The Trend is your Friend
TRADERS’ BIGGEST PROBLEM
Trading is an great way to make a living
and/or accumulate large sums of wealth. As a trader you
alone are responsible for all your decisions that you
may take to make profits and/or losses in the course of
your trading career.
As a trader you alone will be responsible for all or any
loss that you may make and on the other hand you do not
have to thank anyone for your profits. You are the boss
and you are not obligated to anyone expect yourself.
However there is a problem that most traders do not
understand and that is that most of the time the market
does not move in trends. The market only trends only
30-50% of the time. The rest of the time the market is
sleeping or it does not have a discernable trend from
which traders can make money. Professional traders make
most of their profits in a trending market.
By following trends over different time frames, traders
can increase their profit making opportunity in trending
markets and stay away from markets when they are not
trending.
The Trend is your Friend
TREND AND TRADING RANGE
Traders try to profit from changes in prices: Buy low
and sell high or sell short high and cover low. Even a
quick look at a chart reveals that markets spend most of
their time in trading ranges. They spend less time in
trends.
A trend exits when prices keep rising or falling over
time. In an uptrend, each rally reaches a higher high
than the preceding rally and each decline stops at a
higher level than the preceding decline. In a downtrend
each decline falls to a lower low than the preceding
decline and each rally stops at a lower level than the
preceding decline and each rally stops at a lower level
than the preceding rally. In trading range most rallies
stop at about the same high and declines peter out at
about the low.
A trader needs to identify trends and trading ranges. It
is easier to trade during trends than in trading ranges.
PSYCHOLOGY OF TRENDS AND TRADING RANGE
An uptrend emerges when bulls are stronger than bears
and their buying forces prices up. If bears manage to
push prices down, bulls return in force, break the
decline, and force prices to a new high. Downtrends
occur when bears are stronger and their selling pushes
markets down. When a flurry of buying lifts prices,
bears sell short into that rally, stop it, and send
prices to new lows.
When bulls or bears are equally strong or weak, prices
stay in a trading range. When bulls manage to push
prices up, bears sell short into that rally and prices
fall. Bargain hunters step in and break the decline,
bears cover shorts, their buying fuels a minor rally,
and the cycle repeats.
Prices in trading ranges go nowhere, just as crowds
spend most of their time in aimless mulling. Markets
spend most of their time in trading ranges than trends
because aimlessness is more common among people than
purposeful action. When a crowd becomes agitated or
excited, it surges and creates a trend.
THE HARD RIGHT EDGE
Identifying trends and trading ranges is one of the
hardest tasks in technical analysis. It is easy to find
them in the middle of the chart, but the closer you get
to the right edge, the harder it gets.
Trends and trading ranges clearly stand out on old
charts. Experts show those charts on seminars and make
it seem easy to catch trends. Trouble is your broker
does not allow you to trade in the middle of the chart.
He says you must make your trading decisions at the hard
right edge of the chart!
The past is fixed and easy to analyze. The future is
fluid and uncertain. By the time you identify a trend, a
good chunk of it is already gone. Nobody rings a bell
when a trend dissolves into a trading range. By the time
you recognize the change, you will lose some money
trying to trade as if the market was still trending.
Most people cannot accept uncertainty. They have a
strong emotional need to be right. They hang on to
losing positions, waiting for the market to turn and
make them whole. Trying to be right in the market is
very expensive. Professional traders get out of losing
trades fast. When the market deviates from your
analysis, you have to cut losses without fuss or
emotions.
THREE IMPORTANT TRENDS
You may be asking yourself the question, "What is a
trend and how long does it last?" There are countless
numbers of trends, but before the advent of intraday
charts, there were three generally accepted durations:
primary, intermediate and short-term.
The main or primary trend, is often
referred to as a bull or bear market. Bulls go up and
bears go down. They typically last about nine months to
two years with bear market troughs separated by just
under four years. These trends revolve around the
business cycle and tend to repeat whether the weak phase
of the cycle is an actual recession, or if there is no
recession and just slow growth.
Primary Trend
Primary trends are not straight-line affairs, but are
a series of rallies and reactions. These series of
rallies and reactions are known as intermediate or
medium term trends.
The intermediate or medium term trend can vary in length
from as little as six weeks to as much as nine months,
or the length of a very short primary trend.
Intermediate trends typically develop as a result of
changing perceptions concerning economic, financial, or
political events. It is important to have some
understanding of the direction of the main or primary
trend because rallies in bull markets are strong and
reactions are weak. On the other hand, reactions in bear
markets are strong and rallies are short, sharp, and
generally, unpredictable.
If you have a fix on the underlying primary trend, you
will be better prepared for the nature of the
intermediate rallies and the reactions that will unfold.
In turn, intermediate trends can be broken down into
short-term trends, which last from as little
as two weeks to as much as five or six weeks.
Market Cycle Model
As an investor, it is best to accumulate when the
primary trend is in the early stages of reversing from
down to up, and liquidate when the trend is reversing
from up to down. Second, as traders, we are better off
if we position ourselves with the long side in a bull
market since that is when short-term uptrends tend to
have the greatest magnitude. By the same token, it does
not usually pay to short in a bull market because
declines can be quite brief and reversals to the upside
unexpectedly sharp. If you are going to make a mistake,
it is more likely to come from a counter-cyclical trade.
If you're an intraday trader, you may think all of this
does not apply to you, but really, it does. It is
important to remember that even on intraday charts, the
predominant trend determines the magnitude and duration
of the shorter moves. You may not feel a three-hour
rally is closely related to a two-year primary bull
market move, but it is just as related as a five or
six-day trend.
Charles Dow, the author of the venerable Dow theory,
stated at the turn of the century that the stock market
had three trends. The long term trend lasted several
years, the intermediate trend lasted several months and
anything shorter than that was a minor trend. Robert
Rhea, the great market technician of the 1930s, compared
the three market trends to a tide, a wave and a ripple.
He believed that traders should trade in the direction
of the market tide and take advantage of the waves and
the ripples to time your entry and exit.
CONFLICTING TIMEFRAMES
Most traders ignore the fact that markets usually
are both in a trend and in a trading range at the same
time! They pick one time frame such as daily or hourly
and look for trades on the daily charts. With their
attention fixed on daily or hourly charts, trends from
other time frames, such as weekly or 10 minute trend
keep sneaking up on them and wrecking havoc with their
plans.
Markets exist in several time frames simultaneously.
They exist on a 10 minute chart, an hourly chart, a
daily chart, a weekly chart, and any other chart.
Traders often feel confused when they look at charts in
different time frames and they see the markets going in
several directions at once. The market may look for a
buy on a daily chart and a sell on the weekly chart, and
vice versa. The signals in different time frames of the
same market often contradict one another. Which of them
will you follow? Most traders pick one time frame and
close their eyes to others – until a sudden move outside
of “their” time frame hits them.
A FACTOR OF FIVE
When you are in doubt of a trend, step back and examine
the charts in a timeframe that is larger than the one
you are trying to trade. A factor of 5 links all
timeframes. If you start with the weekly charts and
proceed to the dailies, you will notice that there are
five trading days to a week. As your timeframe narrows,
you will look at hourly charts – and there are
approximately 5 to 6 trading hours to a trading day.
Intra day traders can proceed even further and look at
10 minute charts, followed by 2 minute charts. All are
related by a factor of five. The proper way to analyze
any market is to analyze it in at least two time frames.
If you analyze daily charts, you must first examine the
weekly charts and so on. This search for greater
perspective is one of the key principles of the Traders
Edge Multiple Time Frame Trading System.
METHOD AND TECHNIQUES
There is no single magic method to identifying trends
and trading ranges. There are several methods and it
pays to combine them. When they confirm one another,
their message is reinforced. When they contradict one
another, it is better to pass up the trade.
- Analyze the pattern of highs and lows. When
rallies keep reaching higher levels and declines
keep stopping at higher levels they identify an
uptrend. The pattern of lower lows and lower highs
identifies a downtrend, and the pattern of irregular
highs and lows points to a trading range.
- Draw an uptrendline connecting significant
recent lows and a downtrendline connecting
significant recent highs. The slope of the latest
trendline identifies the current trend A significant
high or low on a daily chart is the highest high or
lowest low for at least a week. As you study charts,
you become better at identifying those points.
Technical analysis is partly a science and partly an
art.
- The direction of a slope of a moving average
identifies the trend. If a moving average has not
reached a new high or low in a month, then the
market is in a trading range.
- Several market indicators, such as MACD and the
Directional system help identify trends. The
Directional system is especially good at catching
early stages of new trends.
CONCLUSION
When you trade in the direction of this long a trend,
you are truly following the markets rather than
predicting them. However trading with the trend is hard
to do because a logical give-up exit point will be
farther away, potentially causing a larger loss if you
are wrong. This is a good example of why so few traders
are successful. They can't bring themselves to trade in
a psychologically difficult way. This article contains content from
New Trading Dimensions, written by Bill Williams and
Trading for a Living, written by Alexander Elder. |
