Hello Forex Traders!
Last week’s article discussed the importance, but also the challenges of defining trends. Almost every trader is interested in the concept of trend, and every trader in fact should be. Irrelevant of the fact whether you are a trend trader, a reversal trader or a range trader, all of the aforementioned trader types must know what the trend is before they can decide if they should trade where and when. Basically last week we focused on the significance and potential problems of trends, and if you want to read part I, please do so by clicking on this link.
In today’s article part II we will in fact discuss methods to help with the trend definition in more details. There are many ways a trader could define the trend direction. Let us review them one by one.
Classical highs and lows
Obviously the number one trend definition of all times is the sequence of higher highs (HH) followed by higher lows (HL), or lower lows (LL) followed by lower highs (LH). When price can break through resistance and make a new high or when price can break through support and make a new low, that means:
1) there were enough buyers to push price through resistance or there were not enough sellers at resistance
2) there were enough sellers to push price through support or there were not enough buyers at support
If price pullbacks and finds demand for the currency, then we get a higher low in an uptrend or a lower high in a downtrend. That means that traders were willing trade it a different level than a stop or bottom. Often enough this happens at a Fibonnaci retracement level.
In an established trend, Forex traders are willing to buy and sell at Fibonacci levels, such as the 382, 500 and 618 retracement Fibs because they are aware of the fact that these levels will provide support and resistance as well. They are willing to risk capital in such cases half way in between the tops and bottoms. In range environments, this concept does not apply, because then traders are waiting for price to reach tops and bottoms which could act as a barrier.
Easy way of spotting highs and lows
Obviously analyzing whether there are subsequent higher highs and higher lows and lower highs and lower lows is an important task. One way of simplifying that process is by using the Fractals or Fractal indicator. I do not consider it an indicator myself, but more of a simple tool which provides a great visual support in spotting highs and lows.
The fractal shows spots on the charts where a candle high or low is the highest or lowest of the 2 candles to the left and 2 candles to the right. Tops and bottoms are always fractals, but not all fractals are tops and bottoms. Some fractals are just more important than others, and that depends of course how much price action is below the fractal. A price level or area which has proved to be significant resistance or support in the past is of course a key level for the market. Those levels are referred to as tops and bottoms and are tough levels to break. A price level which has, for instance, has provided resistance for a couple of hours is not as crucial for most traders.
The fractal indicator is invented and created by the great trader Bill Williams. Any trader should be able to add the indicator without any problems. For MT 4 users: go to “Insert”, “Indicators”, “Bill Williams”, and “Fractals”.
Corrective chart patterns
If a top or bottom, high or low, or Fractal, does not break, then this could mean a temporary halt in the trend. A lower high in an uptrend or a higher low in a down trend could point to a corrective chart pattern such as a wedge, triangle and flag. Often enough these are continuation patterns, or at least in a high percentage of the cases. The chart pattern could take a while for the correction to finish, but a break of the chart pattern and then top (uptrend) or bottom (downtrend) signals the trend continuation.
In some cases the retracement goes deeper and a small series of HH’s and HL’s occur within a downtrend, or LL’s and LH’s occur within an uptrend. In these cases the currency is either shifting trends on that particular time frame, or it could still be a retracement on a higher time frame. Therefore, checking one time frame higher and assessing the nature of the move (corrective or impulsive) will help with determining whether there is a new trend in place or whether this is a retracement pullback. This is often the times when Forex traders get confused with defining the trend. And as always, talking about theory is always easier than actually implementing the theory. That is why we have our own live trading room. Here you can gain the experience needed to succeed with trend trading by looking at us. For more information, check out this link.
Trend channels & Moving averages
When a Forex trader connects the highs and lows with each other using trend lines, a currency pair can build a trend channel. The trend channel is a great tool in trends as it helps clarify whether there is a long term trend or not, and it also helps provide a guidance for potential support and resistance.
In theory, you can have 2 HH’s and 2 HL’s, and 2 LL’s and 2 LH’s but that trend is most likely quite fresh and new. When multiple series of HH and HL’s can be detected, a pattern is established and a trend is confirmed or mature. This pattern can be visualized often enough by a trend channel, which connects those subsequent tops and bottoms.
In an uptrend, the bottom of the trend channel will provide support, whereas the top will act as resistance. Forex traders are especially interested in buying close to support and taking profit close to the resistance in an uptrend, and also avoiding taking longs close to the top of the channel. The opposite holds true for a downtrend.
Moving averages can have the same the effect as trend lines and channels. They too can be used to gauge trend direction and potential support. Of course the moving averages are not used for crossovers (poor system), but for something totally else. Moving averages are important due to their angle, the differentials between them, and identifying which fractals are vital. The advantage of the moving averages is that they are more flexible than trend channels. The disadvantage is that they only provide support in an uptrend and resistance in a downtrend, whereas the channel shows areas for both sides.
Exactly how we use the moving averages and trend channels, what angle we look for, what moving average we use, what fractals we deem critical, how we define retracements and reversals, what characteristics we seek in trend channels, what levels within the channel are vital, are concepts which we unfortunately save for our trading room members and mentoring students only. Sorry but hope you understand. In a certain way, if you like, it could be similar to Coca-Cola sharing its exact recipe.
Another tool that a Forex trader could use is the Ichimoku indicator, which has the benefit of providing a Forex trader with directional guidelines as well as support and resistance, just like moving averages. It does provide other information as well, and has multiple layers of information in just 1 tool. Read here more. The disadvantage is that it clutters up the chart quite a lot.
Candle highs and lows are always natural support and resistance levels, and do a decent job of identifying where potential support and resistance can kick in. Also, if a candle is breaking the highs of the previous candles and the lows are not break the previous lows, then an uptrend is in place with these series of candles. A series of candles can last in a trend for quite a while, and in fact can turn into an impulse. An impulse can happen within all environments, with the trend/trend reversal/range, but happens most frequently in trending structures.
Which methods do you use for trend definition? Are there tools which you use that are not mentioned in the above article?
Thanks for reading and sharing and wish you Good Trading!
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