Interpreting Lower Highs and Higher Lows

[RichardCox 10]

One aspect of technical analysis trading that can be especially confusing for newcomers is the dual notion that it is a better idea to trade with the trend (not against it), while at the same time “buying low and selling high.” Of course, anyone with a proper understanding of these two trading practices can tell you that these two concepts are fundamentally at odds with one another: If you are trading in an uptrend you have - by definition - already missed the lows and therefore cannot buy into them. The reverse would be true for traders looking to sell downtrends. So, it would seem that there is no way to do both, and that traders must find one strategy that works best for their temperament, abilities, and time availability. But is that entirely true? Is there no way to find a happy medium and play off of some of the strengths of both of these time-tested market maxims?

 

Here, we will look at some ways to approach trend trading in a manner that allows us to - at least to some extent - buy when prices are cheap, and sell when they have become expensive. Specifically, this means finding lower highs (for short sells) and higher lows (for long positions) within the larger trend. Of course, these strategies will by no means completely fix the inherent problem. It will still be impossibly to “buy low and sell high” in the direction of a trend. But when we look at prices from this perspective, we can start to arrive at a happy medium that plays to the strengths of both strategies.

 

The Importance of Trade Entries

 

Experienced traders will always tell you that finding the proper trade entry requires patience, and in some cases you will be forced to completely miss a trade if prices never extend to your desired level. Here, we are going to look at the way prices behave when lower peaks are seen (in a downtrend), and the way they behave when higher troughs are seen (in an uptrend). The first case is an opportunity for sell positions while the second is an opportunity for buy positions. It is important to wait for these structures to complete before establishing trade entries because, without this, it is much easier to find yourself trying to “catch a falling knife” and lose in a buy position, or sell into a rally before it has completed.

 

Establish the Dominant Trend

 

The first step in the process is to establish the dominant trend. This is important because it will give you context and help you to gain an understanding of which direction your trade will be follow (buys in uptrends, sells in downtrend). There are many different ways to do this but perhaps the simplest and clearest way is to find uptrend or downtrend channels (parallel channels). These structures are relatively easy to spot, and examples of both types can be found in the attached graphics.

 

Standard definitions or these channel will generally say that uptrend channels are marked by higher lows and higher highs, while downtrend channels are marked by lower highs and lower lows. Finding trading opportunities within these trends will require us to the “anti-areas” within these trending moves in order to get a better price and come closer to “buying low and selling high” in the direction of the larger trend.

 

Examples for Long and Short Positions

 

Next, we will use the trend example to spot areas where new longs can be established. The green arrows show areas where prices have dropped to support, given reversal signals (such as a doji candlestick pattern), and then resume the initial upward direction. Traders spotting the fact that prices have become cheaper without breaking the trend would be able to establish positions at lower levels (relatively speaking), and then capitalize on the upward move seen later.

 

Similar logic can be used when selling into downtrends. In these cases, traders are looking for rallies that do not violate the dominant downtrend, yet still give traders an opportunities to sell at preferable levels.

 

Spotting Valid Turning Points

 

Of course, there is not foolproof way of knowing these areas are valid turning points. There will be instances where traders spot a higher low, only to establish a new long position and then to watch prices fall lower once again. So, it is not enough to simply identify areas where higher lows and lower highs can be visually determined. Luckily, there is a wide variety of other tools that can be used to help confirm the validity of a turning point.

 

Some common examples include candlestick reversal patterns, (such as shooting stars, doji, or hammers), indicators (such as the RSI or MACD), or Pivot Points (which show areas where price moves are likely to become overextended). Fibonacci support and resistance levels can also be used within these trends and can help traders to find new levels for trade entries. When using these types of tools, there is a better chance that traders can avoid buying an asset that will start to fall or sell an asset that will continue to rise. This is an important element of the entire process because even though this is trend trading, it can also be viewed as contrarian trading on smaller time frames. Because of this, it is also important to use multiple charting periods in order to get a price perspective that is both wider and smaller at the same time.

 

Stop Losses and Profit Targets

 

When looking for areas to place stop losses and profit targets, the channel trendlines themselves can be particularly helpful. For example, in an uptrend, stop losses can be placed below the rising trendline (support trendline). The reason here is that and downside violation of these areas would invalidate the uptrend channel and remove the initial logic behind the trade. For downtrends, the stop loss would be placed above the descending (resistance) trendline.

 

Conversely, profit targets would take the other side of things. In an uptrend, traders would look to capture profits once prices rise to the descending trendline (as this area is likely to act as resistance). In a downtrend, traders would look to capture profits once prices fall to the ascending (support) trendline (as this area is likely to act as support). Other technical tools (such as indicators or Pivot Points) can also be used to identify turns in price but it is important to watch the channel activity itself as this is the central basis for the logic behind the trade.

 

Conclusion: Buying Low and Selling High Offers Chance to Improve on Entries in Trends

 

Using price channel activity can offer traders a way of playing on seemingly oppositional market maxims. Those looking to rely on the idea that the “trend is your friend” can buy higher lows in uptrends in order to get improved price entries (when compared to strategies like breakouts). Combining these strategies will allow traders to buy low and sell high, while playing off of the dominant underlying momentum that is present in trends. These strategies are relatively easy to spot on a price chart, so these approaches to price activity can be used by traders of all experience levels.