Trading trends we love and hate

Dear Traders,

You have probably heard many times before that the trend is your friend. Financial trends are created by powerful institutions and different economic factors. That's why I always say traders should follow the banks. Think of the bank as a shark and yourself as a small fish - not big enough for the shark to want to eat. The smaller fish always follows the shark and eats the remnants of the shark's food. In trading terms that is exactly what you should do - follow the big companies that actually shape trends, so you can avoid being caught on the wrong side of the market.

The trends we love

Usually, the most difficult aspect of trend trading is trying to figure out when a trend is about to begin with. Typically, trends in a new direction will start with a reversal pattern and MACD divergence.

When a new trend takes shape, the market is likely to begin making thrusts and pullbacks in the trend direction. This is when we use our systems and methods to actually pinpoint a good entry - follow the sharks. If you are patient enough, you will hold on to a trade during a trend and make the most of it. The best trend moves happen when the fundamental picture agrees completely with the technical picture as in this example. By simply aligning fundamental reasoning with technical knowledge, we get no brainer trades i.e. money for jam.

The trends we hate

The Forex market is much more active and fast paced than the conventional stock market and traders definitely need to be cautious. In this highly dynamic market, the market's prevailing supply and demand forces will always affect the currency rates.

But the law of supply and demand also states that prices needs to be in equilibrium. In our everyday life, we observe the equilibrium as a natural process. For example, If a company sells something too expensive, nobody could afford it. On the other hand, if a company sees that it can sell at a higher price because more people want its product - it will. The same is true in the Forex market.

Highly dynamic movement means established trends can often lead the exchange rates to soar too high or low. Consequently, the demand and supply curves will stray far from equilibrium - which is when it gets tricky.

As a result, the central bank is compelled to intervene in the floating market to control the foreign currency exchange rates. This form of intervention is primarily driven by pressure from external sources. The latter aim to stabilize currency rate fluctuations, as investors will hold back their investments if the currency rate is way out of equilibrium. As the central bank plays the vital role in stabilizing the economy of a country, it is forced to step in to curb the fluctuating prices - otherwise known as dirtying the float.

Once there is intervention, we will see a strong one-way directional movement in the exchange rate. This means either the end of a trend we know of, or a huge retracement in the opposite direction. Either way, this is the time when we need to be ready for a possible trend change and analysis re-assessment.

A new trading approach

daxs.jpg

Aside from Forex trading, many traders specialise in other tradeable markets ranging from commodities, gold and company shares to the stock markets. Indices are one of the key markets that I have been monitoring. Indices are an index value of the share price of the various listed companies in that particular share index. It is an Index value, because at some time in the past when the index was normally created (i.e. the base date), its value started with 100 or 1000 points. This would represent the share prices of each of those listed companies in the index, on the base date. For example, the Dax30 index (covering Germany's top 30 companies by market capitalisation) had:

  1. a base date of 30 Dec 1987 and it was 1000pts; but
  2. by April 2015, it touched above 12,400pts; so
  3. in 28 years, it went up 12.4 times or 1240%.

To basically explain how indices change their value in points - as companies grow in size they may force their way into the index and force out the smaller companies. Over time with inflation, listed companies tend to grow their revenues and earnings, which causes the share price to go up. And this is where the indices increase in points. Conversely, during an economic downturn the opposite will occur.

I find that when analysing trends in indices:

  1. using the Simple Moving Average (SMAs) like the 7 day SMA, 20 day SMA and 200 day SMA; are
  2. often very strong references for support and resistance on most of the key Timeframes; such as
  3. 1 min, 2 min, 5 min and 1 hour, 4 hour and Daily.

On the lower timeframes, during strong upward momentum, the Indices will honour the 7 SMA as support for upward movement - with any retracement touching the 20 SMA.

Conversely, during strong downward momentum, the 7 SMA will be strong resistance and the 20 SMA may act as higher level resistance for any abnormal spikes upwards. I also find that the 200 SMA, usually acts as key support or resistance on each of those timeframes. It's therefore important to know where the latter are, for any potential reversal or breakout positions. Always look for a confirmation candle around the 200 SMA mark, for a possible breakout or reversal. Based on these basic rules, you may use other confirmation indicators like MACD and RSI, along with technical chart patterns to assist with your trade entries. You can clearly define your Stop Loss around those various levels of support and resistance too - around the 7SMA, 20 SMA, and 200 SMA's. It's not rocket science, just another market to trade in.

Strong correlations also exist with the Japanese Yen pairs and equities. So if you like trading Yen pairs, you may want to keep an eye on the stock markets because risk-on/risk-off sentiment prevails in these markets.

Have you ever been captured in a wrong trend? Feel free to let us know in the comments below.

Cheers and safe trading,

Nenad

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