3 Ways to Get Back into a Trend

[RichardCox 10]

3 Ways to Get Back into a Trend

 

The most commonly used phrase in technical analysis is that “the trend is your friend, do your best to ride it to the end.” The reason for this comes from the fact that most forex traders are looking to capitalize on the underlying momentum of the market. The fact remains that the forex market is the largest and most liquid market in the world, so siding with the majority has some clear advantages. In addition to this, trends are very easy to identify. Trend spotting can be done by traders even in the earliest phases, as we are essentially just looking for higher highs and higher lows (in an uptrend) or lower highs and lower lows (in a downtrend).

 

One of the biggest problems with trend trading, however, is that the market has already made its move before most traders are able to identify the trend. This can lead to the need to move on unfavorable entry points, where you are buying when prices are elevated and selling after major declines. Is there any way to remedy these difficulties? Is it possible to both capitalize on the market’s underlying momentum and avoid entering into the trend at extreme levels? Here, we will look at three methods for accomplishing this.

 

Buy Low, Sell High or Ride the Trends -- or Both?

 

For full disclosure, most of my own trading is done using contrarian strategies. Generally, I am looking for situations where market moves have become extreme, and then I start to move in the other direction. But I also base a good deal of my trading decisions on fundamentals, and this means there is often a need to go in the direction of the majority trend. I look to bridge the gap between these two approaches (when necessary) by simply waiting for corrective moves within that trend. Here, it is important to understand that the term “corrective moves” suggests that prices essentially need to retrace some of their prior moves and get closer to their historical averages. I will not get into the details of each of the three strategies that follow, as this has already been done in many other articles. Instead, I will discuss the ways these three technical analysis techniques relate to broader trend activity, and can be used in trades that capitalize on the market’s underlying momentum at relatively favorable prices.

 

Mean Reversion

 

First, we look at reversion to the mean, which basically describes the tendency for market prices to eventually move back to their historical averages. Here, the “mean” can literally be anything, as it is entirely defined by the user. Some traders focus on shorter term moving averages, and plot a 10-day, 20-day or 21-day moving average on their charts. Longer term examples typically include, the 55-day, 100-day, or 200-day moving averages. In most cases, traders will use two or three different moving averages, as this can provide additional trading signals (upward or downward crossovers, for example). The first chart graphic shows prices in a downtrend, with prices rising back toward the moving average.

 

 

The conventional wisdom suggests that the market’s bias remains bearish as long as prices hold below this moving averages. But the instances where we rise back toward the moving averages should be viewed as a renewed opportunity to sell the asset. Of course, warning signals would be sent if prices broke sharply above the moving average and many traders would opt to close the position if that were to occur. But we long as the market momentum remains negative, trend traders will be able to get back into the negative trend when prices correct upward. This will create the added benefit of allowing you to capitalize on minor rallies while still being supported by the broader bearish momentum seen in the markets.

 

Of course, these methods apply to bullish markets, as well. But in those cases the market price will be seen holding above the moving averages, and the new buying opportunities will be seen when prices drop back to test moving average support from the topside.

 

Fibonacci Retracements

 

Fibonacci retracements use calculations based on the numbers in the Fibonacci sequence to identify potential turning points once markets have made corrective moves. There are many different Fibonacci levels that can be plotted on your charts, but the measurements that are most commonly used can be seen at the 38.2%, 50%, and 61.8% retracements. To get an idea of what these percentages mean, let’s hypothetically assume the USD/JPY rose from 0 to 100, and then dropped back to 38.2. This would mean prices have retraced 61.8% from their highs, and this would then be referred to as the 61.8% retracement of the move from 0 to 100. The underlying momentum in the market is still positive, but this drastic pullback in price activity creates new buying opportunities for those looking to buy. Below, we can see the basic structure for bullish turning points based on Fibonacci retracement levels. In a bearish scenario, these structures would be flipped upside-down.

 

 

Now, we will look at how these retracement are used on live charts (also using a bullish example). In the chart graphic below, we can see prices that begin an uptrend at point A, stall at point B and retrace 61.8% of the original bullish move. This area marks the entry point to buy the asset, giving you a much lower price while still having the benefit of the broader uptrend.

 

 

Support Turned Resistance

 

Last, we look at support turned resistance levels (and resistance turned support levels). The main logic here is that a price breakout occurs as market sentiment shifts, but markets still end to obey the same levels that were previously important. This occurs because most of the market have based their positions on these levels. If prices break a key resistance level, that same zone can be expected to act as support when tested in the future. If prices break a key support level, that same zone can be expected to act as resistance when tested in the future. These events can be viewed as being similar to a Fibonacci retracement, except for the fact that the areas to watch are based on historical supply and demand areas, rather than Fibonacci calculations.

 

First we have a bullish example, with prices showing an upside breakout, strong follow-through and then a corrective move back to the initial resistance zone. This area now acts as support (shown by the purple line). Buy positions can be established in this area, as the majority of the market’s momentum is positive. Prices are more favorable, however, as we are now seeing a downside correction.

 

 

Next, we have a bearish example, with prices showing a downside breakout, strong bearish follow-through and then a corrective move back to the initial support zone. This area now acts as resistance and is tested two times (a larger number of tests strengthens the argument for the level’s validity). Sell positions can be established in this area, as the majority of the market’s momentum is negative. Prices are more favorable, however, as we are now seeing a upside correction.

 

 

Conclusion: Capitalize on Market Momentum, But Do it at Better Prices

 

It is clear that most traders (especially new traders) are focused on market trends and are looking to trade in the same direction. But this type of approach can create problems when there is no opportunity to buy lower and sell higher (thus, obtaining a better price in your trade). This limits prospects for gains and creates the potential for excessive losses if markets change unpredictably. One way of guarding against this is to use corrective retracements. This method will allow you to benefit from the market’s momentum and gain an advantage relative to your peers, as long as you are patient enough to wait for areas where preferable entry points can be found.

[maui - surftradesurf 10]

darn fine post - this is the trick for us more experienced trend traders - no need to

top or bottom picking - that is the rookies game and the road to ruin. Let the market go there first with out you - now the counter trend is your best friend of all times This is about as low risk and high reward as it gets. Good article - this one is tattooed into my brain...

 

Aloha,

 

Dave

[RichardCox 10]

Hi Dave, thanks for the comments. I do agree that picking tops and bottoms can be some of the most difficult parts of the business, tripping up a lot of traders that are not ready to cut positions when necessary.

[SunTrader 10]

Sar .

[SunTrader 10]

  mitsubishi said:

Since tams stopped posting,the award for the man with least amount of syllables goes to SunTrader.

Just a suggestion if you intend to defend the title going into next year.....drop the full stop,in your case.....it really is superfluous:)

Longer version: KISS SAR.