained: 345 pips
• Equity Gain: +14.75%
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► An Example Of Forward Testing

In addition to back testing, we should also look for live trading opportunities. Forward testing this strategy in real market conditions is required. It gives us more confidence in the strategy. Also, we can see how it really works, candle by candle, on live charts.

Here is such an example in the EUR/USD Daily chart. I have marked two trend lines, an up trend line and a down trend line, on the chart:

I have marked the confluence area in yellow. Please note that this area is 9 candles wide and 51 pips high, as the strategy's rules require:

Now, we just wait and see if price moves towards the confluence area, tests it and bounces off. We are actually interested in two possible scenarios. One scenario is that price tests the confluence area from below and bounces lower:

A different scenario is that price tests the confluence area from above and bounces higher:

I have posted this example on my blog here. I also talked about it in my webinar, "Price Action in Daily And 4 Hour Charts", broadcasted on Dukascopy Community TV.