I’d like to thank Charlie hugely for writing this.
This is a really important article and actually has some connotations with the article that I recently wrote for him about heuristics and biases.
Give Charlie a follow on Twitter and visit his site for more expert info.
‘The trend is your friend’.
You’ve heard this before, haven’t you? You just need to start trend trading! Your broker, your guru, your moving average, Babypips, even your parents are telling you – just go with the trend!
Is it really that easy? Is this the forex trading holy grail?
We are going to find out.
This is the next installment of my series on trading clichés, diving deeper into the soundbite phrases we hear all too often. I’m very proud that David has allowed me to traverse the waters between DavidBelleFX.com and TradingProbability.com to write for him.
A natural problem of people announcing that the trend is your friend: which timeframe do you base this off of? Are you trend trading off of the timeframe above, below, or the same?
Look at this chart of GBPUSD for example, is it in an uptrend or downtrend?
I have outlined the three most obvious ways we could look at the trend. They’re completely conflicting. Long term we have an uptrend, medium term could be seen as a downtrend, short term is uptrend again.
Let’s look at a lower timeframe of the above chart:
We see more conflicting evidence. This chart says uptrend in medium term, the 4-hour chart was saying down in the medium term. This is yet another obstacle to trend trading.
For now, let’s stick to one timeframe.
How do you define a market trend?
Is it a purely visual thing? That doesn’t sound very robust.
Everyone can look at a chart and tell if it’s trending though, just look and see if it’s going up or down. Is the chart going from bottom left to top right? Uptrend.
I’m not as convinced.
Let’s use trendlines
They seem like a good idea.
The clue is in the name, of course they can define a trend well. We’ll draw a trendline and that can tell us which direction to trade!
I’m being facetious, but this how some people think. There is absolutely no rhyme nor reason to how I drew those trendlines. I would wager that many trend traders do the same.
If you draw trendlines as a part of your strategy, do you have rules for them?
Leave a comment below if you do, there is more than one way to skin a cat and we’re curious to know how other people do it.
One simple way would be to look at the structure of highs and lows in the market.
The swing high/low structure of markets
On this chart, I’ve highlighted the swing points which I perceive to be the most prominent.
Ignoring the first third of the chart, these were relatively easy to spot (the first third was pretty much a straight line move, admittedly a downfall of using swing structure).
If we go one step further and label these swing points, we get more clues about the context of the market. Let’s look at them contextually, compared to the previous high or low. We will label them as ‘higher’ or ‘lower’ than the previous high/low. Perhaps then we can get more insight into trend trading.
(Note that the first low and first high are single-lettered, as there is nothing to compare them to). Now that we have some market structure in place, we can potentially use this to define trends, perhaps even to help make trendlines rules-based.
It’s commonly thought of that an uptrend is defined by a market making both higher highs and high lows. We can see this in the most recent state of play. By these rules, the last 4 labels have defined us as currently being in an uptrend.
Let’s use this to draw our trendlines!
Now that we can define swings in the marketplace, we can use this to define trendlines. If we take our ‘base’ to be the first point in the new structure, we can connect swings to draw trendlines!
You may think: ‘that doesn’t look much like one of my trendlines’ – and you may be correct. But it is well-defined.
The ‘LL’ label is the base. The ‘HL’ led to a break of a prior swing point (the LH label) – the move which starts our definition of an uptrend. Every time we break to new highs we can move our trendline along the lows. This is one simple way to define both trendlines and an uptrend.
The trend is your friend, until the end, when it bends
Then there is this part.
What about when it bends? The start of a different trend, or a period of confusion and sideways action.
We can define this too. Remember how to draw those trendlines? Let’s have a look at a way to use those trendlines to define a change in market trend. If we rewind to the previous defined trend, we can get hints as to when a trend will change. These hints come as we make a breakout, through the trendline.
We were in a downtrend, and got early indications of a change in trend. Oftentimes, this is an important area to look for a retest and can often form an area to enter market, once this happens you could start trend trading to the upside. This particular breakout occurred in conjunction with my favoured horizontal support and resistance.
What makes a trend continue?
Without going too far into the dynamics of supply and demand in a trending market – an excess of demand, lack of supply, or both together, is what causes markets to move up.
We can see this for really sustained periods, such as the S&P500:
Clearly, the trend is up. I don’t even need to draw trendlines or high/low structure for you to know that. This is a trend that has been sustained over months and even years, due to the excess of demand (central banks mainly).
The trend is the path of least resistance though?
For a time, yes. You’d be a fool not to buy in that market. There is seemingly a magnet at the top of the screen.
However, this kind of sustained move cannot last forever. Supply and demand mechanics simply will not allow it. If demand has dried up, when supply (read: selling) finally comes into the market, there can be consequences (see: fat tails and skewness). Perhaps the best micro example is what we’ve seen over the last few weeks in the S&P500:
Trend traders: does this mean the riskier trade is trend trading to the upside or the reversal trade to the downside? The slow grind or the fast unwind?
We have seen this time and time again. The vacuum below the people trend trading sucks them in, shattering days and weeks of gains in a fraction of the time. Although not quite as sustained a rally, let’s look at bitcoin:
The rapid unwind of the prevailing trend – it happens time and time again.
Hopefully this article has inspired you to think more closely about forex trend trading. I hope I’ve helped to add some structural definition to trends and trendlines, as well as helping people to think more critically about the trend being a friend to you.
Don’t forget that the path of least resistance is only the path of least resistance for a time. Unwinds of long-term trends can be dangerous if you’re a sitting duck.
I just want to say a massive thanks to David for allowing me to contribute to his site – don’t forget to head over to TradingProbability.com for more from me!