Lessons from the Pros

Back To Basics, Part 1: Trends

Sometimes we just need to keep things simple. I live by this motto in my personal trading career and always send the same message to each and every one of my classroom and Extended Learning Track (XLT) students. Trading should be clear and practical at all times. The minute we make things too complicated, the account usually suffers as a result. I have been there and bought the t-shirt! After experimenting with various technical indicators and chart patterns, I soon realized that the most important requirement for ongoing trading success was not so much in the intricate details of the strategy, but in the consistency of following a simple set of rules time and time again. As we all know, there are many ways to do the same thing in this world and in terms of technical analysis, things are no different. Each trader should make it their aim to decide which tools are right for them, and then use them practically as part of a solid trading plan.

In the process of planning my trades, I like to study three simple aspects before I will consider any market opportunity. These are as follows:

1. What is the Trend?
2. Where can I Buy or Sell for a High Probability Low Risk Trade?
3. Is my Risk worth the potential Reward?

By paying attention to these three vital areas of importance well before I even enter an order, I can always be sure that I am being as objective as possible when scanning for setups. This week I would like to explore our first topic on the list: Trend. If we don’t even have a feel for market direction, there is little point in even considering a trade in the first place.

When it comes down to it, there are only two market conditions we should ever be faced with – a Trend and a Range. Range-bound markets are periods of consolidation and relative to time frame, can offer very little opportunity. Many novice traders suffer heavy losses during ranges, as they try to force trades and are led into buying or selling every time the market looks like it may be gathering steam, only to be stopped out on a false signal. Trending markets, on the other hand, can be much easier to deal with as there is a clear direction one way or the other and setups on these kinds of markets tend to offer the highest rewards for the lowest risk. I would always recommend that the new trader only look for opportunities to trend trade in the early stages of their career. One of the many beneficial aspects of trading the Global Forex Markets is that they tend to create much longer trends in price action than other asset classes and instruments, mainly due to the fact that the market is so large and is fundamentally driven by economic data unique to whole nations and continents. This dynamic allows the trend following traders plenty of high probability opportunities to take part in some of the biggest moves across all the instruments available to trade. It is always easier to go with the trend than to fight it. Therefore, it is vital that before each and every planned speculation, all traders should first gauge market direction and stack the odds on their side by going with the dominant force. Let’s look at a few different ways to identify trend in any Forex pair. (Please note all examples are for downtrends so the reverse is applicable for uptrends).

Using Price Action

By far the most classic method to identify a trend is to just look at price action itself. As we can see from the below example, in a sustained downtrend, we will see a repetition of Lower Highs and Lower Lows. In this example, we can see that the market is continually failing to make new highs every time it puts in a rally. In this case, we would say that the Bears or the Highs are in control. Each rally gives the professional market players another opportunity to load up and sell high, driving prices further to the downside with new lows being made with ease. It is in this environment where we often see previous levels of support broken and becoming new areas of resistance in the future.

Figure 1

One particular technique used to rejoin the trend is to look for rallies in price to previous support areas which are likely to now be recharged areas of supply. Many breakout traders will often sell the market on the break of a previous low, hoping to see the market push further down with increased momentum.

Drawing Trendlines

Technical Analysis is by no means new to the world. Traders and investors have been charting price for years, well before the advent of the digital age and charting software. Many used to draw charts by hand, and one of the original ways in which they would confirm a trend was to physically draw a trendline on their charts. Today, we are lucky enough to have powerful PC applications to chart price and use built-in tools to do the very same job. Trendlines can be useful for clearly illustrating the dominant price direction as show below:

Figure 2

Typically, we need three points to confirm and draw any trendline on a chart, no matter the time frame used. In downtrends, we draw the line above price at the highs, and in uptrends, we would draw the line below price at the lows. After the trendline has been drawn and inserted, we now have two uses for it. The first is as an entry method to join the trend where we would sell the pair when the trend line is tested, looking for a further push to the downside. The second use is as a signal of a possible direction change. If the trendline is broken by price, we could then take this as a signal that the trend is over and now abandon and rethink the plan. As useful as trendlines can be, it is vital to remember that anytime you draw a line, it should be obvious. Each trader may draw their line a little differently from someone else and therefore there is a danger of subjective analysis. Always be as objective as you can.

Moving Averages

Moving Averages are another of the classic Technical Analysis tools. Depending on the setting the user defines, they will dynamically track the average price of an asset over a preset period of time. For example, a 20-period Moving Average will take the current price bar and the 19 bars preceding it and work out the average price over that set period of time. In this example, let’s apply the 50 and 200 Moving Averages to our chart. Remember the longer the period of data analyzed, the more reliable the information becomes:

Figure 3

Confirmation of the downtrend is given by the fact that the Moving Averages are sloping down with price, suggesting that the current price itself is well below average, or falling. When current price is below both the 200 and 50 period Moving Averages, it would be ideal to look for only the highest probability shorting opportunities on offer. Some would even use the Moving Averages as an area of entry, which can be riskier at times. They act in a very similar fashion to the classic trendline when used in this manner, and can also be used for a signal of a break of trend if price manages to trade over them, or can also be used to trail stops to lock in profit from successful trades.

Using the ADX Indicator

I am a big fan of technical indicators which are used to analyze price action rather than give entry signals, and one such tool is the ADX or Average Directional Index. The ADX does not give the trader signals to buy or sell and it is non-directional in nature; however, its fundamental use comes instead from giving us a gauge of how strong the current trend is itself. Typically, it will display a numerical value and anything less than a reading of 15 suggests that there is no trend and when it is above 30, this is a signal that a strong trend is in place. This is how it looks when plotted on a chart:

Figure 4

As we can see, when the ADX is rising, this is a sign that the trend is getting stronger and that momentum is building within the price action. If you were solely a trend trader, this could be a useful tool to help you ascertain the best trend following opportunities available to you in the market. However, I personally have adjusted the readings I use with the ADX. I like to look for trades when the ADX is actually getting to a reading of around 25, rather than the traditional 30. This is due to the fact that I am looking for the trend to strengthen after I have joined the move and I don’t want to be late to the game. A more aggressive trader could adopt this approach if need be but it is important to define rules for yourself in your trading which suit and respect your personality.

So there we have four simple ways to identify a trend and help us to keep on the right side of the market. The tool which you choose to use is not the important part of the puzzle though; rather, it is how you use the tool itself and the rules you build around the trade which really matter in the long run. If you decide that you will only take short trades in a downtrend and long trade in an uptrend, then you have already taken an objective rule-based approach to your trading activities, thus allowing you to be objective and unemotional when it comes to pushing the button. As traders, we need to limit our opportunities to only the times when the odds are stacked in our favor, rather than jumping into the market without any proper planning and this my friends, is only achievable when we start right from the basics. I hope this helped.

Thanks and take care,

Sam Evans sevans@tradingacademy.com