Trading With the Trend: What Every Forex Trader Must Know
One of the most common areas of confusion for forex traders is trying to determine which direction the trend will take. We have all heard the saying: “the trend is your friend till it ends”. This holds true in forex, as the institutional traders who control the majority of volume in the forex market will always trade in the direction of the trend. Many traders know that trading against the trend produces a high percentage of losses, but they still do not invest a little time in learning the correct methods of determining the trend. At the end of this article, trend determination will be a piece of cake for you.
There are three possible trends that can occur in the forex market. These are:
a) Upward trend or uptrend.
c) Downward trend or downtrend.
Each of these three trends will occur at some point in the forex market, and traders must be able to identify them correctly and trade with the information accordingly.
So what is the proper way for traders to determine the trend and trade with the trend?
1) Use the Appropriate Time Frame
Look at these two charts below:
chart a: hourly chart
chart b: daily chart
These are two charts for the same currency and during the same trading day/week. One of the charts is a one hour chart, while the other is a daily chart. Now while the trend seems to be an uptrend on the hourly chart, it is actually an upward retracement in the middle of a downtrend on the daily chart. So if a trader were to make a decision based on the supposed trend as seen on the hourly chart, that position will most likely be taken out by the down-trending price action. In confirmation of this statement, the currency in question, the EURUSD, had just begun a period of sustained downtrend that lasted for four months as a result of very unsavoury news reports coming from the Spanish banking sector and other countries affected by the sovereign debt crisis. If a trader had decided to use the hourly chart for his trend analysis and went long, he would have been stopped out.
The short term charts are not an accurate time frame to use for trend analysis. There is too much noise and very little trade direction that can be deduced from these charts. In contrast, a daily chart shows activity on a currency pair for at least 6 – 8 months, hence it is a more reliable chart for use in determining what the long term outlook (and therefore the likely trend) of a currency is.
It is advisable to at least consider using a Daily chart in conducting trend analysis for any currency pair you may want to trade.
2) Visualize the trend
By looking at the charts and tracing an arrow over the price highs of the candlesticks, the trend of the currency pair will be very obvious. If the candlesticks on the daily chart are posting progressively higher highs or lower lows, then the trend is an uptrend or downtrend respectively. There are times when the currency pair may be range-bound or trade in a tight range. This is a period of consolidation and in this situation, there is no clear trend.
3) Trading with the Trend
Once the trend has been determined, it is not good trading practice to immediately place an order in the direction of the trend. Before placing an order, the trader must first determine that the price at which the currency asset is located is the lowest it can be (for a long trade) or the highest it can be (for a short trade). In practice, there is no way a trader can always buy at the lowest point of a dip or sell at the highest point of a bounce. However, it is possible to use the nearest support/resistance levels to determine a zone in which it is safe to place your orders. This zone must be located as close to the key levels of support (for buy) or resistance (for sell) as possible so that when a stop loss is set for the trade, there is no chance of the trade going as far as the stop to take the trade out.
A trader wishing to go short on this trade should do so at point C or D. Why? This is because there have been previous resistance points formed at point A and B, and so a trader can confidently set a Sell trade on point D knowing that this point corresponds to points where strong resistance has formed. The same principle can be used on this other chart shown below.
Again, there is a strong resistance at points E, F and G, so even if a trader sets a trade at levels corresponding to resistance level G, the price would not be able to advance upwards by too much of a margin (point H) before it moves in the downward direction.