In Today’s Article You’ll Learn:
- What Is The Trend And Why We Need It To Make Money
- The Reasons Why Trends Exist In Financial Markets
- How To Determine What The Current Trend In The Market Is
- A Method You Can Use To Find Out When The Trend Has Changed
Does Trend Trading Work ?
This is something I get asked a lot.
Does trend trading work ?
Of course it does, some of the richest people in the world made their money from trend trading.
An example somebody who you may have heard of (if you’re in the UK at least) who made significant amounts of money from trend trading is guy by the name of John W Henry.
If you follow football you might have heard that name before. John Henry is the owner of Liverpool football club, he brought Liverpool FC off the previous owners for £300 million! most of that money came from the profits he made running his trend trading firm.
At its height his trading firm managed 2.6 billion for clients all over the world, to be honest I think this is all the evidence we need in regards to the question “does trend trading work” if someone is able to buy an entire football club from the profits made from trend trading then I’m sure the answer is a definite yes.
What Is The Trend ?
In its simplest form, a trend is when a market moves in one direction for a long duration of time.
Trends exist in all financial markets due to two psychological biases people have.
The first bias is called Herding
If a market has been going down for a long time then traders will automatically expect it to continue going down in the future, because of this they’ll sell expecting lower prices, this in turn causes the price in the market to move lower, which makes even more people start selling.
The other bias is called Confirmation Bias
Confirmation bias comes from the way people or (traders in our case) will come up with a theory or assumption as to which way they believe the market is going and then weigh up the current evidence available in the market to determine what direction the market might go.
The important thing is these people will place considerable more attention on to the information/evidence which proves their theory right as opposed to the information which proves their theory wrong, this is because people will never prove themselves wrong, it will always take an outside force to show people who their theory is incorrect, in trading this outside force amounts to the market doing the opposite to what you thought it would do, usually resulting in you losing money.
Every trader operating in any financial market around the world will all incorporate the concept of trend into their trading method/strategy.
They have to because without a trend existing in some way shape or form they will not be able to make any money.
If the market was flat nobody would buy.
There has to be some sort of upwards or downwards movement in order for people to believe that an opportunity exists to make money.
This is why the trend is so important!
Because without it, you wouldn’t be able to make any money.
The only way for you to be able to make money from any financial market, is to either buy expecting the market to move up or sell expecting the market to move down.
So the trend, no matter how big or small it may be, represents an opportunity for somebody to make money, no matter what time frame they trade-off or what trading strategy they use.
Which Trend Do I Trade ?
“Which trend do I trade” is a common question asked by many traders.
It only takes one look at your charts to see there can be two trends taking place at the same time.
If you were to look at the daily chart, you may see the market is in a significant downtrend, however if you switch to the 5 minute chart you’ll see the market is in an uptrend.
How can this be and more importantly which trend should you trade ?
Many times in trading literature and online website’s you’ll hear people say to trade in the direction of the trend on the daily chart, this seems like good advice, I mean most of the banks and other financial institutions use the daily time frame to determine the direction of the trend so you should too.
The problem is, if for example the market was in an uptrend on the daily chart and you trade the time frames below this such as 4 hour, 1 hour, 15 minute, if your going to trade in the direction of the daily trend your always going to be late to pick up on when the trend has changed.
The market could start changing from being in an uptrend to being in a downtrend on the 1 hour chart, but because the trend on the daily chart is still up, it’s going to make you believe that’s what the current trend in the market is.
This means all the trades your going to take will be buys, most of these will end up losing you money because you have not reacted quick enough to the change of trend.
This is just another example of how common trading quotes and advice are backwards to the way in which things really work in the markets.
Swing Highs And Swing Lows
If you already have experience trading forex then I would suggest you skip this part as I assume your already pretty familiar with the concept of swing highs and swing lows.
Analyzing the sequence of swing highs and low’s is the most common method of analysis used by traders to determine which direction the market is currently trending. The reason as to why this method is so widely used is mainly down to the fact that its applicable to all time frames.
A trader on the 1 minute chart will determine which way the markets moving using the same method as a trader on the 1 hour chart, both time frames will show the swing highs and swing lows being created in the market.
Before I teach you how to determine what the current trend is, I need to show how to identify what a swing highs and lows looks like on your charts.
Swing Lows
Any time the market moves down then proceeds to move back up the lowest point the market managed to reach after moving back up is identified as the swing low.
In this image Ive have marked all the swing lows.
You can see in each swing low I’ve marked the market was initially moving down but then started to move back up, the swing low is found at the lowest point after the market moves back up, most of the time the low will be found at the bottom of the wick on a candlestick.
Swing Highs
Swing highs are the exact opposite of swing lows.
When the market moves up then moves down the highest point the market reached after the move down is called the swing high.
This is the image we just looked at but with all the swing highs marked instead of the swing lows.
As with the other image you can see from this that when the market has some sort of move up followed by a move down a swing high is created.
It’s good practice to spend some time going through your charts marking swing highs and lows, this will help you pick up the concept of swing highs and lows quicker.
Defining A Trend
Defining what the current trend is, is incredibly important if we want to make significant profits from the market.
If we don’t know what the trend is then we will not be able to make any decent money, if we get the direction of the trend wrong, in other words if we think that the market is a downtrend when it’s really in a uptrend, then all the trades we place will have a lower probability of working out, meaning we have a higher chance of losing money.
Luckily now that we know how to identify what swing highs and swing lows look like we can use them both together to generate a clear bias as to which way the market is currently trending.
Determining Downtrends
Downtrends can be defined by the market making successive lower swing lows followed by lower swing highs.
This image is taken from the daily chart of the EUR/USD.
A quick note:
You can see on the chart I’ve marked LL and LH
LL means this swing low is lower than the previous swing low
LH means this swing high is lower than the previous swing high
The chart above is a good illustration of using swing lows and swing highs to determine the downtrend.
Every time the market made a swing low it was followed by a lower swing high, this means that everyone in the market is accepting lower prices, their happy with the fact that the market is moving lower and have decided to keep selling.
When a lower swing low is made, this also confirms to us that people are happy with the market moving lower, if they didn’t want the market to move lower they would buy before the market makes a new low.
Determining Up-Trends
Uptrend are characterized by higher swing highs followed by higher swing lows.
This is weekly chart of USD/JPY
Just by looking at the swing highs and lows USD/JPY is making we can determine that this market is currently in an uptrend.
Note:
HH means this swing high is higher than the swing high found immediately before it
HL means this swing low is higher than the previous swing low found before it
The psychology of the traders during an uptrend is the opposite of what it is during a downtrend.
The higher swing highs and lows in an uptrend tell us people are happy with the market rising to higher prices. If the market was to suddenly stop making higher swing highs then that would suggest to us the market may be about to change direction.
Which brings me on to my next point.
How Do I Know When A Trend Has Changed ?
So far we’ve learned what a swing high and swing low looks like and also, how to determine what the current trend in the market is by looking at the sequence of swing highs and lows.
There’s one more thing we haven’t yet discussed, how do you determine when the trend has changed ?
Knowing when the market has changed direction from being in an uptrend to a downtrend and vice versa is hugely important.
The quicker we are to pick up on any trend changes the earlier we can be in getting an early entry into a potential new trend.
To tell when a trend has changed we again need to use our understanding of swing highs and lows.
From Downtrend To Uptrend
We’ll start with understanding how the market goes from being in a downtrend to being in an up-trend.
Earlier I explained that a downtrend is characterized by the market making consecutively lower swing lows and lower swing highs, so for a downtrend to turn into an uptrend we need to see some sort of break or change in that sequence.
This break comes from the market making a higher swing high followed by a higher swing low.
I want you to look at the swing high with the tick above it .
This high is higher than the swing high with the arrow pointing to it, when you see this its telling you that something is changing in the structure of the market.
At this point however we do not know if this is a change of trend due to the fact that no higher swing low has been made yet.
Now I want you to look at the higher swing low marked with a tick below it.
This swing low is higher than the previous swing low which has the arrow pointing to it, when this happens it tells us that the trend has in fact changed, now we are in an uptrend as opposed to being in a downtrend.
You can see after the higher low has been made the market starts to advance significantly, making another swing high which is far away from the one I marked with a tick.
When you see the market change from being in an downtrend to an uptrend then you should only be placing buy trades.
The odds of a new trend continuing are very high even if we have 1 winning trade and 3 losers as long as we continue holding the winning trade until the end of this trend we will make a lot of money, more than enough to cover whatever losing trades we might have had.
From Uptrend To Downtrend
Now I’ll show you how to tell when an uptrend has changed to a downtrend, the method we use to do this is exactly the same as what we have just talked about only the other way around.
Before we was looking for a swing high to break a previous lower swing high, in this case though we are looking for a swing low to break a recent higher swing low.
The EUR/USD was in relatively small uptrend until the market made a lower swing low seen on the image as LL.
If we was watching this unfold before us we would know that a lower low does not constitute to a trend change on its own, it needs to be followed by a lower swing high which we see not long after.
When we see that a lower swing high has been made we know for a fact that this market is now in a downtrend, so all of the trades we’ll be placing from now on will be sell’s because we want to take advantage of this new downtrend.
Summary
Knowing when a trend has changed is one of the main problems traders face in the markets.
There are many different methods people use to try and work out when the trend has changed, some use fundamentals, others use indicators, the concept of analyzing the swing highs and lows being made in the market is one of the oldest technical trend identification methods around.
Just because this method is very old ( analyzing swing lows and highs has been in use for at least 100 years ) does not mean its no longer effective. Personally I think its the best way to identify a trend change in the market without having any knowledge of fundamentals, which can be very complicated to new and experienced traders, I hope you have enjoyed reading this guide, if you would like any more information on trends please leave your questions in the comments section below.
