Signs a Market is Topping or Bottoming Out

[RichardCox 10]

One of the oldest maxims in financial markets trading is the idea that traders should be looking to “buy low and sell high.” Now even if this rationale does not inform your strategy (for example, if you look to trade breakouts where you will buy higher and sell lower), it is difficult to argue with the fact that in an ideal scenario, the most potential profit can be gained when having a clear understanding of when a market is topping or bottoming out.

 

Each time a currency changes its trajectory, the fate of traders invested in that currency changes as well, so whether markets are rallying or in decline, it is important to spot the signals before these major turns occur so that traders can capture gains when the corrections unfold. Here are some critical factors that should be considered when we are looking to assess the future trajectory of a currency

 

Avoiding Panic Reactions

 

Of course, it is not essential to pick an exact bottom and top in each trending move in order to capture gains in the forex markets. But the goal of any trader is place trades that capitalizes on the bulk of a large impulse move, as this is the surest way to attain substantial rewards without looking for a large number of separate trade entries.

 

Traders can come into problems when attempting to locate the exact top or bottom of any of these moves, as attempts like these can put traders into a position where trades are held for too long and profits that had accumulated previously are quickly given back. Traders often find themselves in positions where they panic and close a position once they see their previous gains are being lost and these emotional types of reactions can lead traders to close positions at times (or at levels) that are not optimal.

 

Finding Changes in Correlated Currencies

 

One of the earliest indications in identifying a trending move can be seen when the highs for the year have started to roll over and post declines, even if this is not seen in highly correlated currencies. Examples of these situations can indicate that fewer of the correlated currencies are working to sustain the general momentum and this can serve as a hint that investors are changing their minds and have become less optimistic (or pessimistic) in these traded markets and a large correction could be forming in the process. Signals like these can alert traders to buying or selling even before your chosen currency has even made its new top or bottom.

 

Using the Advance Decline Line (ADL)

Since it is essentially impossible to pinpoint exact tops and bottoms (either in terms of price or in time), traders can look for other evidence of strength or weakness when looking to place new trades. This is helpful because even when the previous trend continues (either higher or lower), traders can take some solace in the fact that even though additional gains were missed, the initial signs of a correction were enough to close the trade as the move prudent approach.

 

One of these signs can be seen in the behavior of the Advance Decline Line (ADL) which compares the indicator activity with that of the price to determine the strength of weakness of the prior trend. For example, if the ADL is rising at times when the forex price is advancing, the established uptrend is healthy. The reverse would be true for downtrends and when there is a divergence between the forex values and the ADL reading, traders can expect changes or pauses in the trend that was established previously.

 

The ADL can provide traders with a signal that price momentum is reversing using calculations that make a comparison between the amount of advancing and declining moments that are seen in your chosen market over a given period of time.

 

Watching the Most Liquid (Commonly Traded) Currency Pairs

 

Those with experience trading these markets know that all large price movements are equal in all highly correlated currency pairs. One of the most substantial (and potentially valid) signals that a market in general in changing directions can be seen when the most commonly traded pairs post new and significant highs or lows. This can be true(and possibly easier to visualize) for stock markets as well, as the most commonly watched and traded assets are generally the ones that provide confirmation that a widespread uptrend or downtrend has reached completion.

 

So, then commonly traded forex pairs (like the EUR/USD, GBP/USD, or EUR/JPY), fail to make higher highs and higher lows (in an uptrend) or lower highs and lower lows (in a downtrend), it presents the trader with a good signal that a much wider price move is emerging. Since these tend to be larger price moves, longer term chart time frames (dailies or weeklies) are generally referred to, but this aspect of trading can be adjusted to match your more typically used time horizon. There are some differences with this approach and the first two methods, however, as the signal tends to become clear later in the process.

 

Conclusion

 

The market euphoria that grips markets in an uptrend (or the pessimism seen when markets are in a downtrend) can become attractive, and it can become tempting to enter into new positions rather than taking a step back and look for the critical signals that show whether or not the previously established trend is going to continue or reverse. But this level of discipline is an important element to remember and this is one of the contributing factors when investors look to separate themselves from the actions of simple gamblers.

 

For these reasons, it is important to dismiss any emotions or panic that arises, as this can make it difficult to remain focused on what the market is actually telling you at the moment. Both rising and falling markets will eventually see some form of correction there are generally early warning signals that can be seen before the major change occurs.

When traders are aware of these signals early on, more substantial profits can be captured and a larger portion of the following move can be forecast. These signals can prove to be helpful when making the decision to either execute a position or to stand on the sidelines until a clearer picture presents itself.