Trend following is reputed to be one of the most profitable forex trading strategies. The success and potential of this style has been confirmed and popularized by the exploits of traders of legendary status, such as Ed Seykota, Richard Dennis, and Richard Donchian in the 80’s, and the passing years since then have only reinforced the already strong evidence about the validity of this strategy. In this article we’ll define what a trend is, and will supply you with some guidelines about the drawing of trendlines.
What is a trend?
A trend is a period during which prices have strong directionality. Unlike the more common patterns of range trading where volatility is dominant and prices go nowhere, the price action in a trend has a driving force behind it which cannot be erased by short term price fluctuations. In an uptrend, demand for an asset cannot be absorbed by supply for a significant period of time. In a downtrend, the opposite is the case, as there are more sellers than buyers.
Cause of a trend
In almost all cases, trends are created and maintained by strong fundamental factors. Although technical indicators and patterns are useful for trading a trend by identifying buy or sell signals, they are usually not sufficient to maintain long term trends. Speculators participate in and create forex trends, but businesses which have no interest in speculating are also important actors in the market.
Drawing the Trendline
There is an important caveat about trend lines. It is possible to draw a trend line between any two points on a chart, but it is clear that trends don’t always exist between two such random extremes. In order to identify real trends, and not to get absorbed in periods of volatility, a trader can choose to trade only those events where the price chart itself is showing clear directionality recognizable with a cursory examination. The other important point is to ensure that while drawing the trandline you connect as many extreme values as possible, and not just some outlying exceptions. To connect the ends of spikes, while ignoring the main body of the trend is one of the mistakes common to novice technical traders.
Two kinds of trend lines exist. In an uptrend, the trendline is drawn below the price action, connecting successive bottoms. In a downtrend, the trendline is drawn above the price, and connects successive tops.
Isolate a reasonably smooth part of the price action.
As we observe in the highlighted section of the weekly chart below, the price action in the EURUSD pair evinced considerable upward momentum soon after the end of 2001. The periods of consolidation were mostly flag patterns which signify continuation, and most successive weeks closed up, while zigzags were few and relatively tame. As such, the establishing uptrend presented strong momentum that was easy to identify visually (you can observe the clear rise of the EUR against the dollar), allowing us to regard it as a
Identify two extremes that are close to each other
The most important aspect of drawing a trend line involves the identification of price extremes. You can choose them visually, or you can use indicators like oscillators to identify them for you. In the graph below, we have chosen to points where extremes in the price action coincide with extremes in the Williams percent range indicator, and combined them to build our trendline. One does not always need to use indicators in this manner, but in more complex charts the additional information can help us identify trends easier. We should also add that while analyzing trend we should ensure that we are using trend analysis tools, such as the MACD, and not range indicators like the RSI.
Extend the trend line to include more extreme values
After creating our line on what we believe to be an incipient trend, we will connect as many successive rebounds from the trendline in order to create a strong trigger line for our future trades. As we see in the picture below, even after the price action broke below the trendline and invalidated it, its extension provided a powerful resistance against bulls who tried to take the price higher subsequently. While drawing the trendline, we’ll try to make sure that we connect as many tops or bottoms as possible, as it is always the case that the longer it holds, the stronger the trend will be.
Note that it is also possible to draw the trend by skipping the first phase altogether. However, some traders choose to get into the action as early as possible, and trusting their own judgment, they will not wait till a trend has developed fully to make visual identification easier. In general, it is safer and easier to trade solid, well-developed trends which combine many successive reversal points.
After drawing the trend, we’re ready to trade it by joining as soon as the price action hits the trendline.
Conclusions
It’s not difficult to draw a trendline, but as with any activity, success comes with practice, and experience. Forex is similar to mathematics: there’s no spectator in the game, and someone who’s watching from the sidelines can never expect to achieve any proficiency regardless of how long he remains an observer. Similarly, without the necessary training, we can read all the forex broker reviews in the world, and the information will not bring us a single step closer to profitability. Successful combination of theory and practice was the way of every single successful trader in the past, and it will be the same for future traders as well.