Reading a foreign exchange quote may seem a bit confusing at first. However, it's really quite simple if you remember two things: 1) The first currency listed is the base currency and 2) the value of the base currency is always 1.
The US dollar is the centerpiece of the Forex market and is normally considered the 'base' currency for quotes. In the "Majors", this includes USD/JPY, USD/CHF and USD/CAD. For these currencies and many others, quotes are expressed as a unit of $1 USD per the second currency quoted in the pair. For example, a quote of USD/JPY 110.01 means that one U.S. dollar is equal to 110.01 Japanese yen.
When the U.S. dollar is the base unit and
a currency quote goes up, it means the dollar has appreciated in value and the other currency has weakened. If the USD/JPY quote we previously mentioned increases to 113.01, the dollar is stronger because it will now buy more yen than before.
The three exceptions to this rule are the British pound (GBP), the Australian dollar (AUD) and the Euro (EUR). In these cases, you might see a quote such as GBP/USD 1.7366, meaning that one British pound equals 1.7366 U.S. dollars.
In these three currency pairs, where the U.S. dollar is not the base rate, a rising quote means a weakening dollar, as it now takes more U.S. dollars to equal one pound, euro or Australian dollar.
In other words, if a currency quote goes higher, that increases the value of the base currency. A lower quote means the base currency is weakening.
Currency pairs that do not involve the U.S. dollar are called cross currencies, but the premise is the same. For example, a quote of EUR/JPY 127.95 signifies that one Euro is equal to 127.95 Japanese yen.
When trading forex you will often see a two-sided quote, consisting of a 'bid' and 'ask':
The 'bid' is the price at which you can sell the base currency (at the same time buying the counter currency).
The 'ask' is the price at which you can buy the base currency (at the same time selling the counter currency).
Thursday 24 January 2008
Using Indicators to Identify Trends
Of the many market sayings thrown around by traders, perhaps none is more overused and less understood than the old adage 'the trend is your friend'. All too often, the phrase is used after a trader has taken a counter-trend position and subsequently been stopped out at a loss. Remorse sets in at this point and most traders kick themselves not only for having lost on a counter-trend trade, but also for not having caught the latest move in the trend itself.
To avoid this all too common scenario, we will suggest using several technical tools to identify whether or not a trend is in place and then use additional indicators to help maximize trading profits. Having a strategy in place to identify trends is essential to successful trading in any market, but especially so in the case of the forex markets. Currencies have a greater tendency to move in trending fashion due to the longer-term macroeconomic elements that drive exchange rates, such as interest rate cycles or global trade imbalances. Currencies are also pre-disposed to short-term, intra-day trends due to international capital flows reacting in unison to day-to-day economic and political news.
Identifying the Trend
In its most basic sense, a trend is simply a prolonged market movement in one general direction, either up or down. From a traders' perspective, though, that simple definition is so broad as to be relatively meaningless. A more relevant definition of a trend would be one where a trend is defined as a predictable price response at levels of support/resistance that change over time. For example, in an uptrend the defining feature is that prices rebound when they near support levels, ultimately establishing new highs. In a downtrend, the opposite is true-price increases will reverse as they near resistance levels, and new lows will be reached. This definition reveals the first of the tools used to identify whether a trend is in place or not-trendline analysis to establish support and resistance levels.
Trendline analysis is often underestimated because it is perceived as overly subjective and retrospective in nature. While both criticisms have some truth, they overlook the reality that trendlines help focus attention on the underlying price pattern, filtering out the noise of the market. For this reason, trendline analysis should be the first step in determining the existence of a trend. If trendline analysis does not reveal a discernible trend, it's probably because there isn't one.
Trendline analysis is best employed starting with longer timeframes (daily or weekly charts) first and then carrying them forward into shorter timeframes (hourly or 4-hourly) where shorter-term levels of support and resistance can then be identified. This approach has the advantage of highlighting the most significant levels of support/resistance first and less important levels next. This helps reduce the chances of following a short-term trendline break while a major long-term level is lurking nearby.
Another technical tool that can be deployed to verify the existence of a trend is the directional movement indicator system (DMI), developed by J. Welles Wilder (see Wilder, New Concepts in Technical Trading Systems, c. 1978). Using the DMI removes the guesswork involved with spotting trends and can also provide confirmation of trends identified by trendline analysis. The DMI system is comprised of the ADX (average directional movement index) and the DI+ and DI- lines. The ADX is used to determine whether or not a market is trending (regardless if it's up or down), with a reading over 25 indicating a trending market and a reading below 20 indicating no trend. The ADX is also a measure of the strength of a trend--the higher the ADX, the stronger the trend. Using the ADX, traders can determine whether or not there is a trend and thus whether or not to use a trend following system.
As its name would suggest, the DMI system is best employed using both components. The DI+ and DI- lines are used as trade entry signals. A buy signal is generated when the DI+ line crosses up through the DI- line; a sell signal is generated when the DI- line crosses up through the DI+ line. (Wilder suggests using the "extreme point rule" to govern the DI+/DI- crossover signal. The rule states that when the DI+/- lines cross, traders should note the extreme point for that period in the direction of the crossover (the high if DI+ crosses up over DI-; the low if DI- crosses up over DI+). Only if that extreme point is breached in the subsequent period is a trade signal confirmed.
The ADX can then be used as an early indicator of the end/pause in a trend. When the ADX begins to move lower from its highest level, the trend is either pausing or ending, signaling it is time to exit the current position and wait for a fresh signal from the DI+/DI- crossover.
CHART 1: JUMP IN AND HANG ON FOR THE RIDE. If you are an aggressive trader and entered a long position at Point A, and only exited your position at Point C, you would be pleased with the results. This can be achieved with a few simple indicators.
Let's look at recent long-term trend (chart 1) and put trendline analysis together with the DMI system to illustrate the utility of these tools when used in conjunction with each other. An aggressive trader might initiate a long position as the daily resistance line is breached on 11/12/03 (point A). A trader looking for confirmation might wait a day, when the DI+ crosses up through the DI- line, generating a buy signal. A conservative trader might wait for confirmation of the DI+/- crossover by waiting for the extreme point (high) to be exceeded, in line with Wilder's extreme point rule. This confirmation is given the following day (11/14/03). As the market begins to move higher, the support trendline drawn off the lows is tested, but holds, underscoring its validity to a nascent trend. Although the market has moved higher in line with the DI+/DI- crossover and trendline support, the ADX is still below 25 until 12/2/03 (point B), when a trend is finally confirmed. At this point, a trader should recognize that they are in a trending market and trend following systems can usefully be employed.
This brings us to the point of introducing some additional tools that can be used to maximize profit within a trending market. We have already suggested using the ADX as an early indicator of the end of a trend. Note that from point B, when it first registers above 25 indicating a trending market, the ADX continues to make new highs until 01/14/04 (point C) when it closes lower signaling a likely end to the uptrend and that it's time to exit the long position.
A second tool used to identify an exit point and possibly the end of a trend is the parabolic indicator. The parabolic indicator follows the price action but accelerates its own rate of increase over time and in response to the trend. The result is that the parabolic is continually closing in on the price, and only a steadily accelerating price rise (the essence of a trend) will prevent the price from falling below the parabolic, signaling an end to the trend. Chart 2 shows the parabolic indicator overlaid on the previous chart. Note that the parabolic gives an exit signal (point D) the day after the ADX experienced its first lower close.
CHART 2: ADD A COUPLE MORE INDICATORS. Here, the parabolic indicator was used. The exit signal was given one day after the ADX gave its exit signal.
The very basic trendlines that are drawn also could have signaled the end to the uptrend. Note that the price accelerates above the upper channel line in the final extension of the uptrend, tests back to the break and then goes on to make new highs. The subsequent price decline back below the upper channel line would then signal the end of the up-move. As well, another support line similar to the parabolic could also be drawn, and its breach would have been the earliest signal of the end of the upmove.
What About Short-term Trading?
The same tools outlined above can be used for short-term decision making, even in markets that are trading sideways, or so-called trendless markets. While the market may not be trending in a long-term sense, there are multiple smaller, short-term movements taking place that can be exploited. (One caveat must be noted, though: traders need to be aware of what is happening in the bigger picture. If shorter term ADX readings indicate a trending market, traders must be circumspect in initiating trades that are counter to the larger, daily trend.)
CHART 3: INTRADAY BASIS. On this hourly chart of the Australian dollar, the first entry signal was at point A. You could have held until point D, where you should have sold your position. The next entry signal was point AA (short) with a signal for covering that short position at point CC.
Let's then look at a short-term scenario using an hourly chart of the Australian dollar (chart 3). The first hint of a potential trading opportunity is the quick convergence of the DI+/DI- lines in the hour marked by point A. This is caused by the sharp bounce in price during that hour. The next hourly bar breaks through and closes above trendline resistance, precipitating DI+ crossing up through DI-. Following Wilder's extreme point rule, we wait for the previous high to be surpassed, which happens in the next hour at point B. At this point, we have several signals indicating a long position-the break of trendline resistance, crossover of DI+/DI-, extreme point rule satisfied, break of parabolic. As the market moves higher, the ADX begins to rise as well, peaking at point C and declining at point D, giving us our signal to exit the long. Basic trendline and parabolic supports are then broken several hours later setting the stage for the next potential move.
The next signal is given at point AA as the DI- crosses up through the DI+, generating a sell signal. This coincides with the price falling below recent hourly lows. The ADX begins to move up, indicating the possibility of a trend forming and eventually rises over 25 at point BB indicating a trend is in place and that the parabolic should be followed. Trendline and parabolic resistance are then breached and the ADX stalls at point CC, indicating an early, but profitable exit to the trade.
The Trend is Your Friend
Profiting from market trends is the essence of making the trend your friend. The first step to profiting from both short- and long-term trends is understanding what constitutes a trend and knowing how to identify them. The next step is employing a disciplined trading strategy that is specific to trends. A conscientious approach utilizing trendline analysis, the DMI system, and the parabolic indicator should help traders make more friends of market trends.
To avoid this all too common scenario, we will suggest using several technical tools to identify whether or not a trend is in place and then use additional indicators to help maximize trading profits. Having a strategy in place to identify trends is essential to successful trading in any market, but especially so in the case of the forex markets. Currencies have a greater tendency to move in trending fashion due to the longer-term macroeconomic elements that drive exchange rates, such as interest rate cycles or global trade imbalances. Currencies are also pre-disposed to short-term, intra-day trends due to international capital flows reacting in unison to day-to-day economic and political news.
Identifying the Trend
In its most basic sense, a trend is simply a prolonged market movement in one general direction, either up or down. From a traders' perspective, though, that simple definition is so broad as to be relatively meaningless. A more relevant definition of a trend would be one where a trend is defined as a predictable price response at levels of support/resistance that change over time. For example, in an uptrend the defining feature is that prices rebound when they near support levels, ultimately establishing new highs. In a downtrend, the opposite is true-price increases will reverse as they near resistance levels, and new lows will be reached. This definition reveals the first of the tools used to identify whether a trend is in place or not-trendline analysis to establish support and resistance levels.
Trendline analysis is often underestimated because it is perceived as overly subjective and retrospective in nature. While both criticisms have some truth, they overlook the reality that trendlines help focus attention on the underlying price pattern, filtering out the noise of the market. For this reason, trendline analysis should be the first step in determining the existence of a trend. If trendline analysis does not reveal a discernible trend, it's probably because there isn't one.
Trendline analysis is best employed starting with longer timeframes (daily or weekly charts) first and then carrying them forward into shorter timeframes (hourly or 4-hourly) where shorter-term levels of support and resistance can then be identified. This approach has the advantage of highlighting the most significant levels of support/resistance first and less important levels next. This helps reduce the chances of following a short-term trendline break while a major long-term level is lurking nearby.
Another technical tool that can be deployed to verify the existence of a trend is the directional movement indicator system (DMI), developed by J. Welles Wilder (see Wilder, New Concepts in Technical Trading Systems, c. 1978). Using the DMI removes the guesswork involved with spotting trends and can also provide confirmation of trends identified by trendline analysis. The DMI system is comprised of the ADX (average directional movement index) and the DI+ and DI- lines. The ADX is used to determine whether or not a market is trending (regardless if it's up or down), with a reading over 25 indicating a trending market and a reading below 20 indicating no trend. The ADX is also a measure of the strength of a trend--the higher the ADX, the stronger the trend. Using the ADX, traders can determine whether or not there is a trend and thus whether or not to use a trend following system.
As its name would suggest, the DMI system is best employed using both components. The DI+ and DI- lines are used as trade entry signals. A buy signal is generated when the DI+ line crosses up through the DI- line; a sell signal is generated when the DI- line crosses up through the DI+ line. (Wilder suggests using the "extreme point rule" to govern the DI+/DI- crossover signal. The rule states that when the DI+/- lines cross, traders should note the extreme point for that period in the direction of the crossover (the high if DI+ crosses up over DI-; the low if DI- crosses up over DI+). Only if that extreme point is breached in the subsequent period is a trade signal confirmed.
The ADX can then be used as an early indicator of the end/pause in a trend. When the ADX begins to move lower from its highest level, the trend is either pausing or ending, signaling it is time to exit the current position and wait for a fresh signal from the DI+/DI- crossover.
CHART 1: JUMP IN AND HANG ON FOR THE RIDE. If you are an aggressive trader and entered a long position at Point A, and only exited your position at Point C, you would be pleased with the results. This can be achieved with a few simple indicators.
Let's look at recent long-term trend (chart 1) and put trendline analysis together with the DMI system to illustrate the utility of these tools when used in conjunction with each other. An aggressive trader might initiate a long position as the daily resistance line is breached on 11/12/03 (point A). A trader looking for confirmation might wait a day, when the DI+ crosses up through the DI- line, generating a buy signal. A conservative trader might wait for confirmation of the DI+/- crossover by waiting for the extreme point (high) to be exceeded, in line with Wilder's extreme point rule. This confirmation is given the following day (11/14/03). As the market begins to move higher, the support trendline drawn off the lows is tested, but holds, underscoring its validity to a nascent trend. Although the market has moved higher in line with the DI+/DI- crossover and trendline support, the ADX is still below 25 until 12/2/03 (point B), when a trend is finally confirmed. At this point, a trader should recognize that they are in a trending market and trend following systems can usefully be employed.
This brings us to the point of introducing some additional tools that can be used to maximize profit within a trending market. We have already suggested using the ADX as an early indicator of the end of a trend. Note that from point B, when it first registers above 25 indicating a trending market, the ADX continues to make new highs until 01/14/04 (point C) when it closes lower signaling a likely end to the uptrend and that it's time to exit the long position.
A second tool used to identify an exit point and possibly the end of a trend is the parabolic indicator. The parabolic indicator follows the price action but accelerates its own rate of increase over time and in response to the trend. The result is that the parabolic is continually closing in on the price, and only a steadily accelerating price rise (the essence of a trend) will prevent the price from falling below the parabolic, signaling an end to the trend. Chart 2 shows the parabolic indicator overlaid on the previous chart. Note that the parabolic gives an exit signal (point D) the day after the ADX experienced its first lower close.
CHART 2: ADD A COUPLE MORE INDICATORS. Here, the parabolic indicator was used. The exit signal was given one day after the ADX gave its exit signal.
The very basic trendlines that are drawn also could have signaled the end to the uptrend. Note that the price accelerates above the upper channel line in the final extension of the uptrend, tests back to the break and then goes on to make new highs. The subsequent price decline back below the upper channel line would then signal the end of the up-move. As well, another support line similar to the parabolic could also be drawn, and its breach would have been the earliest signal of the end of the upmove.
What About Short-term Trading?
The same tools outlined above can be used for short-term decision making, even in markets that are trading sideways, or so-called trendless markets. While the market may not be trending in a long-term sense, there are multiple smaller, short-term movements taking place that can be exploited. (One caveat must be noted, though: traders need to be aware of what is happening in the bigger picture. If shorter term ADX readings indicate a trending market, traders must be circumspect in initiating trades that are counter to the larger, daily trend.)
CHART 3: INTRADAY BASIS. On this hourly chart of the Australian dollar, the first entry signal was at point A. You could have held until point D, where you should have sold your position. The next entry signal was point AA (short) with a signal for covering that short position at point CC.
Let's then look at a short-term scenario using an hourly chart of the Australian dollar (chart 3). The first hint of a potential trading opportunity is the quick convergence of the DI+/DI- lines in the hour marked by point A. This is caused by the sharp bounce in price during that hour. The next hourly bar breaks through and closes above trendline resistance, precipitating DI+ crossing up through DI-. Following Wilder's extreme point rule, we wait for the previous high to be surpassed, which happens in the next hour at point B. At this point, we have several signals indicating a long position-the break of trendline resistance, crossover of DI+/DI-, extreme point rule satisfied, break of parabolic. As the market moves higher, the ADX begins to rise as well, peaking at point C and declining at point D, giving us our signal to exit the long. Basic trendline and parabolic supports are then broken several hours later setting the stage for the next potential move.
The next signal is given at point AA as the DI- crosses up through the DI+, generating a sell signal. This coincides with the price falling below recent hourly lows. The ADX begins to move up, indicating the possibility of a trend forming and eventually rises over 25 at point BB indicating a trend is in place and that the parabolic should be followed. Trendline and parabolic resistance are then breached and the ADX stalls at point CC, indicating an early, but profitable exit to the trade.
The Trend is Your Friend
Profiting from market trends is the essence of making the trend your friend. The first step to profiting from both short- and long-term trends is understanding what constitutes a trend and knowing how to identify them. The next step is employing a disciplined trading strategy that is specific to trends. A conscientious approach utilizing trendline analysis, the DMI system, and the parabolic indicator should help traders make more friends of market trends.
Trend vs. No Trend
Which Technical Indicators to Use?
If "the trend is your friend," what happens when there is no trend? This is more than just a rhetorical question, since markets tend to move sideways much more frequently than they trend. For example, currency markets are particularly well known for long-term trends, which are in turn caused by long-term macro-economic trends, such as interest rate tightening or easing cycles. But even in currency markets, historical analysis reveals that trending periods only account for about 1/3 of price action over time, meaning that about two-thirds of the time there is no trend to catch.
By Brian Dolan
As published in TRADERS' Magazine July 2005
The Trend/No Trend Paradox
To make matters worse, many traders typically utilize only one or two technical indicators to identify market direction and trade-timing. This one-size-fits-all approach leaves them exposed to the trend/no-trend paradox – an indicator that works well in trending markets can give disastrous results in sideways markets and vice versa. As a result, individual traders frequently find themselves exiting positions too early and missing out on larger moves as a bigger trend unfolds. Conversely, traders may end up holding onto a short-term position for too long following a reversal, believing they are "with the trend," when no trend exists.
To avoid getting caught in the paradox, this article will suggest using several technical tools in conjunction to determine whether or not a trend is in place. This will in turn dictate which technical indicators are best used to gauge entry/exit points as well as provide some risk management guidance. Rather than setting forth a list of concrete trading rules, this article seeks to outline a dynamic approach to the use of technical analysis to avoid getting caught in the trend/no-trend paradox.
Trend-friendly Tools
The obvious starting point for this discussion is to define what is meant by a trend. In terms of technical analysis, a trend is a predictable price response at levels of support/resistance that change over time. For example, in an uptrend the defining feature is that prices rebound when they near support levels, ultimately establishing new highs. In a downtrend, the opposite is true – price increases will reverse as they near resistance levels, and new lows will be reached. This definition reveals the first of the tools used to identify whether a trend is in place or not – trendline analysis to establish support and resistance levels.
Trendline analysis is sometimes underestimated because it is perceived as overly subjective in nature. While this criticism has some truth, it overlooks the reality that trendlines help focus attention on the underlying price pattern, filtering out the noise of the market. For this reason, trendline analysis should be the first step in determining the existence of a trend. If trendline analysis does not reveal a discernible trend, it's probably because there isn't one. Trendline analysis will also help identify price formations that have their own predictive significance.
Trendline analysis is best employed starting with longer time frames (daily and weekly charts) first and then carrying them forward into shorter timeframes (hourly and 4-hourly) where shorter-term levels of support and resistance can then be identified. This approach has the advantage of highlighting the most significant levels of support/resistance first and minor levels next. This helps reduce the chances of following a short-term trendline break while a major long-term level is lurking nearby.
A more objective indicator of whether a market is trending is the directional movement indicator system (DMI). Using the DMI removes the guesswork involved with spotting trends and can also provide confirmation of trends identified by trendline analysis. The DMI system is comprised of the ADX (average directional movement index) and the DI+ and DI- lines. The ADX is used to determine whether or not a market is trending (regardless if it's up or down), with a reading over 25 indicating a trending market and a reading below 20 indicating no trend. The ADX is also a measure of the strength of a trend – the higher the ADX, the stronger the trend. Using the ADX, traders can determine whether or not there is a trend and thus whether or not to use a trend following system.
As its name would suggest, the DMI system is best employed using both components. The DI+ and DI- lines are used as trade entry signals. A buy signal is generated when the DI+ line crosses up through the DI- line; a sell signal is generated when the DI- line crosses up through the DI+ line. (Wilder suggests using the "extreme point rule" to govern the DI+/DI- crossover signal. The rule states that when the DI+/- lines cross, traders should note the extreme point for that period in the direction of the crossover (the high if DI+ crosses up over DI-; the low if DI- crosses up over DI+). Only if that extreme point is breached in the subsequent period is a trade signal confirmed.
The ADX can then be used as an early indicator of the end/pause in a trend. When the ADX begins to move lower from its highest level, the trend is either pausing or ending, signaling it is time to exit the current position and wait for a fresh signal from the DI+/DI- crossover.
Non-trend Tools
Momentum oscillators, such as RSI, stochastics, or MACD, are a favorite indicator of many traders and their utility is best applied to non-trending or sideways markets. The primary use of momentum indicators is to gauge whether a market is overbought or oversold relative to prior periods, potentially highlighting a price reversal before it actually occurs.
However, this application fails in the case of a trending market, as the price momentum can remain overbought/oversold for many periods while the price continues to move persistently higher/lower in line with the underlying trend. The practical result is that traders who rely solely on a momentum indicator might exit a profitable position too soon based on momentum having reached an extreme level, just as a larger trend movement is developing. Even worse, some might use overbought/oversold levels to initiate positions in the opposite direction, seeking to anticipate a price reversal based on extreme momentum levels.
The second use of momentum oscillators is to spot divergences between price and momentum. The rationale with divergences is that sustained price movements should be mirrored by the underlying momentum. For example, a new high in price should be matched by a new high in momentum if the price action is to be considered valid. If a new price high occurs without momentum reaching new highs, a divergence (in this case, a bearish divergence) is said to exist. Divergences frequently play out with the price action failing to sustain its direction and reversing course in line with the momentum.
In real life, though, divergences frequently appear in trending markets as momentum wanes (the rate of change of prices slows) but prices fail to reverse significantly, maintaining the trend. The practical result is that counter-trend trades are frequently initiated based on price/momentum divergences. If the market is trending, prices will maintain their direction, though their rate of change is slower. Eventually, prices will accelerate in line with the trend and momentum will reverse again in the direction of the trend, nullifying the observed divergence in the process. As such, divergences can create many false signals that mislead traders who fail to recognize when a trend is in place.
Putting the Tools to Work
Let's look at some real-life trading examples to illustrate the application of the tools outlined above and see how they can be used to avoid the trend/no-trend paradox. For these examples, MACD (moving average convergence/divergence) will be used as the momentum oscillator, though other oscillators could be substituted according to individual preferences.
The first example (Figure1) illustrates 4-hour EUR/USD price action with MACD and the DMI system (ADX, DI+, DI-) as accompanying studies. Following the framework outlined above, trendline analysis reveals several multi-day price movements, identified by trendlines 1 and 2. Looking next at the ADX, it rises above the "trend" level of 25 at point A, indicating that a trend is taking hold and that momentum readings should be discounted. This is helpful, because if one looked only at the MACD at this point, it might be tempting to conclude that the upmove was stalling as the MACD begins to falter. Subsequent price action, however, sees the market move higher.
Along the way however, trendline 1 is broken and the ADX tops out and begins to move lower (point B). While the price action has been extremely volatile around this point, it should be noted that the ADX over 25 negated the premature crossover signal of MACD as well as the break of support on trendline 1. At point C, the ADX has fallen back below 25 and this suggests taking another look at the MACD, which is beginning to diverge bearishly, as new price highs are not matched by new MACD highs. A subsequent sharp downmove in price generates another negative crossover on the MACD, and since ADX is now below 25, a short position is taken at about 1.3060 (point D).
Following along with trendline 2 now, MACD is clearly weakening as prices move lower. The ADX initially continues to fall indicating the absence of any trend, but begins to turn up after a failed test of trendline resistance at point E. The focus remains on the MACD at this point as the ADX is still below 25. As price declines slow, MACD crosses upward indicating it is time to exit the position at around 1.2900 at point F. Subsequent price action is extremely whippy and the ADX again fails to signal an extended trend, confirming the decision to exit.
The above example showed the interplay between ADX and momentum (MACD), where the absence of a trend indicated traders should focus on the underlying momentum to gauge price direction. Let's now look at an example where a trend is present and it essentially cancels out signals given by momentum.
Figure 2 shows USD/CHF in an hourly format with DMI and MACD as the studies. Beginning with trendline analysis again, trendline resistance from previous highs is broken at point A. Momentum as shown by MACD has been moving higher and supports the break higher. The ADX also rises above 25, confirming the break higher and indicating a long position should be taken at approximately 1.1650. The trade entry could also have been signaled earlier by the crossover of DI+ over DI- and the application of Wilder's 'Extreme Point Rule.'
Subsequent price moves are modest initially, but the relevant feature to note is that the ADX remains well above 25, suggesting momentum signals should be disregarded. This is critical since the MACD quickly generates a signal to exit the trade at point B. Relying on the ADX alone at this point, however, the long position is maintained and subsequent price gains cause MACD to reverse higher again. ADX continues to rise with the price gains, which are also adhering to trendline support. MACD again generates a sell signal at point C, but this is ignored as the ADX approaches 50, suggesting a strong trend is now in place. Price gains become more explosive and the ADX goes on to register new highs. Contrast that with the MACD which is indicating a bearish divergence from point D onwards, even though the uptrend remains intact. The ADX also indicates a bearish divergence, implying trend intensity is fading. Only at point E are exit signals given by the break of trendline support and the decline of ADX below 25 at point E around 1.2000. In this example, a short-term trade was able to capitalize on a much larger move by employing the ADX in addition to the MACD. A strictly momentum based approach would have been caught in multiple whipsaws, or even a premature short based on bearish divergence.
Bottom line
Financial markets are inherently dynamic environments. Nowhere is this more apparent than in the trend/no trend paradox. Trading rules or themes that apply one day might be obsolete by the next day. Carrying that notion over to technical analysis suggests traders need to employ dynamic technical tools to adapt to ever changing markets. An approach that utilizes trendline analysis, Wilder's DMI system, and momentum oscillators can yield far better results across varying market conditions than a single-indicator approach.
If "the trend is your friend," what happens when there is no trend? This is more than just a rhetorical question, since markets tend to move sideways much more frequently than they trend. For example, currency markets are particularly well known for long-term trends, which are in turn caused by long-term macro-economic trends, such as interest rate tightening or easing cycles. But even in currency markets, historical analysis reveals that trending periods only account for about 1/3 of price action over time, meaning that about two-thirds of the time there is no trend to catch.
By Brian Dolan
As published in TRADERS' Magazine July 2005
The Trend/No Trend Paradox
To make matters worse, many traders typically utilize only one or two technical indicators to identify market direction and trade-timing. This one-size-fits-all approach leaves them exposed to the trend/no-trend paradox – an indicator that works well in trending markets can give disastrous results in sideways markets and vice versa. As a result, individual traders frequently find themselves exiting positions too early and missing out on larger moves as a bigger trend unfolds. Conversely, traders may end up holding onto a short-term position for too long following a reversal, believing they are "with the trend," when no trend exists.
To avoid getting caught in the paradox, this article will suggest using several technical tools in conjunction to determine whether or not a trend is in place. This will in turn dictate which technical indicators are best used to gauge entry/exit points as well as provide some risk management guidance. Rather than setting forth a list of concrete trading rules, this article seeks to outline a dynamic approach to the use of technical analysis to avoid getting caught in the trend/no-trend paradox.
Trend-friendly Tools
The obvious starting point for this discussion is to define what is meant by a trend. In terms of technical analysis, a trend is a predictable price response at levels of support/resistance that change over time. For example, in an uptrend the defining feature is that prices rebound when they near support levels, ultimately establishing new highs. In a downtrend, the opposite is true – price increases will reverse as they near resistance levels, and new lows will be reached. This definition reveals the first of the tools used to identify whether a trend is in place or not – trendline analysis to establish support and resistance levels.
Trendline analysis is sometimes underestimated because it is perceived as overly subjective in nature. While this criticism has some truth, it overlooks the reality that trendlines help focus attention on the underlying price pattern, filtering out the noise of the market. For this reason, trendline analysis should be the first step in determining the existence of a trend. If trendline analysis does not reveal a discernible trend, it's probably because there isn't one. Trendline analysis will also help identify price formations that have their own predictive significance.
Trendline analysis is best employed starting with longer time frames (daily and weekly charts) first and then carrying them forward into shorter timeframes (hourly and 4-hourly) where shorter-term levels of support and resistance can then be identified. This approach has the advantage of highlighting the most significant levels of support/resistance first and minor levels next. This helps reduce the chances of following a short-term trendline break while a major long-term level is lurking nearby.
A more objective indicator of whether a market is trending is the directional movement indicator system (DMI). Using the DMI removes the guesswork involved with spotting trends and can also provide confirmation of trends identified by trendline analysis. The DMI system is comprised of the ADX (average directional movement index) and the DI+ and DI- lines. The ADX is used to determine whether or not a market is trending (regardless if it's up or down), with a reading over 25 indicating a trending market and a reading below 20 indicating no trend. The ADX is also a measure of the strength of a trend – the higher the ADX, the stronger the trend. Using the ADX, traders can determine whether or not there is a trend and thus whether or not to use a trend following system.
As its name would suggest, the DMI system is best employed using both components. The DI+ and DI- lines are used as trade entry signals. A buy signal is generated when the DI+ line crosses up through the DI- line; a sell signal is generated when the DI- line crosses up through the DI+ line. (Wilder suggests using the "extreme point rule" to govern the DI+/DI- crossover signal. The rule states that when the DI+/- lines cross, traders should note the extreme point for that period in the direction of the crossover (the high if DI+ crosses up over DI-; the low if DI- crosses up over DI+). Only if that extreme point is breached in the subsequent period is a trade signal confirmed.
The ADX can then be used as an early indicator of the end/pause in a trend. When the ADX begins to move lower from its highest level, the trend is either pausing or ending, signaling it is time to exit the current position and wait for a fresh signal from the DI+/DI- crossover.
Non-trend Tools
Momentum oscillators, such as RSI, stochastics, or MACD, are a favorite indicator of many traders and their utility is best applied to non-trending or sideways markets. The primary use of momentum indicators is to gauge whether a market is overbought or oversold relative to prior periods, potentially highlighting a price reversal before it actually occurs.
However, this application fails in the case of a trending market, as the price momentum can remain overbought/oversold for many periods while the price continues to move persistently higher/lower in line with the underlying trend. The practical result is that traders who rely solely on a momentum indicator might exit a profitable position too soon based on momentum having reached an extreme level, just as a larger trend movement is developing. Even worse, some might use overbought/oversold levels to initiate positions in the opposite direction, seeking to anticipate a price reversal based on extreme momentum levels.
The second use of momentum oscillators is to spot divergences between price and momentum. The rationale with divergences is that sustained price movements should be mirrored by the underlying momentum. For example, a new high in price should be matched by a new high in momentum if the price action is to be considered valid. If a new price high occurs without momentum reaching new highs, a divergence (in this case, a bearish divergence) is said to exist. Divergences frequently play out with the price action failing to sustain its direction and reversing course in line with the momentum.
In real life, though, divergences frequently appear in trending markets as momentum wanes (the rate of change of prices slows) but prices fail to reverse significantly, maintaining the trend. The practical result is that counter-trend trades are frequently initiated based on price/momentum divergences. If the market is trending, prices will maintain their direction, though their rate of change is slower. Eventually, prices will accelerate in line with the trend and momentum will reverse again in the direction of the trend, nullifying the observed divergence in the process. As such, divergences can create many false signals that mislead traders who fail to recognize when a trend is in place.
Putting the Tools to Work
Let's look at some real-life trading examples to illustrate the application of the tools outlined above and see how they can be used to avoid the trend/no-trend paradox. For these examples, MACD (moving average convergence/divergence) will be used as the momentum oscillator, though other oscillators could be substituted according to individual preferences.
The first example (Figure1) illustrates 4-hour EUR/USD price action with MACD and the DMI system (ADX, DI+, DI-) as accompanying studies. Following the framework outlined above, trendline analysis reveals several multi-day price movements, identified by trendlines 1 and 2. Looking next at the ADX, it rises above the "trend" level of 25 at point A, indicating that a trend is taking hold and that momentum readings should be discounted. This is helpful, because if one looked only at the MACD at this point, it might be tempting to conclude that the upmove was stalling as the MACD begins to falter. Subsequent price action, however, sees the market move higher.
Along the way however, trendline 1 is broken and the ADX tops out and begins to move lower (point B). While the price action has been extremely volatile around this point, it should be noted that the ADX over 25 negated the premature crossover signal of MACD as well as the break of support on trendline 1. At point C, the ADX has fallen back below 25 and this suggests taking another look at the MACD, which is beginning to diverge bearishly, as new price highs are not matched by new MACD highs. A subsequent sharp downmove in price generates another negative crossover on the MACD, and since ADX is now below 25, a short position is taken at about 1.3060 (point D).
Following along with trendline 2 now, MACD is clearly weakening as prices move lower. The ADX initially continues to fall indicating the absence of any trend, but begins to turn up after a failed test of trendline resistance at point E. The focus remains on the MACD at this point as the ADX is still below 25. As price declines slow, MACD crosses upward indicating it is time to exit the position at around 1.2900 at point F. Subsequent price action is extremely whippy and the ADX again fails to signal an extended trend, confirming the decision to exit.
The above example showed the interplay between ADX and momentum (MACD), where the absence of a trend indicated traders should focus on the underlying momentum to gauge price direction. Let's now look at an example where a trend is present and it essentially cancels out signals given by momentum.
Figure 2 shows USD/CHF in an hourly format with DMI and MACD as the studies. Beginning with trendline analysis again, trendline resistance from previous highs is broken at point A. Momentum as shown by MACD has been moving higher and supports the break higher. The ADX also rises above 25, confirming the break higher and indicating a long position should be taken at approximately 1.1650. The trade entry could also have been signaled earlier by the crossover of DI+ over DI- and the application of Wilder's 'Extreme Point Rule.'
Subsequent price moves are modest initially, but the relevant feature to note is that the ADX remains well above 25, suggesting momentum signals should be disregarded. This is critical since the MACD quickly generates a signal to exit the trade at point B. Relying on the ADX alone at this point, however, the long position is maintained and subsequent price gains cause MACD to reverse higher again. ADX continues to rise with the price gains, which are also adhering to trendline support. MACD again generates a sell signal at point C, but this is ignored as the ADX approaches 50, suggesting a strong trend is now in place. Price gains become more explosive and the ADX goes on to register new highs. Contrast that with the MACD which is indicating a bearish divergence from point D onwards, even though the uptrend remains intact. The ADX also indicates a bearish divergence, implying trend intensity is fading. Only at point E are exit signals given by the break of trendline support and the decline of ADX below 25 at point E around 1.2000. In this example, a short-term trade was able to capitalize on a much larger move by employing the ADX in addition to the MACD. A strictly momentum based approach would have been caught in multiple whipsaws, or even a premature short based on bearish divergence.
Bottom line
Financial markets are inherently dynamic environments. Nowhere is this more apparent than in the trend/no trend paradox. Trading rules or themes that apply one day might be obsolete by the next day. Carrying that notion over to technical analysis suggests traders need to employ dynamic technical tools to adapt to ever changing markets. An approach that utilizes trendline analysis, Wilder's DMI system, and momentum oscillators can yield far better results across varying market conditions than a single-indicator approach.
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Click here to enlarge
Experience the power of FOREXTrader Charts
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Traders seeking a robust, yet easy-to use charting tool will find FOREXTrader Charts to be a comprehensive technical analysis package. Powered by a third-party composite rate feed, FOREXTrader Charts is fully integrated into both FOREXTrader and FOREXTrader.web.
Some features include:
Ability to overlay multiple indicators for advanced technical analysis
Auto trend line & indicator continuation on charts
Easily save, export, print or email charts
Customize your charts to your individual preferences, including chart type, colors, intervals and more
FOREX Trader Charts' unique modal candlestick and modal bar, which show the price most heavily transacted for the current bar's time interval.
FOREXTrader Charts' impressive array of over 18 technical indicators includes simple and exponential Moving Averages, Bollinger Bands, Relative Strength Index (RSI), Parabolic SAR, Stochastics, MACD, GANN Lines, Keltner Channels and Fibonacci studies.
Choose from 11 intervals, including 8 intra-day charts. Intra-day chart types include candlestick, line and bar. Daily, weekly and monthly charts also include additional chart types, such as FOREXTrader Charts' unique modal candlestick and modal bar, which show the price most heavily transacted for the current bar's time interval.
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