Has the Trend Reversed? Or It is Ready to Resume? 3 Strategies to Know the Difference

[RichardCox 10]

Has the Trend Reversed? Or It is Ready to Resume? 3 Strategies to Know the Difference

 

A wide variety of studies show that forex markets tend to operate in a trending fashion more than other classes (such as stocks or commodities). The reason for this comes from the fact that valuations in currencies are most closely tied to the broadest macroeconomic factors -- on both the national and global levels. These factors have less of an impact on assets like specific stocks. So for those that spend most of their time trading forex, trend analysis becomes much more important in determining your ability to generate consistent gains.

 

The key questions for any trend-based trade center around the assessment of its cyclical position:

 

• Is an old trend ending?
  
• Is a new trend beginning?
  
• Is the trend in need of a correction (an oppositional move toward historical averages)?
  
• Is the previously established trend ready to resume after a correction has completed?
  

 

Inaccurate to these questions result in losing positions. This means you will buy into an uptrend that is ready to reverse, sell a downtrend just before it begins making an upside correction, etc. There are many potential scenarios that could result in losing positions.

So the real work when basing your decisions on trends comes from your work in determining which stage the trend has reached in its overall life cycle. This is obviously a broad topic, so the scope of this article will focus on one potential scenario, asking the question: Is the previous trend ready to resume? When an established trend is ready to resume, high probability positions can be taken and it becomes possible to capitalize on the underlying momentum that is present in the market. Here are three types of market events to watch.

 

Understanding Corrections

 

 

First, we must have an understanding of what a market correction looks like. This is the scenario that will need to complete before the trend can resume. In the first chart example, we can see a series of relatively minor downside corrections within a broader uptrend (shown as red arrows). “Market corrections are essential, because no asset can rise or fall indefinitely,” said Sam Kikla, markets analyst at BestCredit. “The market needs an opportunity to ‘take a breath’ and return to its historical averages in order to generate fresh momentum for prices to continue further.” These corrections allow traders to re-enter the market and establish new positions. These new positions are what enable valuations to continue higher or lower.

 

Fibonacci Levels Validated

 

The first chart example shows price corrections that are relatively random in nature. They are all of varying degree and follow no predictable sequence. Of course, there is nothing wrong with this, and this is the way most corrections will unfold as you are watching the trend. But when we add Fibonacci retracements to the equation, we can start to quantify the price lengths that will mark the smaller correction within the larger trend. I will not go into the intricacies of Fibonacci but I have written about some of these previously here. The most commonly watched areas when Fibonacci zones are plotted can be found at the 38.2%, 50%, and 61.8% retracements of the larger move.

 

 

These levels are used to plot potential points of support (for uptrends) and resistance (for downtrends). In the chart example above, we can see the 38.2% Fibonacci level act as resistance in a broader downtrend. If this level did not hold, it would be a short-term indication that the downtrend could be over -- and traders would then begin to target larger corrections back into the 50% and 61.8% Fib levels (at least). In the example below, the 38.2% retracement does hold, and this then places the focus back on the previous lows that marked the measured move in the downside Fibonacci wave. Aggressive traders could have entered into short positions once prices started to fail at the 38.2% retracement. More conservative traders might want to wait until the longer term support level to break before committing to a position. In both cases, we have signals that the longer term trend is resuming.

 

Consolidation Breakouts: Triangles and Ranges

 

Consolidation Breakouts in the direction of the previous trend mark the second way of determining whether or not the previous trend is in place. Consolidation points are essentially periods of indecision in the market. There is not enough available information for the majority of traders to be swayed in one direction or another. But these periods cannot last forever. When consolidation patterns eventually do break, the break tends to be forceful and decisive. The market has likely received the information it wanted and now prices are ready to make a strong move. When this happens in the direction of the original trend, the signal is more valid as it is supported by the already established momentum of the prior trend.

 

 

In the example above, we can see that an uptrend has established itself with a strong series of higher highs. This is followed by a period of sideways consolidation that is marked by a decreasing range of constricting support and resistance levels. This gives us the Triangle formation that will be important in determining whether or not the original uptrend will be able to continue. In this example, the breakout is to the upside, and this would be an indication that long positions can still be taken as a way of capitalizing on the broader trend.

 

 

Next, we look at range-bound conditions, where the support and resistance levels are not constricting and sideways trading dominates. Breakouts from these patterns tend to be less forceful. This is because a greater tightening of market energy is required to form a triangle but these are important patterns to watch nonetheless. The chart above shows another bullish scenario, where prices enter the range from the bottom (in an uptrend). Prices test both sides of the range multiple times before breaking to the upside. This confirms that the original bullish trend is still in place and that long positions can still be established.

 

Elliott Wave Completions

 

For those unfamiliar with the basics of Elliott Wave patterns, I have written previously about the main structures here and here. For the purposes of this article, we are mostly concerned about the corrective A-B-C periods, as these points mark the levels where the trend will either resume or begin to fail. A-B-C patterns do not require prices to be trading within a constrictive range, so this allows traders to spot new instances of trend resumption when a Triangle or sideways range is not present.

 

 

In a bullish scenario, we would want to see a structure similar to what is pictured above. Prices begin to correct to the downside after an uptrend, hitting point A before rising to a lower high at point B. Prices than fall below point A to carve out new support zones at point C. This is the critical area, however, as we will need to see prices turn upward here in order to confirm that the broader uptrend is still in place. If this does not occur, avoid new long entries. If prices break above the B point, the correction has ended and the uptrend should resume. Conservative traders might wish to wait before the highest high is broken in order to confirm long position entries. More aggressive traders will enter after the B point is broken, as this signals the downside move was only a short term correction. Here, the conservative trader would receive more confirmation before entering the trade. The aggressive trader would be able to capitalize on a better (lower) price level.

 

 

As with any strategy, these ideas can be combined and in the chart above we can see an example of prices hitting the C point in a corrective Elliott wave move just as prices have also completed a 50% retracement of the original uptrend. A bounce out a zone like this creates a highly bullish scenario as you are receiving multiple signals that are all in agreement. So, while most of the examples above are bullish, the same rules apply when downtrends are seen (just in reverse). In all of these cases, traders can use the market’s information as a way of assessing whether or not the broader trend has completed. These events can form the basis of a new bias for trade positioning.

[SIUYA 11]

or apply a very simple idea....

 

if your odds of picking a top/bottom in a trend and getting the exact reversal point are very low, then

the odds of not picking the top/bottom in a trend while trading with the trend are very high.

 

No matter how you measure a trend - odds are high you will not buy at the top or sell at the bottom. So to a large extent worrying about if the trend is reversed is irrelevant.

..................

One problem is always that many day traders focus on the smaller trends within a larger trend and hence never really get a chance to participate in the larger trend constantly getting chopped out which goes to the issue for most short term traders that they should be focusing on - is it ready to resume?

How then can I participate, but hang on for longer than a day with little risk in order to participate in the dominant trend?

 

Not being able to ride the main trend is always going to be an issue, and while there is nothing wrong with trading counter trend if you are good at it.....my guess is many are not and they waste focus and time trying to pick tops and bottoms intraday without thinking about where they are within the dominant trend

Richard offers some good simple ideas to use to determine if a trend may have changed......but given its probably irrelevant to most short term traders you may as well keep it simple.

Edited March 7, 2014 by SIUYA

[MidKnight 12]

My dear Uncle F* Siuya - I agree that daytraders are focused on the intraday trends rather than the larger trends. As I'm sure you know, part of that focus comes down to wanting to combine the effects of leverage and frequency to enhance gains. As a daytrader that tries to utilize the big picture within my trade ideas, I have at times missed fought great intraday trends as I'm trying to get into the big picture trends. When this happens, I start to question how much value the big picture has in day trading and maybe its best just to focus on reading the flow. After all, if one could read the general intraday sentiment then they would align with the big picture when the time was right. All sounds good, but I so far, have failed to find a way to stay in alignment with the current intraday sentiment in a timely manner. I still explore though.

 

With kind regards,

MK

[SIUYA 11]

Hi MK,

yes its a dilemma.

I guess there are a number of options available.

1) ignore the larger trend - focus only on what you see in the day. Have some rule that helps you determine the order flow for the day.

...very hard to do and chop will likely get you as well as indecision (unless its automated) as you are likely to have no point of reference.

 

2) go only one way. eg; say in a simplistic manner. its an up/down trend. So I will only take longs/shorts --- you might reverse this is you feel say in an uptrend it consists of large overnight gaps ups and grinding down days.

 

3) work out where you are in a longer term trend and adjust focus to try and accommodate trades based on expectations of this.

 

4) go both ways - be a genius and make plenty (or get chopped with indecision, doubt and be proved right but actually loose money)....I suspect this happens to many folks.

 

Ultimately as you point out MK, finding the way to stay aligned is difficult.

Personally I find that the easiest solution is to either wait and wait and wait for the right days and go harder at it. You might get chopped a few times, keep the losses small gut the rewards still pay off - so long as you are not hoping to do this every day.

or

look for where the best opportunities across a number of instruments that are trending (and hence likely to continue that direction) and apply the same above logic.

(This is all assuming you are not holding overnight)

 

Controversy corner - I quite like TRO (rat, maze - drain the banks) and the simplicity he offers. Determine a direction to trade (based on stats), wait for a simple area of opportunity (within 20 tics of the current high/low), apply a simple entry and exit technique (red green red etc, and 10 tic stop), use discretion as to when the actual high/low is relevant (the discretionary part which still causes the problem and cant be replicated by automation). Hence the only real focus and training required is - how can i improve my discretionary element of looking for when to apply this.

 

///////////////////////

(As you mention leverage is a positive for a day trader, but I feel frequency is more often not a positive. It raises an interesting point as a thread itself - which is more inappropriately applied by failing day traders - frequency of trades, or over leverage.

As I am not a fan of the idea of an 'edge' as its commonly referred to for day traders as opposed to a real 'edge' for arbitragers, markets makers and such I probably side on the idea of less frequency is better.)