Does this sound familiar?
You decide to trade with the trend. You identify the trend and enter a trade in that direction. The market then stops moving in the direction of the trend and you lose on the trade.
If you have ever used a trend following strategy then you will recognise this outcome.
It can happen so regularly that you may have decided that a better approach is to wait for the market to move in a clear direction and then trade against it. How did that work out?
I don’t know when the trend of ever bigger beards will end but all trends will eventually end. Until then, trading with the trend is the bast basis for success.
Trading with the Trend
Trading with the trend is one of the most basic strategies in trading and is an important element of the 4x4BOSS strategy. It’s captured in the old saying that ‘the trend is your friend’.
The logic of trading with the trend is compelling. A trend is no more than a bias for the market to move in a particular direction. A trend continues until it ends, and it only ends once.
Winning trades are those that are entered in the direction in which the market moves. So then, why is it so difficult to trade with the trend?
For a start, dismiss any thought that there is some sort of conspiracy or that someone is fixing the market so that it is rigged to move against you when you have placed your trade.
If you stick to markets with even a moderate amount of liquidity then it’s a safe assumption that there is no such fixing going on.
The truth is that while markets do trend, no trend is a straight line and all trends have counter movements. Furthermore, except in the very rare occasions when the market is absolutely flat, every market is trending in some timeframe all the time.
Think about that for a moment because it means that a market might be trending one direction on the daily chart and in a different direction on the hourly chart.
This is important as it means you must ensure that you match the time to expiry of your trade to the timeframe of your analysis. That can be tricky.
The general rule is that if you see a trend in a particular timeframe then trade in line with the trend. The trick is to avoid entering a trade just when a pullback is about to start or is underway.
So you need to be able to spot the times when this is likely to happen.
We will refer to this as the times when the trend is likely to come to an end but this is not really all that accurate as most of the time a trend will reappear after a pullback.
There are 4 main reasons for a trend to end:
• The market hits support or resistance.
• A news event disrupts the market.
• The trend has become overly extended.
• The move is exhausted.
Some markets may also experience times when big traders seek to balance their open positions or times when there is a lot of market noise or volatility but these times can be identified and avoided.
Let’s look at each of the 4 main reasons in turn.
Support and Resistance
Every trader should be familiar with the concept of support and resistance. At the simplest, these are price levels where the market has previously experienced reversals and it can be something of a self-fulfilling prophesy that the same will happen again.
Support and resistance can also be found at trendlines, Bollinger bands and levels such as Fibonacci projections.
At the very least the market can stall for a time so that it will move against the trend when viewed in a shorter timeframe.
The best assumption to make is that the support or resistance will hold and the market will stall. Change this assumption only when the support or resistance is clearly broken.
So, don’t enter a trade in line with a trend it the market is approaching one of these levels.
Indeed, the working assumption means that it can be profitable to enter a trade on a shorter timeframe against the main trend since the market can bounce from the support or resistance level and you can catch this.
If the support or resistance is broken then the longer term trend is likely to be even stronger and trades should be in line with the trend only.
By definition, you do not know what a news release will contain and you certainly do not know how it will impact the market.
Trying to trade the news is no more than a 50:50 bet and that is not good enough.
However, you do generally know when important news that can affect the market is likely to be released.
The best strategy is relation to news is simply not to trade in advance of an important news release. It’s a random variable and randomness is your enemy when trading.
Wait for the market to digest the news and settle down. Then see if the trend has reappeared. News is often the reason a trend ends and reverses, but you have no way of knowing in advance if this will be the case.
Overly Extended Trends
This a major issue for trend followers and I would suggest it is one of the main reasons why so many enter trades only to see the market reverse.
There is a fine balance to be found. You want to trade with the trend so you need to see that a move is established, but you don’t want to wait until it is to late.
If there is a strong move then the market may move away from a sustainable level. Markets tend to be mean reverting.
In other words, there is always some level that can be considered to be the most probable future level for the market and if it moves away from this then it is likely to reverse course.
The problem is that this ‘mean’ level is itself a moving target. So it is not possible to be precise.
A good way to address this problem is to see the market as likely to move within a particular range.
Bollinger bands provide a good way to identify this range. So, if the market is trading within the bands then it can continue to move in its recent direction.
However, if it moves so far that it is outside the bands then it is likely to move back in either by pulling back or by consolidating while the band ‘catches up’ to its recent move.
It’s not a perfect solution, but it’s a pretty good rule that if you trade in the direction of the trend only while the market is inside the Bollinger band then you improve the chances that the market will continuing to move in the direction of the trend.
The Move is Exhausted
It stands to reason that when a market moves in a trend, many traders will initially trade in that direction.
However, as the trend progresses it will appear to an increasing number to be either over priced or under priced if it continues to move. So, a trend will eventually lose momentum.
The exception is where there is a blow off move up or a total capitulation where the highest momentum can be seen just before a reversal. But these events are relatively rare.
One of the greatest dangers for a trader is to enter a well established trend just as it is about to run out of steam.
There’s no single best way to avoid this but you need to have a consistent means of identifying when the trend is weakening.
Various indicators can be used with an oscillator such as MACD being widely favored. The rule is to be careful if there is a divergence between the direction in which the market is moving and the oscillator.
This should not be interpreted as a conclusion to trade against the trend. But the risks of trading with the trend have increased.
The best approach is to wait for the market to regain its momentum usually after a pullback or a period of consolidation. Then trade with the trend.
Trading with the trend provides the highest probabilities of success. But you must be able to spot when this is likely to break down.
Don’t trade if there is support or resistance ahead. Wait for it to either break or hold.
Don’t trade ahead of news. You don’t know what will happen.
Don’t trade if the market is extended. Wait for it to pull back and then trade with the trend.
Don’t trade if a move is exhausted. Wait for the market to regain momentum.
Integrating these principles into your trading will greatly improve your chances of success.
Each is an integral part of the 4x4BOSS trading system. You can find out more by downloading the free eBook ‘An Introductory Guide to Trading Binary Options’.
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