As a trader, you have probably heard the old adage that it is
best to trade with the trend. The trend, say all the pundits, is your
friend.
This is sage advice as long as you know and can accept that the trend can end. And then the trend is not your friend.
So the important question is, how can we determine the direction of the trend? I believe in the KISS rule, which says, "keep it simple, stupid!" Here is a method of determining the trend, and a simple method of anticipating the end of the trend. (Knowing when trends are about to reverse is tricky business, but the MACD can help Spotting Trend Reversals With MACD.)
Before we get started, I want to mention the importance of time frames in determining the trend. Usually, when we are analyzing long-term investments the long-term time frame dominates the shorter time frames. However, for intraday purposes, the shorter time frame could be of greater value. Trades can be divided into three classes of trading styles or segments: the intra-day, the swing and the position trade. (For more on time frames, check out Trading Multiple Time Frames In FX.)
Large commercial traders, such as those companies setting up production in a foreign country, might be interested in the fate of the currency over a long period of such as months or years. But for speculators a weekly chart can be accepted as the "long term."
Averages Moving in PairsWith a weekly chart as the initial reference, we can then go about determining the long-term trend for a speculative trader. To do this we will resort to two very useful tools that will help us determine the trend. These two tools are the simple moving average and the exponential moving average.
In the weekly chart above, you can see that for
the period of May, 2006 until July, 2008 the blue 20 interval period
exponential moving average is above the red 55 simple moving average and
both are sloping upward. This indicates the trend is showing a rise of
the euro and therefore a weakening dollar.
In August, 2008, the short-term moving average (blue) on the chart below turned down, indicating a potential change in trend although the long-term average (red) had not yet done so.
Finding the Change in TrendIn October, the 20-day moving average crossed over the 55-day moving average. Both were then sloping downward. At this point the trend has changed to the downside and short positions against the euro would be successful.
Still looking at Chart 2, we notice that the
short-term moving average goes relatively flat in December, 2008 and
starts to turn up, now indicating a potential change in trend to the
upside. But a closer look at the 55-day moving average as of December,
2008, shows that the long-term moving average has remained downward
sloping. (Learn more on how to trade using charts, read our Technical Analysis Tutorial.)
By checking Chart 2, we can see that the first arrow from the left indicates that the long-term moving average has turned down, indicating that the weekly or longer term trend for the EUR/USD has now gone down. The second arrow indicates where a new short position could have been successfully taken once the price had traded back to the down sloping moving average.
The goal here is to determine the trend direction, not when to enter
or exit a trade. Of course this is not to say that there were no trading
opportunities in the shorter time frames such as the daily and hourly
charts. But for those traders who want to trade with the trend, rather
than trading the correction, one could wait for the trend to resume and
again trade in the direction of the trend.
Double Bottom Indicator
Let's switch to Chart 3 and see what happens as the 20-day exponential moving average trades down to a double bottom.
Given that a double bottom on a chart suggests support at the bottom,
we can watch the price action on the daily to give us an advance clue.
The arrow indicates where the short-term moving average is turning up.
Once again, the moving averages are not used as trading signals but only
for trend direction purposes. (Discover how these influential levels
can switch roles, see Support And Resistance Reversals.)
Catch a WaveBy setting up a short-term exponential moving average and a longer term simple moving average, on a weekly and a daily chart, it is possible to gauge the direction of the trend. Knowing the trend does help in taking positions but bear in mind that the markets move in waves. These waves are called impulse waves when in the direction of the trend and corrective waves when contrary to the trend.
By counting the waves or pivots in each wave, one can attempt to anticipate whether a trading opportunity will be against the trend or with the trend. According to Elliot wave theory, an impulse wave usually consists of five swings and a corrective wave usually consists of 3 swings. A full wave move would consist of five swings with two of the swings being counter trend. (For more see Elliott Wave Theory.)
The image above gives an example of an Elliot
wave. Because Elliot wave theory can be very subjective, I prefer to use
a pivot count to help me determine wave exhaustion. This usually
translates into a minimum of seven pivots when going with the trend,
followed by five pivots during a correction.
Sometimes the market will not cooperate with these technical
assumptions but it can occur often enough to provide some very lucrative
trading opportunities. Below is an example of the wave in action (blue
arrows mark the direction).
The Bottom LineBy combining
the moving average diagnosis with the pivot count and then fine-tuning
the analysis with an observation of candle patterns, a trader can stack
the odds of making a successful trade in his or her favor. Remember
trading is a craft, which means that it is both art and science and
requires practice to develop consistency and profitability. (Go beyond
the basics! Learn to identify and trade island reversals, kicker
patterns and more, see Advanced Candlestick Patterns.)
This is sage advice as long as you know and can accept that the trend can end. And then the trend is not your friend.
So the important question is, how can we determine the direction of the trend? I believe in the KISS rule, which says, "keep it simple, stupid!" Here is a method of determining the trend, and a simple method of anticipating the end of the trend. (Knowing when trends are about to reverse is tricky business, but the MACD can help Spotting Trend Reversals With MACD.)
Before we get started, I want to mention the importance of time frames in determining the trend. Usually, when we are analyzing long-term investments the long-term time frame dominates the shorter time frames. However, for intraday purposes, the shorter time frame could be of greater value. Trades can be divided into three classes of trading styles or segments: the intra-day, the swing and the position trade. (For more on time frames, check out Trading Multiple Time Frames In FX.)
Large commercial traders, such as those companies setting up production in a foreign country, might be interested in the fate of the currency over a long period of such as months or years. But for speculators a weekly chart can be accepted as the "long term."
Averages Moving in PairsWith a weekly chart as the initial reference, we can then go about determining the long-term trend for a speculative trader. To do this we will resort to two very useful tools that will help us determine the trend. These two tools are the simple moving average and the exponential moving average.
 |
| Chart 1: May 2006-July 2008 |
| Source: Netdania.com |
In August, 2008, the short-term moving average (blue) on the chart below turned down, indicating a potential change in trend although the long-term average (red) had not yet done so.
Finding the Change in TrendIn October, the 20-day moving average crossed over the 55-day moving average. Both were then sloping downward. At this point the trend has changed to the downside and short positions against the euro would be successful.
 |
| Chart 2: October Short-Term Moving Average |
| Source: Netdania.com |
By checking Chart 2, we can see that the first arrow from the left indicates that the long-term moving average has turned down, indicating that the weekly or longer term trend for the EUR/USD has now gone down. The second arrow indicates where a new short position could have been successfully taken once the price had traded back to the down sloping moving average.
Double Bottom Indicator
 |
| Chart 3: Double-Bottom Support |
| Source: Netdania.com |
Catch a WaveBy setting up a short-term exponential moving average and a longer term simple moving average, on a weekly and a daily chart, it is possible to gauge the direction of the trend. Knowing the trend does help in taking positions but bear in mind that the markets move in waves. These waves are called impulse waves when in the direction of the trend and corrective waves when contrary to the trend.
By counting the waves or pivots in each wave, one can attempt to anticipate whether a trading opportunity will be against the trend or with the trend. According to Elliot wave theory, an impulse wave usually consists of five swings and a corrective wave usually consists of 3 swings. A full wave move would consist of five swings with two of the swings being counter trend. (For more see Elliott Wave Theory.)
 |
| Chart 4: Example Of An Elliot Wave |
| Source: Investopedia.com |
 |
| Chart 5: Elliot Wave |
| Source: Netdania.com |
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