Just Follow the Trend…ah? What’s a trend?

Just Follow the Trend…ah? What’s a trend?

Back in the early days of forex trading everyone would tell you: Just identify the trend and trade in the same direction: that’s everything you need to do to trade profitably. But, what exactly is a trend? How can we identify it so we increase the odds of being profitable?

There are practically thousands of ways in which we can determine the trend: based on technical indicators (such as ADX or moving averages), based on levels (break out of important support and resistance levels), Fibonacci (projections), and more.

But which one of those techniques can help us better understand when the market is trending and when is that trend has a probability to reverse. This article will help you get a better idea based on a simple yet effective methodology to determine the trend and key levels where the trend is likely to reverse.

The Million dollar question: What’s a Trend?

According to the NFA the trend is “The general direction…in which prices has been moving” (this or more generalist?) AsiaChart goes a little further describing the trend as “A prevailing direction of the market…during the course of a term”. And that’s exactly what we were after: Yes, the trend is the direction in which prices have been moving but you need to specify on which periods of time you are focusing on.

A while back, I was trading 15 min chart and was absolutely sure that the Pound was trending down, I had no doubt about it, I was about to take a short term trade but turned on Bloomberg just to make sure I was making the right decision. They were explaining the favorable conditions for all European currencies (including the Pound). I was shocked, and finally decided not to take that trade.

Who was wrong? My 15-min analysis or the one from Bloomberg analysts? Neither.

Let me explain, I was focusing on the short term charts while Bloomberg had a longer term outlook (weeks) I was focusing on days or even several hours. By the way, that day the Pound plumbed for about 100 pips (which would had hit my take profit order because I usually use around 70-60 pips on my short term trades). And to my surprise, the next week the market went up again and gained around 300 pips…so we were both right, we were focusing in different timeframes.

So for now, there could be as many trends as there are time frames on each chart. So make sure whenever you are asking someone else opinion on your analysis please tell him/her the time frame you are focusing on…

The General or Prevailing Direction

Ok, we have answered the second and easiest part of the trend. Now we should focus on the first and most important part of it: The General or Prevailing Direction.

To help us answer that part, we are going to use a very old technique: Pivot Points. Let’s dive in PP a little to get familiar with them because they are an important tool that can help us identify the general feeling of the market.

Pivot Points (PP)

Usually pivot points are used to predict possible support and resistance levels (S1, R1, S2 and R2). These levels are calculated using the PP as a reference, but we are not going to calculate those levels as we don’t try to forecast any level, we like to let the market tell us which levels are important.

To calculate today’s PP simply take the following data of the previous day:

Close Price (C)
High (H)
Low (L)

The formula is:

PP = (H + L + C)/3

Let’s see a concrete example.

The chart above is the USDJPY 5 min. The red line is the PP for the 27th of August (calculated from H, L and C taken from the 26th). In this chart it is clearly seen the level in which bulls (buyers) want to take control over the market was around 116.13. Every time the market approached to that level bulls entered aggressively pushing up the market (support). At one point however (around 15:20), bears (sellers) sold aggressively just at the PP making the market fall down below the PP. Once the market is below the PP, notice how sellers start trading aggressively when the market approaches to the PP (the support has now become an important resistance).

The paragraph above is how you can address that level as an important support and resistance. But imagine that level as a sentiment measure instead of an important level. And that’s exactly how PP was meant to work: as a measure of sentiment.

When the market is trading above the PP it said that the sentiment is slightly bullish. Obviously bulls will act aggressively (Zone A) when the market approaches to the PP because they know once the market goes below that level, bears won that battle. The same goes when the market is trading below the PP, as the market is seen as slightly bearish, every time the market goes up to the PP bears will enter aggressively (Zone B) as an attempt to take prices to lower levels (again).

A Different Approach to Measure the Trend

We are getting closer to the definition of the trend, we know there could be different trends in the same currency and now we know how to measure the sentiment of the market. But we are short yet, we need an objective way to determine the trend. We need to know exactly when the market is trending up, down, slightly up, slightly down, or not trading at all.

To do that, we are going to add some levels that will give us some more insight:

LOPS1 - Low of the previous session
HOPS1- High of the previous session
LOPS2 - Low of the session before the previous session
HOPS2 - High of the session before the previous session

We take the previous session high and low, and draw those levels on today’s chart. The same is done with the session before the previous session.

The psychology behind this approach is simple. We know that for some reason the market stopped there from going higher/lower the previous session, or the session before that. We don’t know the reason, and we don’t need to know it. We only know the fact: the market reversed at that level. We also know that traders and investors have memories. They do remember that the price stopped there before, and the odds are that the market reverses from there again (maybe because the same reason, and maybe not) or at least find some support or resistance at these levels.

At first glance it might seem a little complicated but let’s throw those levels into a chart and you will see how they can help you determine the trend and its strength at any time.

Lets take a closer look to this chart. Our day of interest is October 18th. HOPS1 and LOPS1 are taken from the high and the low of October 17th while HOPS2 and LOPS2 are taken from the low and the high of October 14th.

Right at the beginning of October 18th session, the market went above the PP. This tells us the market has a slightly bullish sentiment. But notice how at point 3 the market makes it first attempt to break HOPS1 and HOPS2. This is a natural resistance zone as the market reversed around those levels on October 17th and 14th. Finally the market makes it above HOPS1 and HOPS2, at that point we are sure the market is trending up.

Golden Rules for Trend Detection

Market Trading above the PP – Slightly bullish sentiment
Market Trading below the PP – Slightly bearish sentiment
Market above HOPS1 – Definitely trending up
Market below LOPS2 – Definitely trending down
Market above both HOPS’s – Strong uptrend
Market below both LOPS’s – Strong downtrend

Here are some questions you might be asking…

How can this information help me as a trader?

With this information you can make some rules for your trades, for instance:

The market is trading between HOPS1 and LOPS1 – There is no definite direction, so under these circumstances long and short trades are in play.

The market is trading above HOPS1 – Here we are absolutely sure the market is trending up, it is easier for the market to continue going up than down, so will disregard all short trades and focus only on long opportunities.

Sometimes the high of the day is printed above HOPS1, if we don’t take a short there we could miss a profit opportunity? The same goes when the market is below LOPS1, the low of the session could be printed there, with this set of rules we can’t take those trades…

Yep, if you are thinking this you are absolutely right. But you should know that picking top and bottoms is definitely not the way to go, the accuracy of your system will drop substantially. The main point I’m trying to make here is: if the market has been going up, why go against it, its easier for the market to continue its way up than turning around, isn’t it? So why go against the trend? The same goes when the market is trading below LOPS1, it’s a definite trend, at that point we know it is easier for the market to go down than up, why decreasing the probability of success trying to catch the bottom if we have the opportunity to short the market and follow the flow, the way of least resistance/support?

Isn’t this approach a bit subjective?

I don’t think so, in fact, I think it is more objective than following any other indicator, why? Because only one pip above HOPS1, you would be only looking for long trades, one pip below HOPS1 both trades are in play, it’s that easy. Now, remember the market reverse there the last session, if the market gets past HOPS1 for instance, then the force that was holding the market from reaching newer levels is gone leaving you the opportunity to follow the flow.

Conclusion

The market is always changing and it can always behave in a thousand unexpected ways. We need to adapt our strategies to the market conditions because the market will never adapt to our strategy. Using this simple methodology to determine the trend can help you take better trading decisions, trades with higher probabilities because you are just following the way of the least resistance/support.

Just Follow the Trend…ah? What’s a trend?

Just Follow the Trend…ah? What’s a trend?

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