Ways to trade with the trend Part II

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Keep It Simple and Trade With the Trend

As a trader, you have probably heard the old adage that it is best to “trade with the trend.” The trend, say all the pundits, is your friend. This is sage advice as long as you know and can accept that the trend can end. And then the trend is not your friend.

So how can we determine the direction of the trend? We believe in the KISS rule, which says, “keep it simple, stupid!” Here is a method of determining the trend, and a simple method of anticipating the end of the trend.

Before we get started, we want to mention the importance of time frames in determining the trend. Usually, when we are analyzing long-term investments, the long-term time frame dominates the shorter time frames. However, for intraday purposes, the shorter time frame could be of greater value. Trades can be divided into three classes of trading styles or segments: the intra-day, the swing, and the position trade.

Large commercial traders, such as those companies setting up production in a foreign country, might be interested in the fate of the currency over a long period of such as months or years. But for speculators, a weekly chart can be accepted as the “long-term.”

Averages Moving in Pairs

With a weekly chart as the initial reference, we can then go about determining the long-term trend for a speculative trader. To do this we will resort to two very useful tools that will help us determine the trend. These two tools are the simple moving average and the exponential moving average.

Chart 1: May 2006-July 2008

In the weekly chart above, you can see that for the period of May 2006 until July 2008 the blue 20 interval period exponential moving average is above the red 55 simple moving average and both are sloping upward. This indicates the trend is showing a rise of the euro and therefore a weakening dollar.

In August 2008, the short-term moving average (blue) on the chart below turned down, indicating a potential change in trend although the long-term average (red) had not yet done so.

Finding the Change in Trend

In October, the 20-day moving average crossed over the 55-day moving average. Both were then sloping downward. At this point, the trend has changed to the downside and short positions against the euro would be successful.

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Chart 2: October Short-Term Moving Average

Still looking at Chart 2, we notice that the short-term moving average goes relatively flat in December 2008 and starts to turn up, now indicating a potential change in trend to the upside. But a closer look at the 55-day moving average, as of December 2008, shows that the long-term moving average has remained downward sloping.

By checking Chart 2, we can see that the first arrow from the left indicates that the long-term moving average has turned down, indicating that the weekly or longer term trend for the EUR/USD has now gone down. The second arrow indicates where a new short position could have been successfully taken once the price had traded back to the down sloping moving average.

The goal here is to determine the trend direction, not when to enter or exit a trade. Of course, this is not to say that there were no trading opportunities in the shorter time frames such as the daily and hourly charts. But for those traders who want to trade with the trend, rather than trading the correction, one could wait for the trend to resume and again trade in the direction of the trend.

How to Trade “Trend From the Start” Type of Trends

How to trade “trend from the start” type of trends

This lesson will cover the following

  • How do different traders perceive trends from the start?
  • First attempt to end a trend usually fails
  • The case with pullbacks

It is useful to note that the majority of strong moves demonstrate at least two legs. Therefore, if a trader manages to enter on the first pullback, then he/she has a good opportunity for a successful trade. What is more, this entry is of utmost importance during a trend from the start day in case the trader has missed the first entry. However, it is worth mentioning that during strong trends the move, which is to represent the first pullback, often is unclear to be seen. It is so, as these trends often create two-three sideways bars, which do not breach any key trend line. So, they may not be considered as important enough in order to represent a pulling back move. Some traders, however, think that even though no actual retracement or pullback is to be observed, because a pause is a sideways correction, it can be perceived as a version of a pullback.

An important moment to note is that trading particularly strong trend from the start days is complicated, because the trend does not appear to be that strong as it is developing. No prominent spikes or high-probability pullbacks to the exponential moving average are to be spotted. Price action creates a lot of trend bars in the opposite direction, while pullbacks occur after every few bars. It often seems that the market has entered a weak channel.

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Beginner traders often do not seem to notice that all pullbacks are short, prices do not manage to return to the exponential moving average and the market is gradually distancing from the open. Traders with more experience usually notice these circumstances and take them as signs that the developing trend probably has considerable strength. These traders may feel confident enough to take even swing trades. Despite that bars seem to belong to a weak channel (which implies low-probability trading setups), if these bars appear during a bull trend day with small pullbacks, they provide high-probability swing trading setups.

Any pullback, that occurs during trend from the start days, provides decent opportunities to enter in the direction of the trend, no matter how weak a pullback may appear to be. In fact, some traders may still be confident to make entries in the direction of the trend even after a pullback breaches a key trend line. During a strong uptrend one should look to enter the market long at or below the low price of the prior bar. The size of pullbacks, occurring after the start of the trend, is another factor to take into consideration. If we have a bull trend with small pullbacks and the largest of all pullbacks during the past 2-3 hours has been only ten ticks, a trader should buy on a limit order at, say, six ticks below the daily high. If we have a strong downtrend, a trader should look to go short at or above the high price of the prior bar, or on every bounce, which appears to almost match the size of the average bar.

First attempt to end a trend usually fails

As the market has gained momentum, the first attempt to halt a trend usually is unsuccessful. If a key trend line has been breached and a considerable pullback has occurred, this means that the first leg of the trend has probably ended. Even in such a situation the first breach of the trend line may have a good chance to produce entries in the direction of the trend, which would eventually cause a second leg of the trend, thus, a new extreme level in this trend.

The case with pullbacks

Pullbacks in these trends, in many cases, contain weak signal bars and a number of trend bars in the opposite direction. During a strong uptrend the majority of bars, providing buy signals, may appear to be bear trend bars with small bodies or doji bars, while several of the entry bars may be small outside bull trend bars. They may appear after a number of bear trend bars or bear micro channels. This selling pressure urges traders to look for appropriate sell signals. These signals, however, may not be strong enough, but traders take advantage of them, because they appear more reliable than buy signals. They spot a pullback after almost every buy signal, that extends enough to trigger a breakeven stop, which makes them believe this is probably a sign of a weak uptrend. Some traders may be willing to enter long, but have trouble deciding exactly how, as they view every buy signal as not so reliable. All pullbacks are short, while setups are not strong.

Because of the rare occurrence of trend from the start days within a month, many traders are conditioned to other trading days, when selling pressure usually provides opportunities to go short. Because of that, they continue to sell short setups, which seem unreliable. These setups are unreliable, because they mark the start of bull flags and not reversals (to the downside in this case).

Traders with more experience, on the other hand, will probably understand the whole situation, when spotting an uptrend with short pullbacks, which does not fall below the exponential moving average. These traders know that others have probably been trapped out of their long positions and also been misled, looking for peaks, while, at the same time, being unaware that this uptrend is actually particularly strong. Experienced traders know that quite many other traders have been playing against the trend and will need to exit their losing short positions, after which they will probably chase the uptrend. This will likely lead to tension on the upside (many traders would like to go long, but do not), while experienced traders would buy massively and end the trading day at considerable profits.

We’ve all heard the saying “The trend is your friend”, and while it sounds nice it doesn’t really teach us anything about trading a trending market or how to identify one. In today’s lesson, I am going to give you guys some solid information on trend trading that you can begin using immediately. Today’s lesson is all about trading trending markets with price action, and we are going to talk about how to tell when a market is trending and how to take advantage of these trends.

I hope you guys pay close attention to today’s article and refer back to it when you have any questions about how to trade or identify a trending market. In fact, if you email me asking about trends…I will probably refer you to this article!

Let’s get started…

The first step: Learn to identify a trend with nothing but raw price action

As you probably already know, there are tons of different indicators that you can put on your charts to ‘help’ you identify a trending market and trade with it. Many traders spend countless hours and dollars on trend-following trading systems or on indicators that just end up confusing them and making the process of trend discovery a lot more difficult than it needs to be.

I have always been a strong proponent of visual observation of the raw price action of a market, as you probably know. I also believe that simply observing a market’s raw price action, from left to right, is the easiest and most effective way to identify a trend and to spot high-probability entries within it.

Let me make a quick note before we proceed: A trend is not actually a strategy by itself; it’s just an added point of confluence that increases the probability of a trade. However, just randomly jumping in with a trending market is not an edge or a strategy.

As a market moves higher or lower, its previous turning points, or swing points as I like to call them, become reference points that we can use to help us determine the trend of a market. The most basic way to identify a trend is to check and see if a market is making a pattern of higher highs and higher lows for an uptrend, or lower highs and lower lows for a downtrend. This is just plain old visual observation of a market’s naturally occurring price action…no mumbo-jumbo trading systems or magic-bullets here. I’d like you guys to take a look at this simple diagram that I drew below; it shows us the basic idea of looking for higher highs (HH) and higher lows (HL) for uptrends and lower highs (LH) and lower lows (LL) for downtrends:

Note: each colored circle is highlighting what we would consider a ‘swing point’ in the market:

Thus, general observation of a market’s swing points is the first point of call in determining if a market is trending. If you do not see a pattern of HH HL or LH LL, but instead you see sideways price movement with no obvious general up or down direction to it, then you are probably looking at a range-bound market or one that is simply chopping back and forth.

Tip: You shouldn’t have to think too hard about whether a market is trending or not. Most traders make trend discovery WAY too difficult. If you take a common sense and patient approach, it’s usually fairly obvious if a market is trending or not just by looking at the raw price action of its chart, from left to right. Make sure you mark the swing points on your chart, as it will draw your attention to them and help you see if there’s a pattern of HH and HL or LH and LL, as discussed above.

Trending markets tend to make strong moves in the direction of the trend followed by periods of consolidation or a counter-trend retrace before the next leg in the direction of the trend. You will notice this pattern happens in almost any trend you can find. Typically, what happens to many traders is that they will make some money during the periods of strong directional trend movement, but then they continue to trade as the market takes a breather from the trend and consolidates. It’s these periods when traders give up all of the gains they just made when the market was moving aggressively.

You need to learn to identify the different parts of a trend, this will help you avoid over-trading during the choppy / consolidation periods and will give you a better chance at profiting when the trend makes a strong move.

Here is an example of what I’m talking about:

In the diagram above, we can see that a trending market tends to move in spurts, moving in the direction of the trend and then stalling to take a breath before another leg in the direction of the trend. Now, all trends are obviously not exactly the same, but we do typically see the general pattern described above; a forceful move in the direction of the trend followed by a period of consolidation or a retracement in the opposite direction.

Now, these retraces are when we have the highest potential for a high probability entry within the trend. Often, a market will retrace to approximately the level of its previous swing point before the trend resumes. In an uptrend these swing points are support and in downtrends they are resistance. Look at the very first diagram in this article for a quick refresher on what I’m talking about. Also, let’s look at the chart we just looked at but this time with the support levels marked. These support levels resulted after the market began to retrace lower within the structure of the broader uptrend.

Note the ‘stepping’ pattern left behind by the swing points in this uptrend. As the market retraces back down to these ‘steps’ or support levels, we would focus our attention and watch for price action signals forming near these levels to rejoin the uptrend:

Note: These same principles apply in a down trending market but we would be looking for price action setups from resistance rather than support.

As we discussed previously, a trending market will tend to surge in one direction and then slow down and either consolidate in a sideways manner or retrace lower or higher, depending on what direction the dominant trend is. It is during these contraction or retrace moves that we can focus extra hard through our ‘sniper-scope’ and begin searching for high-probability price action trading strategies forming from previous swing points within the overall trend.

My primary mission as a price action trader is to watch for obvious price action setups that form after a market retraces back to a confluent level in the market. This can be a swing point like we discussed above, a moving average level, or some other support or resistance level. Whatever the case, I am looking to trade from ‘value’ in a trending market. By value, I mean from an optimum point in the market that has proved significant before.

For example, in an uptrend I would consider ‘value’ to be support, since that is where the price of the market is likely to be seen as a good ‘value’ for the bulls, and thus they will tend to buy from that level and push the price higher. Whereas, in a downtrend, ‘value’ is seen at resistance, since the price has rotated higher within the broader downtrend; so it’s a good ‘value’ to sell from resistance in a downtrend. These rotations back to value points can also be called ‘trading from the mean’ or the ‘average’ price, this is why moving averages tend to act as dynamic support or resistance levels.

One tool we can use to find ‘value’ in a market is a moving average. I don’t use them all the time, but when I do I like to use the 8 and 21 day exponential moving averages. I use them as a general guide and a helper to find confluent points in a market. For example, often the 21 day EMA will align with a swing point in a trending market, this would be considered a confluent level since you have multiple factors lining up together. Then, if we see a price action signal there, we know we are seeing a setup form in a very high-probability area on the chart. See here:

Note: these moving averages should only be used as a ‘general guide’ and never as an actual signal (as in the old ‘moving average crossover signal’). We only use them as a helper to see dynamic support and resistance levels (to add confluence) and for trend direction. But just to be clear, our main focus is on visual observation of a market’s price action and levels, that is to say without any EMAs.

Don’t fall into the ‘breakout’ trap – Many amateur traders get stuck in a cycle of trying to trade breakouts all the time…this is not really an effective long-term strategy because the ‘big boys’ all know that amateurs are constantly trying to buy and sell breakouts. Instead, we want to enter closer to key market levels, swing points, EMA levels (confluent levels) in the market…always with confirmation from a price action signal. As a ‘regressive’ price action trader, we are looking to buy or sell from value within the trend…waiting for the inevitable pullback and then pouncing on an obvious price action signal if one forms.

One aspect of trend trading that I want to touch on briefly is that trends in Forex tend to differ from those in other markets, especially equities.

In Forex, bearish and bullish trends are typically equally as violent and potent…whereas in equity markets we tend to see slower moving price action in a bull market, along with lower volatility. Down-trending markets tend to be fast and volatile in equity markets. Forex trends tend to be the same in their volatility and price action whether the trend is up or down. The main reason is because it’s one currency against another in any given currency pair and this results in more balanced price movement.

Thus, in Forex, your trading strategy and plan will generally be the same for both up and down markets. Here’s an example of the EURAUD daily chart recently that shows just how consistent both down trends and up trends can be in this market…note how the volatility and speed of these trends were about the same:

In the equity markets, traders typically need to adjust their strategies or systems as a market moves from bull to bear or vice versa. But in Forex, whether you’re trading long or short, bull or bear, the volatility of a currency pair tends to say about the same. That’s not to say that volatility never changes in Forex, it just means that the particular direction of a Forex pair doesn’t have a very big impact on that pair’s volatility or price action, as it does in the equity markets for example.

Take advantage of trends when they happen – There is never anything concrete with trends…meaning you never know how long they will last for, so try to take advantage of them when they do occur. Markets typically only trend about 25 to 35% of the time, and the rest of the time they are range-bound or chopping in a sideways fashion. The trick is to learn how to identify a trending market so that you can get the most out of it and get on board as early as possible.

Counter-trend trading – Overall, trend trading should make up about 70% of the trades you take, and the other 30% might consist of counter-trend trades or trades in range-bound markets. It’s best to learn how to trade with near-term trend before you try trading counter-trend, because trading with the trend is naturally higher-probability than trading against it.

In conclusion, trend trading is perhaps the ‘easiest’ way to make money in the forex markets. Unfortunately, markets don’t trend all the time, and it’s the time in between trends that traders do the most damage to themselves. This damage is a result of not having the discipline to wait for high-probability setups to appear, and not being able to properly read a market’s price action to determine whether or not it’s trending.

I trust that today’s lesson has helped you get an idea of how to determine whether a market is trending or not and how to trade a trending market. Remember, there’s no ‘Holy-Grail’ for trend trading, but if you’re in doubt, the best thing to do is to just relax and take some time to visually observe the last few weeks of price data in a market…without indicators. This no-nonsense approach is hard to beat and will work if you know what you’re looking for.

Finally, I leave you with this little formula:

The Best Trades = Trend + Confluent level + Price action signal

I’ve touched on some topics that traders can use for short-term trend analysis today, and I expand on these topics in the members’ article section of my price action traders’ community. Trend following is a large part of my Price Action Forex Trading Course and of my general trading strategy. I’d really love to hear your feedback today, so please remember to leave your comments below & click the ‘like button’.

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