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TECHNICAL ANALYSIS

Trading Trends – An Art or Science?

technical analysis forex trend trading

What is trend trading?

Trend trading is an approach to the money markets that is unfamiliar to most private traders. To understand this concept, one first needs to define the term “trend”. The easiest analogy to use is “a fashion trend”. When buying a clothes item, the minimum time we would expect it to stay in fashion is at least the season it has been designed for. That’s a minimum of 3 months.

Most consumers would be pretty annoyed to have purchased the item, only to find out it is no longer fashionable after a day, a few hours or minutes, or worse, even before it has stepped out of the shop.

Price action in the money markets should be viewed in exactly the same light. Long-term traders look for trends, both in a bull or a bear market, to establish themselves not in minutes or hours but days to weeks, or months.

A paradigm shift

This requires a shift in understanding the way most private traders use charts and time frames. All too often, traders make the mistake of going down to a lower time frame to manage stops. This is a critical error as managing on a lower time frame will mean getting stopped out too early on intraday noise. And how is money made in trading? By letting your winners run and then compounding into the trend as it matures over time, accelerating returns on an initial small risk.

The roots

So where does this approach of relying on lower time frames stem from? The answer lies in  knowledge - more than psychology. Without the right understanding of trends, it would be the ingrained human trait of “fear” to bank profit, as soon as a trade starts entering into a positive territory. Throw “greed” into the equation based on an over-leveraged trade size, simply to make a small scalp or move in the market worth a decent monetary gain, and it becomes a hairy ride that all too often ends in a disaster.

Big brother/little brother

Now consider this; like fashion, if trends in the market last days to weeks to months then why  not shift your trading up to the weekly and daily time frame? We have what is called the big  brother/little brother scenario, where the weekly (big brother) gives us a macro view of price  action and where the daily (little brother) is then used for entries and, most crucially, for stop  management.

A knowledgeable trader would then also know how to go down to a lower time frame, even say a 1 hour chart, to find an entry point but will always manage stops on the daily chart, allowing him to be in that trade days, weeks or possibly months later.

In simple terms; we need to understand natural market movement, and eliminate psychology - the bane of most traders.

The benefits

Shifting your trading and exit management from a lower time frame to the daily and weekly brings a host of benefits to it:

1. It eliminates intraday noise - allowing for a stress-free ride through the trading day.

2. It allows for pullbacks in the trend - which means a longer time in a trend and hence larger profits.

3. It allows for compounding (scaling in) - further positions can be added to winning positions, accelerating profits.

4. It allows for an initial low risk - which again removes the stress compared to when one risks large but the rewards are far greater because of the above reasons.

Optimal entries are important but it is ultimately your stop loss management - and the power of compounding - that determines how much money you exit with.

This is, in essence, “the art” of trend trading – a mechanical and emotionless approach that is coupled with human discretion of knowing when to trade and when to stand side.

Heard this before

Managing your stops on the daily time frame is, of course, not a totally new concept. Many have tried with reasonable levels of success but most will tell you that they still get stopped out too quickly. The Parabolic SAR is often a tool used to manage stops but it will stop you out on pullbacks. Another typical approach is the low of the previous bar in a bull trend and the high of the previous bar in the bear trend, again an approach which gets you out of your winners too early.

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