Trading with the trend is trading with the flow. When the prevailing trend is up, why would you want to look for short entries when buying might result in much smoother trades? Many amateur traders, even when facing a long-lasting trend that has been going on for months, can’t stop trying to predict reversals, whereas they could have made so much more money by simply joining the trend.
But even if you are not a trend-following trader, you can combine the concept of trading with the higher timeframe trend with your regular trading approach: you start on the Daily timeframe and see if the trend its up, down or sideways and you use that information on your lower, execution timeframe to time your trades (read here: how to perform a multi-timeframe analysis). To be able to correctly read price action, trends and trend direction, we will now introduce the most effective ways to analyze a chart.
Intro: The different market phases
Before we start going over how to identify the trend, we should be first clear what we are looking for. Markets can do one of three things: go up, go down, or move sideways.
The picture above shows you the three possible scenarios and how markets keep alternating between the phases. But knowing what has happened after the fact is always the easy part. The hard part is finding out what is currently happening when markets are moving in real time and the space on the right is empty – that’s where this article comes in. To be clear, the article is not meant to show you how to identify trading entries, but to understand price and trends in a more efficient way.
1. The simple way: line graph
Most traders only use bars and candles when it comes to observing charts, but completely forget about a very effective and simple tool that allows them to look through all the clutter and noise: the line graph. The purpose of bars and candles is to provide detailed information about what is happening on your charts, but is this really necessary when it comes to identifying the overall trend? Probably not.
A trader would do well to zoom out from time to time (at least once a week) and switch to the line graph to get a better and clearer picture of what is currently happening. And since our only goal is to identify the direction, the line graph is a perfect starting point, especially when we are on the higher timeframe and just want to identify the overall market direction.
2. Highs and lows
This is my personal favorite way of analyzing charts and although it sounds so simple, it is usually everything you need. The conventional technical analysis says that during an uptrend you have higher highs because buyers are in the majority and push the price higher, and lows are also higher because buyers keep buying the dips earlier and earlier. It works the same during a downtrend: lows are lower when the seller surplus moves price lower and highs are lower because sellers sell earlier and buyers are not as interested.
Again, it is not too important to get totally lost if you are using the trend direction just as a filter for your trades. In most cases, you should be able to tell relatively quickly whether you are in an uptrend, in a downtrend or in a range.
Rule of thumb: If you can’t tell what is happening on your charts quickly, it is usually better to stand aside until you can see clearly again.
3. Moving Averages
Moving averages are undoubtedly among the most popular trading tools and they are great to identify the market direction as well. However, there are a few things to be aware of when it comes to analyzing trend direction with moving averages.
The length of the moving average highly impacts when you get a signal when markets turn.
A small (fast) moving average might give a lot of early and false signals because it reacts too soon to minor price movements. On the other hand, a fast moving average can get you out early when the trend is about to change.
A slow moving average might provide signals too late. Or, it can help you ride trends longer when it filters out the noise.
In the screenshot below we used the 50 EMA which is a mid-term moving average. You can see that during an uptrend, price always stayed well above the moving average and once the price has crossed the moving average, it entered a range. In a range, price does not pay too much attention to moving averages because they fall in the middle of the range, hence average.
If you want to use moving averages as a filter, you can apply the 50 MA to the daily timeframe and then only look for trades in the direction of the daily MA on the lower timeframes.
4. Channels and trend lines
Channels and trend lines are another way of identifying the direction of a trend and they can also help you understand range markets much better.
Whereas moving averages and the analysis of highs and lows can also be used during early trend stages, trendlines are better suited for later trend stages because you need at least 2 touch-points (better 3) to draw a trendline.
I mainly use trendlines to identify changes in established trends; when you have a strong trend and suddenly the trendline breaks, it can signal the transition into a new trend. Trendlines during ranges are ideal when it comes to finding breakout scenarios when price enters the trending mode again. Also, trendlines can be combined with moving averages nicely because of the complementary characteristics.
If you want to learn more about trendlines, take a few minutes and watch our video here: learn how to draw trendlines.
5. How to use the ADX indicator
The ADX is an indicator that you could use to determine the direction of the trend and for the strength as well. The ADX indicator comes with three lines: the ADX line that tells you the strength of the trend (we deleted this line in our example, since we only want to analyze the direction of the trend), the +DI line which shows the bullish strength (green line) and the -DI line which shows the bearish strength (red line).
As you can see in the screenshot below, the ADX signals an uptrend when the green line is on top of the red line, and it signals a downtrend when the red line is higher than the green line. When the price is ranging, the two DI lines are very close together and hover around the middle.
The ADX can be combined with moving averages nicely and you can see that once the DI lines cross, the price also crosses the moving average. In the video below we explain how to use the ADX in more detail with the other concepts.
Combining the best trading tools
As we have seen in this article, every tool and concept has its advantages and limitations – nothing will work all of the time. However, it is not necessary that you find a way to achieve a 100% win rate (which will not happen anyway) as long as your winners are bigger than your losses.
In the end, it comes down to how well you choose your trading tools, how well you understand them and how good you are when it comes to applying them to live market conditions.
The original article is written by Rolf, appears on tradeciety.com and is available here.