When a market is moving in one general direction from left to right on the chart, either up or down, it is called a trend or a market bias. If a market is moving up, it’s said to have an uptrend or a bullish trend, if it’s moving down it’s said to have a downtrend or bearish trend. These can also be called bullish bias or bearish bias.
The most obvious and important trend for us as swing traders, is seen on a daily chart. Trends may be small or large in size, it depends on your time horizon and time frame.
Short-term counter-trend pressure (movements against the broader trend) tend to be aborted and result in subsequent failures. Over 70% of counter trend movements fail, so it’s important we try to stick with the broader trend where possible.
Dominant market trends are like comparing a cruise liner to a runabout speed boat, dominant trends are slow, cumbersome and take a long time to gain momentum. They are the most important influence on price behavior on all time frames being traded. To determine the dominant daily chart trend we generally want to look at the last 3 to 6 months of price data. Note: A “long-term trend” is typically identified by taking an even longer-term view by looking at a weekly or monthly chart. We are mainly concerned with the dominant daily chart trend and the short-term daily chart trend. More on the weekly / longer-term trend later.
Short-term trends that are in line with the long-term trends tend to result in continuation and increase profit potential as well as increase risk reward scenarios. To determine the short-term trend we are looking at the last 1 to 3 months of price data.
It’s important to always refer up to see what the time frames above the one you’re looking at are doing. Example: if you’re looking at trading a 1 hour or 4 hour chart, be sure you know what the daily chart is doing and whether or not it’s trending and which direction it’s trending if it is. You always want to make sure any intraday trade you’re considering (1hr or 4hr time frame) ‘makes sense’ with the daily chart price action (PA) and trend.
You will generally want to trade the 1hr or 4hr in the same direction as the daily chart trend (ideally after a retrace back to a daily chart value area, more on this later), and if you are considering trading against that daily trend on the 1hr or 4hr, you better be damn sure that the counter-trend intraday signal has formed rejecting or false-breaking at a very strong / obvious key daily chart level of support or resistance, more on this later.
Don’t get ‘tunnel vision’ on one chart time frame, you want to know if you’re trading in-line with the higher time frame trend if you’re considering a 1hr or 4hr chart trade. In some cases, as in a daily / weekly trend, it’s OK to trade against the higher time frame trend, more on this later as well.
Chart Time Frames
Chart time frames range between 1 minute to 1 year or more. We are only going to be concerning ourselves with the 1 hour time frame and up, more specifically; the 1 hour, 4 hour, daily and weekly time frames, and occasionally the monthly.
Larger time frames, tend to provide more reliable / stronger trends and price signals. This means that a trend formation on a weekly or daily chart has more weight than that of a 1 hour or 4 hour. A trading pattern and trend on an hourly chart will have more reliability than a 5 minute chart etc.
Trading from a 1 hour chart is more reliable than a 30 minute chart, and a Daily chart is more reliable than a 4 hour chart in terms of perceiving a trend bias as well as identifying price action trading patterns…you get the idea.
Again, the higher the time frame, typically the more weight the trend and price action trade signal has.
I won’t cover all the reasons why I prefer higher time frame charts, and specifically the daily chart, because you’ve probably already read a lot of my free lessons on this, but for those of you who may have missed them (you should read them), here are the links to a few:
All examples that follow in this course are daily charts unless otherwise marked on the chart or in the text. The daily chart trend is the most important trend.
How to Identify a Trend Using Raw Price Action
I have always been a strong proponent of visual observation of the raw price action of a market, as you probably know. I also believe that simply observing a market’s raw price action, from left to right, is the easiest and most effective way to identify a trend and to spot high-probability entries within it.
As a market moves higher or lower, its previous turning points, or swing points as I like to call them, become reference points that we can use to help us determine the trend of a market. The most basic way to identify a trend is to check and see if a market is making a pattern of higher highs and higher lows for an uptrend, or lower highs and lower lows for a downtrend. This is just plain old visual observation of a market’s naturally occurring price action…no mumbo-jumbo trading systems or ‘magic-bullets’ here. I’d like you guys to take a look at this simple diagram that I drew below; it shows us the basic idea of looking for higher highs (HH) and higher lows (HL) for uptrends and lower highs (LH) and lower lows (LL) for downtrends:
Note: each colored circle is highlighting what we would consider a ‘swing point’ in the market:
In the diagram above and chart below, you’ll notice that in green I have marked where the trend changed from down to up. As price broke up above that first blue higher high (HH), a new uptrend was tentatively ‘confirmed’. I say tentatively because you need to remember that nothing is ‘for sure’ in the market…a trend can begin and end quickly or it may persist for months. As traders, all we can do is trade what we see on the chart in front of us while also remembering market conditions can change in a flash, thus don’t become overly attached to a particular position or idea….just look at the price action on the chart and act accordingly.
Here’s a real chart example of what I just discussed in the diagram above. It’s important to remember that in real-life trading, it will take you some screen time to get good at identifying trends and trend changes based on price action; not every situation will be as clean looking as the drawing I made above.
Thus, general observation of a market’s swing points is the first point of call in determining if a market is trending. If you do not see a pattern of HH HL or LH LL, but instead you see sideways price movement with no obvious general up or down direction to it, then you are probably looking at a range-bound market or one that is simply chopping back and forth.
Tip: You shouldn’t have to think too hard about whether a market is trending or not. Most traders make trend discovery WAY too difficult. If you take a common sense and patient approach, it’s usually fairly obvious if a market is trending or not just by looking at the raw price action of its chart, from left to right. Make sure you mark the swing points on your chart, as it will draw your attention to them and help you see if there’s a pattern of HH and HL or LH and LL, as discussed above.
Trending vs. non-trending price action
In the chart below we can clearly see an example of a downtrend followed by a trading range and then another downtrend. Often, a market will trend for a while before going into a long consolidation / ranging pattern, prior to trending again. An easy way to identify a range-bound market is if a market is swinging between a horizontal level of support and a horizontal level of resistance. Trading ranges can be big or small, if they are small we call it ‘chop’, when a market is choppy and in a very tight trading range, we can’t really trade it, in these cases it’s best to sit on our hands. Larger-swinging trading ranges can be traded, as we will discuss later.
Trading from swing points and 50% retraces in a trending market
As a market trends, it creates swing points as we discussed above. Trends ebb and flow and they will often retrace back to the previous swing point or slightly beyond it, before the trend resumes again. In an uptrend, this means when a market retraces to the downside, that retrace will often terminate around the previous swing high as that old resistance becomes new support. In a downtrend it’s opposite; the old support will often act as new resistance.
Important note: A market will not ALWAYS retrace to the previous swing point, but when it does, it’s an important clue to pay attention to, because a price action signal in-line with the trend, at a swing point following a retrace, is usually a high-probability trade setup. Also, in strong trends, the market will often just blow right through the previous swing point and not retrace back to it. We see both examples of this below…
The first blue box shows a swing high point within the uptrend, note the market retraced back to it and formed a pin bar buy signal which led to a strong trend-continuation move. The second blue box was also a swing high point, but the market just busted right through it and didn’t retrace.
For more examples of swing points in trending markets, checkout this lesson on How to Trade Trends.
50% retraces in trending markets
Often times, you will notice that a retrace within a trend will end at about the 50% level of the last move. These 50% retraces will also sometimes line up with the previous swing high or low like we just discussed. When we have multiple supporting factors come together like this it’s called ‘confluence’ (more on this later in the course). When a price action signal forms from a confluent level in the market it’s a strong signal and something to definitely take note of and potentially trade if it makes sense.
The 50% retrace ‘phenomenon’ doesn’t just happen in ‘perfectly’ trending markets. If you do some ‘exploring’ on the charts, you’ll notice that many moves, both big and small will tend to eventually retrace approximately 50% before moving back in the direction of the initial move. Knowing this, we can watch for price action signals at these 50% levels, as they are often high-probability plays…
Trends can have large swings in direction or smaller ‘tight’ ones as in the chart above. We need to be flexible when reading and trading price action, after a while you will get better at seeing what the market is doing and will be able to differentiate a trending from non-trending market, even if a trend is not perhaps super-obvious as in the example below:
‘Laws’ of the Market
- Large players, hedge funds, banks, etc. take positions with a very informed bias. Their activity in the market creates market movement, and the ‘ebb and flow’ from this movement creates market rotation and price action.
- There is never usually one distinguishing factor that drives a market movement, instead, it is a group of catalysts which create volatility, turning points and trends.
- Prices move around a central point, that is called the “MEAN” or moving average. Trending or rotational price behavior will always be either moving back towards the mean or away from the mean. As traders, when a definite trend is identified, we trade in line with the direction of the slope of the mean.
- Advanced traders will also trade from extremes (areas distant from the mean), in attempt to capture profit as price rotates back toward the mean. However, they will mostly employ this method once a price signal is printed. Trading from extremes is more profitable when there is no major trend pressure, IE: sideways to neutral market periods.
- Trading with a trend, and trading from extremes are 2 different strategies that can be employed. However, the most reliable events in markets arise from trading from the mean (average price) within a trending market, static support and resistance (simple horizontal levels), dynamic moving support (trending moving averages), swing points and of course, price action signals.
- Counter-trend trades have less chance of success, unless the price action signal is from a major level, we avoid fighting the dominant daily chart trend.
- Every trading pattern or event in the market will always fall back on the above variables. Is the trade in line with the trend, or is it moving back to the mean or against the trend, etc? These are questions we must learn how to answer, as well as trade upon.
Mean Reversion and Moving Averages
Mean reversion is the heart of all market movement. Prices are either traveling away from the mean, or snapping back toward the mean. We have low trending volatility and high trending volatility. High trending volatility will see a market move substantially in one direction before a retracement occurs. Low trending volatility will see a minor fluctuation around the mean. (choppy trend movement or minor slope).
Note: The ‘mean’ is really just another word for ‘average’. It is the average price over a certain number of time periods. Example: a 21 period moving average shows the mean price or average price over the last 21 time periods, be it days, weeks etc.
It is a well-known fact that all trends, will retrace at some future point, even if it takes days, weeks or years, the mean (moving average) will be tested.
In summary, prices are always either moving back to a central point (mean) from an outer extreme or prices are moving away from central point to an outer extreme, or in the case of a range-bound market they are oscillating back and forth across the mean. This is the basic understanding of all quantitative models in finance (see image).
Some points you need to know:
- The mean acts as a dynamic trend line (value point).
- Broader term price trends move in-line with the longer term moving average (mean) direction. This is why counter-trend signals fail so often. We must try to avoid trading counter-trend reactions.
- Put simpler, we aim to sell strength in falling markets, and buy weakness in rising markets.
- Trade only from Price Extremes (support or resistance), where we expect prices to head back towards the Mean.
Example of price reverting back to the mean / average and then pushing away, back in-line with the uptrend and then downtrend…
Key point: Markets have to move up to move down, and have to move down to move up.
- Price rotation, trading ranges, and trends, all carry the one simple law: Prices have to move up to move down, and down to move up.
- Knowing this, we can now understand why prices rotate the way they do. As well as why so many break outs are “faded” or used as opportunity to take a trade in the opposite direction.
- How often do you see a textbook break out pattern fail? How often do you see a forex pair make a new recent high or low and then snap back in the opposite direction?
- This is the forex market…The trading game is designed to trap you, to trick you, and to test your nerve. If trading was easy, we would all be rich, this is why the simple textbook strategies don’t work, and why narrow-minded traders who can’t adapt to new ideas and changing market conditions fail over and over.
In chart below, we can see price rotating back to the mean after collapsing lower from swing highs. Note the overall trend is up, but the market has to push higher and then retrace lower to keep moving. The red line is the 8 day EMA and the blue line is the 21 day EMA…
Forex markets tend to be contrarian in nature, this is why false-breaks create opportunity over and over (more on false-breaks later in the course). As I said above, markets have to do this in order to move!
The key take away here is that you can’t just get long because a market is moving higher or get short because it’s moving lower. Often, just when it looks or ‘feels’ safe to enter a strong move in a market, it’s about ready to retrace the other direction. This is why so many beginning and struggling traders get stopped out and lose money; they don’t understand price dynamics and how the market’s ‘work’. Luckily, you are reading this course and so hopefully you can avoid being one of these traders who constantly get caught buying the top or selling the bottom. I’m not saying that breakouts to new highs or lows in a trend can’t be traded, because they can be if you do it properly, but if you go around trading every breakout, you’re going to lose money, that’s the point, much more on breakouts in the inside bar chapter.
If you got caught buying this breakout to new highs you would have gotten sucked out when the false-break occurred and the market changed direction….
Using Moving Averages to Buy and Sell from “Value”
So, how do we avoid getting sucked out by all the false-breaks that occur in markets? Well, in a trending market is pretty easy to avoid them. We do so by waiting for price action signals from value points in the trend, that is to say, after the market retraces / rotates back to the ‘mean’ / average price following a push in the direction of the trend.
A ‘value’ point can be a horizontal level of support / resistance, a small consolidation area that price has recently ‘liked’ to trade in for a while (this will also be referred to as a support or resistance ‘zone’ or a ‘area’ sometimes), or it can be an EMA (exponential moving average) dynamic support or resistance layer.
Exponential Moving Average:
- Wikipedia Definition: An exponential moving average (EMA), sometimes also called an exponentially weighted moving average (EWMA), applies weighting factors which decrease exponentially. The weighting for each older data point decreases exponentially, giving much more importance to recent observations while still not discarding older observations entirely.
- Layman’s Definition: A moving average is simply the average of a series of numbers (days) over a period of time which is constantly updated by dropping the oldest value and then adding the newest value and recalculating the average. So a 5-day moving average of prices would add up the closing prices for the last 5 days and then divide that total by 5. After the next trading day, we would drop the oldest day and calculate the average with the latest days’ price in its place. So over time the average moves as new data is added and old data is dropped.
- What EMAs do is smooth out fluctuations in prices, thereby making it easier to spot trends. We’ve all heard the expressions “the trend is your friend” and “trade with the trend” but often it’s difficult to identify the trend. That’s because financial instruments don’t move in straight lines as well as the fact that the trend may be different depending on your time frame.
- Moving averages are lagging indicators, they do not react instantly to price behaviour and thus are used only as trend filters and “value” reference points.
- Moving averages have a smoothing or dampening effect on the price chart. The longer the average the smoother, the shorter, the more jagged.
- The slope of longer term moving average tells us the longer term bias in the market. The slope of the shorter term moving average tells us the shorter term bias in the market. When the 2 are combined and are diverging in the same direction, you can define the trend.
- If prices spend more time above or below a moving average, we can define a bias in the market. Below the EMA’s and the bias is bearish. Above the EMA’s and the bias is bullish.
- Moving averages also act as the “dynamic mean” and become support and resistance points when the market is trending strongly over time. This will also be referred to as “dynamic support / resistance” or the “dynamic support / resistance layer”.
In the chart below, we can see the 8 and 21 day EMA’s, the 8 EMA is the red line and the 21 EMA is the blue line. The only EMA’s I use anymore are the 8 and 21 EMA’s on the daily chart and sometimes on the weekly charts. Their main purpose is to identify the trend easier and to highlight dynamic support and resistance areas or ‘value’ points.
Typically, if the 8 day EMA is crossed above the 21 day EMA you have an up-trending market, if the 8 is crossed below the 21 then you may have a down trending market. I say “may have” because in a range bound market the EMAs are no longer relevant, in range bound markets we rely 100% on horizontal support and resistance, I’ll show an example of this later.
As a market retraces back to these dynamic value points, we can watch for price action signals to form from them, as it’s at this time that a trend has the highest probability of resuming. Look at all the times the market rotated back to the 8 or 21 day EMA in the chart below and then very soon after began pushing back in the direction of the dominate trend…
- When the 8 day EMA is sloped in an obvious direction or crossed above or below the 21 day EMA, we can assume that a strong short-term trend is present. Usually, this means short-term counter-trend moves will fail whilst they remain crossed. They are not perfect, but the direction of the slope of the short-term mean can be a very accurate guide for price movement.
- Amazingly, price can close past the 8 and 21 day moving averages for several days, but the moving averages won’t cross. The trend will often then continue. They are good for a quick guide, because they are accurate and not instantly reactive, they take some time to give a signal. Ideally you will use them as a ‘filter’ for trend; after analyzing the trend based on the pure price actin method discussed at the start of this chapter, you can then apply the 8 / 21 day EMAs to ‘confirm’ trend and look for value areas to watch for price action signals after price retraces back to them.
- After a cross of the 2 lines, when the market retraces back and may even move well above the 2 lines, often a quick snap back in prices occurs. What this means is that as a guide, markets use these levels to find value and repel away from them.
- We use them as a regressive tool, to identify an area of opportunity. We often use them in combination with price action. We never trade based solely on the cross-over of the averages.
- They are not a pure trading strategy by themselves, they are a tool to combine with price action. We are not in the business of trading the crosses of moving averages, on its own, this is unprofitable.
In the chart below, we are looking at how we can combine price action signals and the 8 / 21 day EMAs on the daily chart. In this case, it’s a downtrend, so we would be waiting for a retrace back to the 8 / 21 day EMA dynamic resistance layer or area. We can see a pin bar sell signal formed after a retrace to just above the 21 day EMA (blue line), which led to strong down move and continuation of the trend. Then, we can see a coiled inside bar setup formed at the 8 day EMA (red line), which led to another leg lower in the downtrend. You’ll learn more about the pin bar signal and inside bar signal in the coming chapters. Note: In an up-trending market this would all just be ‘flipped’, that is to say we’d be watching for price action buy signals from the dynamic support at the 8 / 21 day EMA’s.
‘Perfect’ Trends Vs. ‘Imperfect’ Trends
Markets do not always trend as perfectly as we would like. Sometimes a trend will have large swings in it, where it swings away from the mean / moving average a relatively long ways before swinging back. Sometimes price will even swing past the mean significantly before moving back in-line with the overall daily chart trend direction. In these situations, we need to rely more on price action than the EMAs and look for patterns of HH / HL or LH / LL as we discussed at the start of this chapter. Perfect trends will respect the EMAs very well and just look ‘better’, they tend to have less volatility than imperfect trends. Let’s look at an example of both:
Below we see an example of what would be considered an ‘imperfect trend’ because whilst price is still trending higher overall (making HH and HL), it is not exactly doing so in a ‘perfect’ stepping manner that we would prefer. The advantage of such wide-swinging trend is they to produce powerful movements in both directions, opening the door for both trend and counter-trend trading, which we will discuss more soon…
When a market is perfectly trending, the price action often provide clues, because it will respect the moving average level and then move back in the opposite direction. Once a trader begins to recognize these clues on the daily charts, he can make an entry from a low risk point.
Traders should learn to wait for a price action signal at or near the moving average level (pin bar, inside bar, fakey etc.), then as they gain experience and ‘gut trading feel’ they may be able to entire ‘blindly’ from the moving average level in a ‘perfectly’ trending market like this. A ‘blind’ entry is an entry from a level in the market without a price action signal (I don’t advise trying this until you’ve MASTERED trading from a price action signal at the EMA)
You will notice over time, that when a market is trending it always provides clues, and nearly always provides opportunities to enter on a retest of the averages.
Also, a trend is strong and most likely to continue when the averages are sloped in an obvious direction. The more aggressive the divergence between the two moving averages is, the stronger the trend. By ‘divergence’ I mean that the two moving averages are diverging away from each other.
The mainstream trading community fails to use moving averages correctly, because they concentrate on the crossover, rather than the slope and the levels.
Trends provide clues, watch for them.
The chart below shows us an example of a ‘perfectly’ trending market that is respect the 8 / 21 day EMAs…These are the types of trends we prefer as they are the easiest to trade and mean money in our pockets. Unfortunately, they don’t happen extremely often, but when they do you need to pay attention and look for signals after the market rotates back to the 8 or 21 day EMA….
The chart below shows us that when the moving averages are sloped in the same direction but diverging apart from one another, the trend is very strong and increasing in intensity…
Moving average notes:
- No analysis tool is perfect, but EMA’s are our most likely clues for short term trend direction and also a reference for value in the short term momentum
- Look for the price to show you what it wants to do. Often price action will provide clues, e.g. “perfect trends”
- The more time price spends on one side of the moving average, the bias and trend will start to turn in that direction.
Trading Against the Trend
Let me preface by saying I do not advise beginning or struggling traders attempt trading against the daily chart trend. Trading against the trend is inherently riskier and more difficult than trading with the trend. However, you need to know what to look for because trading counter-trend can be very lucrative sometimes if done properly.
Counter-trend trading is more difficult and riskier than trading with the trend, period. However, it can be done if you are experienced and know what to look for, and counter-trend daily chart signals can often lead to large moves and mid-term or even long-term trend changes.
The main things you want to see lining up for a counter-trend trade to be worth taking, are the following:
- The counter-trend trade signal you’re considering taking is on daily chart time frame or weekly chart (you can take pins on the weekly chart sometimes, just understand you’ll need a bigger stop loss in most cases). Often on a weekly chart signal you can look for a better entry on the daily or 4 hour chart once the week begins. Most of the counter-trend pins I trade are on the daily time frame though.
- The signal is at, rejecting and(or) ideally false-breaking through a key daily chart level of support or resistance.
- The signal has good definition / form, it just ‘looks right’….meaning you don’t have to squint your eyes or email me asking if it’s a good signal or not…it should ‘jump’ off the chart at you!
- 4 hour counter-trend signals can work sometimes, but these take even more experience to attempt and shouldn’t be tried until you’ve mastered trading with the trend on the daily chart and you understand how to trade counter-trend signals on the daily chart. The same criteria apply for 4 hour signals; they need to be well formed and be obvious, and they need to be at, rejecting or false-breaking through a daily chart key level.
- Counter-trend trading on the 1 hour chart is extremely risky and should only be attempted after you’re very experienced on the daily and 4 hour. There won’t be very many worth-while 1 hour counter-trend trades, so it’s something you can trade successfully without ever even concerning yourself with.
The chart below shows 3 successful counter-trend pin bars. They all occurred on the daily chart and at a key level of resistance, and they all had nice long tails protruding up through the key level and good definition (long tail / small body). Note the large down moves that followed. The pin on the far left and the pin long-tailed pin on the right, actually changed the daily chart trend from up to down…
Markets don’t always trend. They also spend a lot of time, perhaps the majority of the time, in trading ranges or in consolidation / tight ‘chop’. We can make use of trading ranges, but ‘chop’ is something we need to stay away from, more on that next.
A trading range is simply when price is oscillating between a horizontal level of support and resistance. Typically, the levels will be easy to see and price will respect them exactly or almost exactly. In the example below, we see a well-defined trading range and three pin bar sell signals that formed at the top of it, each pin bar would have been a profitable trade had you sold them…
‘Chop’ is basically when a market is consolidating in a very tight range, a range that’s too tight to trade effectively and is usually somewhat erratic in nature. Choppy price action will occur more frequently the lower in time frame you go. The example below will clarify…
Most of my trading takes place on the daily and 4 hour charts, actually about 99% of it does. But the weekly chart is good for longer-term analysis of trends and key levels. I don’t ever trade a signal on the weekly chart simply because the risk / reward is usually not favorable and the time horizon is longer than I like. Also, I’ve found that if you do get a good signal like a pin bar or a fakey on the weekly chart, you can usually find a better entry on that signal on the daily or 4 hour chart once the week begins.
I get a lot of emails about how to trade the daily and weekly charts together and what to do if the trends are differing on both time frames. The simple answer is that we identify the daily chart trend first, and trade with the daily chart time frame trend momentum, but we need to always checkout the weekly chart to see what it’s doing.
For example, if you have an uptrend on the daily chart but the longer-term weekly trend is still down, you will want to check the weekly chart for any key long-term resistance levels that may be coming in soon, because you don’t usually want to buy right into a key weekly chart resistance level, etc.
If you get a scenario where the daily and weekly chart trends are the same, this can be especially strong and a signal on the daily or 4 hour that’s in-line with the both daily and weekly trend can be a very high-probability trade. For example: The daily is trending higher along with the weekly, the daily has retraced to the dynamic 8 / 21 day EMA support layer and formed a buy signal, etc.
Quick note on trend lines
In reality, we feel there is no real advantage in the application of trend lines.
Trend lines can be good to determine trend change, but then again, they are often a “hindsight method” and are open to different interpretations from trader to trade. Whilst discretion is required for price action trading, trend lines are TOO discretionary in nature and simply unnecessary I feel.
Trend lines will not become a major part of our trading approach.
Here are some other resources on trend-trading for you to checkout (you need to watch / read these):
Please proceed to Chapter 4: The Pin Bar Signal