In technical analysis the most common refrain is: The trend is your friend. Who hasn’t heard this axiom before? In other words, identifying the trend (the dominant direction of price movement) is first and foremost in the analysis, so that the trades that are taken are always in the direction of the prevailing market trend. This type of trend following strategy is fine, provided there’s a strong trend and that the trend persists long enough to produce profits.
The fact is, that although markets do tend to trend in the longer term, in the short term they spend a good portion of the time moving sideways. In fact, the reality is that uninterrupted strong momentum moves are actually less frequent. In my experience, I have found that very few traders have the mental fortitude to sit through those spells where the markets are range bound, as they typically tend be before the next leg of the trend resumes. Typically, what happens is that traders become impatient and exit their trades; invariably and to their frustration, this happens just before the next leg of the move gets underway.
In the chart below we can see that although the S&P E-mini market was clearly in a defined uptrend on a 8 hour time frame, it spent weeks going sideways before resuming its upward trajectory. This may be surprising to some, but this is where the challenges that I mentioned before come into play.
Another challenge that traders have implementing this trend following strategy is knowing when the market trend has changed direction. In addition, identifying those periods where there isn’t a strong market trend, or there is a range bound market can also be a hurdle.
Often times, when price exhibits the earliest signs of a trend change it’s too late for traders to find the lowest risk trades, primarily because there are many false fits and starts before a trend gains momentum. In conventional technical analysis, a trend change is demonstrated by price holding prior highs or lows and then changing the direction. In other words, if a downtrend is defined as a series of lower lows and lower highs, then price would have to reverse that pattern and start forming a series of higher highs and higher lows. This is how most traders learn to trade.
An alternative way to trade low risk, high probability trading is to acquire the skill of learning to identify high quality levels of supply and demand so you can actually anticipate where the market trend is likely to reverse. This flies in the face of conventional thinking because everyone has been indoctrinated in the notion that trying to pick tops and bottoms is a fool’s game. However, it can be done if this skill is honed. And yes, it’s all about probabilities and not everyone can do it because although it seems simple, it takes discipline, focus and practice.
In its most simplistic form, the idea is that trends tend to reverse at larger time supply and demand levels. Below, we can see an example of this in the platinum futures market.
The key is identifying the highest quality supply and demand levels as this would suggest that in these zones is where we would have the most amount of unfilled orders. This insinuates that by the time these levels are touched most of the buying (in a strong uptrend) and, conversely, the selling (in a strong downtrend) has been exhausted. Furthermore, these zones give a trader the lowest risk opportunities to enter a trend at its inception. Keep in mind that doing this consistently requires plenty of skill.
If this different way of looking the markets intrigues you, then stop by one of our offices or sign up for a workshop to learn more.
Until next I hope everyone has a great week.