How To Correctly Identify The Trend

by Aspen Trading Group

If there is one piece of the trading puzzle that remains a bit unclear for traders it is that of the ‘trend’. Depending on whom you speak to, each will have a different answer. Regardless, of their answer however, it is critical that you arrive at the correct answer in the context of how that person trades. Failure to correctly identify the trend will greatly reduce the odds of success. The first place to start is identifying which time frame you plan to make your trade off of. For me, I only have three choices, 60-minute, 240-minute or the daily chart, as these are the only three time frames I follow for trade set-ups. The vast majority of the trades are based on the 60-minute chart however. So, for the time being, let’s keep it simple, I will not factor in the other time frames as it can get a bit confusing.

What is the trend on the following chart?

http://www.forexfactory.com/pics/art...end1_img_1.jpg

In all fairness, it is a bit of a trick question. The answer, based on my approach, is that there is simply not enough information to make that call. Sure, the last several bars have been moving up, but overall prices are still trending lower.

Let’s add one more piece of information to the chart.

http://www.forexfactory.com/pics/art...end1_img_2.jpg

By adding a moving average, one can much better analyze the ‘current’ trend. Remember, I am not terribly interested about what happened several hours ago, but I am interested in what has happened in the last 4-6 hours.

Without the moving average, it is nearly impossible to correctly identify what the current trend is.

Let’s look at another example.

http://www.forexfactory.com/pics/art...end1_img_3.jpg

I suspect there were some readers who said; “The trend is up, I will look to buy into this pull-back.” But again, there is simply not enough information to draw that conclusion presently. Let’s add in the moving average.

http://www.forexfactory.com/pics/art...end1_img_4.jpg

If you did not correctly identify the trend, many will succumb to buying the pullback into support, or in this case fib support – this losing trade could easily have been avoided if you correctly identified the trend.

Needless to say, this trade would have flamed out badly.

Later this week I will go into more detail about correct trend definition as well as factoring in other time frames in order to refine your definition of the trend.

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In last week’s article I discussed the way I determine the trend prior to entering trades in the FX market. While the article was rudimentary in terms of its approach, it drove the point home.

Naturally, the drawback to that one dimensional approach is that it only dealt with determining the trend on one time frame. While this style/approach may suit some traders, I find it more efficient to look at multiple time frames as a way to potentially increase the odds of success on a trade.

This week, I will build upon the concepts from last week and begin to demonstrate how looking at one or two additional time frames can be a useful process.

First, let’s review what was discussed last week. What is the trend on the chart of EUR/USD below?

http://www.forexfactory.com/pics/art...end2_img_1.jpg

There are actually two correct answers, 1. Sideways or 2. Down

Prices are below a slightly downward sloping moving average.

This is not a chart that demonstrates an up-trend. However, what is your answer if at the same time you were looking at the 240- min chart of EUR/USD versus the 60-min chart noted above?

http://www.forexfactory.com/pics/art...end2_img_2.jpg

Here, there is only one answer; the trend is ‘Up’.

So, when you combine the analysis of both charts you sort of have a dilemma. If you are looking to execute the trade off the 60-min chart, it makes it tough to go short (despite 60-min trend being down) when the next higher time frame is indicating that you are going against the overall trend. Conversely if you are looking to execute off the 240-min chart, the 60-min chart is less relevant and you would look to isolate high probability long entries. Higher time frames should always take precedent.

This is the part of trading where it can become more ‘art’ than ‘science’ and hence highlights the serious limitations of a purely mechanical approach. As we get further into this series of lessons, it will become even clearer how subjective the distinctions can become.

Let’s look at another example. In this case we are presented with three time frames for analysis. While the 240-min and daily charts are in a clear downtrend, the 60-min chart is likely to limit downside moves due to its current technical condition.

http://www.forexfactory.com/pics/art...end2_img_3.jpg

What is the answer then? Wait for more information.

For those that are familiar with my work, you know that I am always of the mindset that sitting on your hands can be the most effective trade. Is there a way for a trader to make money on EUR/JPY to the long side? Absolutely, but the probabilities of this trade playing out are reduced because of the higher time frames.

While I understand that this week’s lesson may have been a bit confusing and left you with no clear answers, (it’s OK, it is a tough concept to grasp when you continue to add new variables) in the lessons that follow, there will be new studies added that will begin to offer you an ideal and relatively simple way to identify the trades that have the higher probability of playing out. While trend identification is key, it is only one piece of the puzzle.

As always, feel free to send me your comments and questions.

In the previous two installments of this ongoing series of FX Trading Basics I outlined the methods I use for determining the trend. In today’s installment I want to discuss, how I combine multiple time frame analysis and stochastics in identifying high probability set-ups versus low probability set-ups.

First, some bullet points to outline my thoughts:

1. Higher time frames, generally, but not always, take precedent over lower time frames
2. Stochastics, for me, are a filtering mechanism; not a timing mechanism

To review, I use three primary time frames in day-to-day analysis:

60-minute
240-minute
Daily chart.

I do use a weekly chart to identify key support and resistance levels, rarely as a timing mechanism.

Identifying the trend is simply but one piece to the puzzle, once the trend is correctly identified, you then need to determine whether or not prices will continue to exhibit the trend. There are many times when the trend is easily identified, but is actually on the verge of changing trend
direction. For purposes of this article, let’s assume that the time frame that we do the primary analysis (i.e. the time frame we will execute on) is the 60-min chart.

The charts below are the 60 & 240-min of EUR/USD. On each chart, the trend is quite clear. If we then defer to bullet point # 1 above - Higher time frames, generally, but not always, take precedent over lower time frames – we would have to resist the temptation to short EUR/USD based on the 60-min chart.

http://www.forexfactory.com/pics/art...end3_img_1.jpg

http://www.forexfactory.com/pics/art...end3_img_2.jpg

However, this simple analysis, will often lead you to miss trades. In order to make a proper assessment, you need to add one more indicator to your chart in order to conclusively know to not short EUR/USD based on the 60-min chart – stochastics.

http://www.forexfactory.com/pics/art...end3_img_3.jpg

In this case, the stochastics simply confirm the conclusion we drew from looking at the first 2 charts we posted without the stochastics. However, there are many times when this will not be the case.

As always, feel free to send me your comments and questions.

Dave

([email protected])

Aspen Trading Group

All right! I like this one! another good reference.. Thanks Mr. Editor!