Lessons from the Pros

The Trend is Your Friend – But in What Time Frame?

The basic tenet of following the trend is one that for most traders is as common as “buy low and sell high”;  however, as simple as both these principles seem, they are the hardest to actually put into practice.

Two of the main issues surrounding trading in the direction of the trend are first, identifying this type of environment (trending), and second, understanding that there are multiple trends working concurrently.  

Spotting trends after they’re underway is somewhat easier than identifying them when they begin to emerge.  The difficulty in recognizing a trend is due to the fact that there are many false stops and starts before the trend becomes evident.  Moreover, knowing how long a trend will persist also becomes an imponderable.  Most new traders are admonished not to try and pick tops and bottoms; still, there are points on the charts that will show to reverse the dominant move quite often, and will prove to be low risk, high reward trades.   Below are two examples of short-term trends in force.

Figure 1

Figure 2

In a sound trend-following strategy, the primary focus is finding low risk entry points in alignment with the line of least resistance—that is– as long as the prevailing trend is not approaching a support or resistance level in a longer time frame.  If you look at the bigger time frame support and resistance levels, you’ll find that these areas tend to reverse the minor trends.

Let me explain:  In the above example the red candles are trending lower in a 5-minute time frame, however, in the chart below we see that the short-term trend was reversed when it reached the support level on the bigger time frame (15 min).   

Figure 3

This example serves to illustrate the importance the role the larger time frames play in containing the smaller trends.

One other example of the larger trend imposing its force on smaller trends is in the daily chart of the TF (shown below).  In it, notice that every correction (pullback) we’ve seen since the March lows has held at prior support levels.  Some technicians will point out trend line breaks, reversal patterns such as double-tops, double-bottoms, or head and shoulders patterns to confirm a change in a dominant move. These patterns can indeed signal a potential reversal, nonetheless, I find that a breach of the prior turning points can be more reliable in projecting a change in direction.  

Figure 4

If you think about it, isn’t the simple definition of a downtrend a series of lower lows, and lower highs. Therefore, the first indication that the sellers are beginning to gain the upper hand would be when the buyers are no longer able to hold prices at the prior turning points (major support levels).

Moreover, the emergence of a new trend can often begin when the market fails to make new highs or lows after a protracted move.  As we can see below, the descending tops on the TF chart portended the steep decline last month, and just as telling was the series of higher lows that led to the current rally.

Figure 5

All in all, trend-following methods are widely used by professional traders because they can be very profitable.  In fact, a large number of the “market wizards” (those highly successful traders interviewed by Jack Schwager in his book by the same title) subscribe to this trading philosophy.

For most traders however, this method of trading can be very difficult.  Some of the reasons I mentioned earlier, but more specifically there are two primary challenges traders face in implementing this method. First, most traders cannot endure the many losses associated with the consolidation (sideways) periods between trends. Second, once they finally get on board a trend they lack the mental fortitude to ride the trend for the duration, as pullbacks that are normal to any move usually induce early exits.

Finally, when you buy or short any financial instrument, you need a favorable trend to follow– how else will you sell higher or cover at much lower prices, if there isn’t any movement. Those are just simple market dynamics at work. The key for short-term traders though, is defining in what time frame to trade, identifying the trend, hopping on board, and respecting the larger trends.  Because as market wizard Ed Seykota says, “one good trend pays for ’em all.”

Until next time, I hope everyone has a profitable week.

If you have questions or comments, please email me at gvelazquez@tradingacademy.com

- Gabe Velazquez