According to some analysis: although defining trade parameters is important to traders in any market, it is particularly important in the currency market since over 80% of the volume is speculative in nature. This means that currencies can spend a very long time in a certain trading environment. Also, the currency market obeys technical analysis particularly well given its large scale and number of participants.
Too many traders have tried to pick the top within a trend, only to wind up with consistently unprofitable trades.
There are basically 2 types of trading environments, which means that at any point in time an instrument is either range trading or trending. The 1st step every trader needs to take is to define the current trading environment. The shortest time frame that traders should use in step one is daily, even if you are trading on a 5-minute time frame.
How to Trade Trend?
To trade trend the trader needs to answer 3 basic questions:
1. Trend detection - When is a trend in place?
2. Trade entry – How is a position initiated?
3. Trade exit – What constitutes trend exhaustion?
The use of Bollinger Band is a more accurate way to glean trend, though it is often used for range-bound markets.
What is trend really? The author will postulate that trend is actually a deviance in price. Typically, in all markets prices stay in a range somewhere between 70 and 80% of the time. Therefore, when prices decide to trend they in fact deviate from the norm. That is why Bollinger Band (“BB”) becomes one of the best tools to measure deviation in technical analysis. The BB formula contains the standard deviation (“SD”) calculation within it. BB measures the standard deviation of price away from its 20-period moving average. … Price action is captured within the 1SD – 2SD Bollinger bands.
THESE BB bands divide the price action into 3 separate areas. If prices are between the upper 1 standard deviation BB and the upper 2 standard deviation BB, they are in the buy zone. If a specific currency is trading between the lower 1 SD BB and the lower 2 SD, then its price is in the sell zone. Price candles that exists in the area between the 2nd BB bands are in effect in no-man’s-land as markets struggle to find direction.
With the BB bands approach, the trend detection rule is quite straightforward. The author considers the uptrend to have commenced once the price closes – not simply penetrates, but closes – in the buy zone. The idea behind this rule is that buyers must have enough conviction behind their actions to sustain a rally into the upper BB channel. If prices merely pierce the channel but cannot hold their value, then we do not have enough evidence of a clear up move in place.
The second component of the trade is perhaps the trickiest. Instead of simply entering the trade at market we will look for an opportunity to buy on any small dip into the no-man’s-land zone. IF the penetration of the buy zone is so powerful that prices reach the upper 2 SD BB, then we will wait for prices to retrace to the middle of the bands or to the 1 SD band. Why such hesitation? Shouldn’t we jump in the moment the trend becomes clear? No. Not if you want trade FX like a professional.
When it comes to trend trading in FX, the difference between professionals and amateurs is that while the pros are trend followers, the amateurs are trend chasers. The distinction may seem like nothing more than semantics, but in fact it’s often what separates those who earn money through trading from those who lose it.
Where would the trader abandon his position? At what point on the chart will be proven most likely wrong? If prices retreat all the way back to the lower 1 SD BB, then the trader should stop out. The probability that trend is over is very high. Note the difference in approach. In order for us to consider the trend valid, prices must not only touch but close through the upper 1 SD BB. As for our exit, a mere tag of the lower 1 SD BB will take us out of the trade. Why be so slow to enter and so quick to exit? Because, as I noted before, trend is not the common state of price, so price must really prove to the trader that it is making a directional move. Once price can’t hold trend, there is absolutely no reason for the trend t trader to stay around. His risks far outweigh potential rewards because he now faces 3 possible scenarios – consolidation, trend reversal, or trend continuation. 2 out of the 3 outcomes are unfavorable to his position and the last choice, which is advantageous, is usually the least likely under such circumstances.
Using the lower 1 SD BB provides ample room for the trend trader not to be falsely shaken out of the trade while the price meanders through the no-man’s-land zone before it decides whether it wants to continue its initial impulse higher.
Understanding the exits – the 3rd rule of the trade – may now be helpful to appreciating the 2nd rule of buying only when price retraces. It all has to do with risk and reward. Remember that in real life prices frequently fake out the trade. Just because price enters into the trend channel is no guarantee that it will remain there. If markers were highly predicable most traders would make money rather than losing it. The key to positioning in a trend-based setup is to minimize the amount of losses for the countless times you will inevitable be wrong, rather than to maximize the gains for the few times that you will be right. In trading, trends are the exception, not the rule, and in order to avoid being wiped out, traders need to try to always enter the market under the most advantageous of circumstances no matter what the market environment holds. Novice traders tend to succumb to the lure of the crowd and not restrain themselves from buying at the top or selling at the bottom. The more patient trader, however, who would wait for a retracement down to the upper 1 SDBB, would suffer only a smaller loss.
- Boris Schlosseberg, Technical Analysis of the Currency Market
