Hello traders! Like many of you United States based traders, I too had family in visiting from out of town over the Thanksgiving holiday. While seeing family and enjoying the holiday is terrific fun, getting back into the swing of things in trading sometimes takes an extra day or two, especially considering I don’t like to waste food. All of the leftovers had to be disposed of “properly,” which means in my belly. If you see me over the next few weeks, please understand that I do regret my decisions of how much I ate. Multiple times. All of which is irrelevant to this week’s newsletter, where I hope to explain a simple way that I trade against the trend to pull out a few pips in the forex market. On with the show!
First of all, for those of you who are new, one of the oldest sayings in trading is to “trade with the trend,” or even “the trend is your friend.” Generally speaking, your win:loss ratio should be better when joining a trend in progress, your losses should be small (if you are placing your stops properly!), and your gains should be larger as you “ride the wave.” However, eventually all trends come to an end. What I’m about to show you is a pattern that shows a way to counter-trend trade, and occasionally also indicates a change in overall trend direction.
With this pattern, you must first understand the two basic ways that most retail traders use to define trend, moving averages and trendlines. I’ve covered both topics in numerous newsletters; even dozens of trading books have been written about them. To avoid rehashing these topics I’ll let you go do a little digging on moving averages and trendlines-perhaps including channels-before we continue. Done? OK, let’s get started.
In the following EURUSD 15 minute chart, I’ve inserted a basic 50 period exponential moving average (MA). Most traders will look at a common MA like this and only trade in the direction that it is pointed: pointing down, look for shorts; pointing up, look for longs. Very basic. Other traders will use trendlines to determine their trend direction: trendlines pointing down, look for shorts; trendlines pointing up, look for longs. Very simple stuff so far. Over time, traders begin to realize that these two trend following rules may not be sufficient, especially when the trend begins to reverse direction. At these “turns,” moving average traders are very often left scratching their heads since MAs can lag price action by quite a bit. I prefer to use a combination of trendlines and MAs to go against the trend, and here’s how.
On this chart I’ve put in three trendlines, and a demand zone that was from price action way back in April of this year. Trendline “A” indicates a downward trend connecting lower highs. Trendline “B” indicates the bottom of a channel, where price rallied back up to trendline A. The dotted trendline indicates the midpoint of the channel, where price will sometimes pause/bounce before moving to either the upper or lower trendline.
Now, notice at the blue arrow how price moved cleanly outside of the previously drawn channel, straight into the demand zone. Most traders will look at this and think that this is the beginning of a very strong move to the downside. However, such is not always the case! With the combination of the MA pointing down many are already short, and with the trendlines pointing down many others are already short. When the price action hits a high quality demand zone, the counter-intuitive trade is to go long! As you can see, this combination of things showed us the beginning of a new trend.
In the following GBPJPY 240 minute chart I’ve done the same but the opposite. We have an upward sloping trendline “C” indicating the bottom of a channel, another trendline “D” indicating the top of the channel, and the dotted trendline indicating the midpoint of the channel. Obviously, all are pointing up which would lead us to believe that many traders are ALREADY long. The same 50 period exponential moving average is pointing up as well, indicating that a group of traders is probably already long as well. At the blue arrow, price had rapidly moved outside of the channel indicating to most retail traders that a strong move is under way! However, most of them are probably either already long or looking to buy this breakout. (By the way, this pair had already moved about 2,000 pips in two months when this happened! It was getting a little extended, perhaps.) If you look back on your own charts, you should clearly see a significant supply zone from September of 2008. Using this combination of tools – upward sloping MA, upward sloping channel, a breakout to the upside of the channel into a major supply zone – should lead us to believe that the trend might be running out of gas, or even is completely done. Taking a short here, going against the trend, would have led to many pips in your account!
As you can see, this little pattern worked on both a small time frame for short term traders, and a longer time frame for the swing traders among us. Combining this with proper trade management techniques (taught in our on-location classes and Extended Learning Tracks), you should be well on the way to making many more pips!
Until next time,
Rick Wright – firstname.lastname@example.org