The old saying ‘the trend is your friend’ is so often repeated in Forex trading circles that it has almost become a clique but nevertheless there is still a lot of truth in it. Trading against the trend is usually a bad idea, especially on medium to long term time frames. On a long enough time frame the long term trend can make a bad trade come good, while a trade entered at a very favourable price against the direction of the market’s long term underlying trend can easily turn into a disaster.
But what exactly is ‘the trend’, how exactly do we detect the trend and why does a trend occur in the first place? In this short article I am going to try and answer these questions…
What is the trend?
I would define the trend as the market’s directional bias on a given time frame. However I should warn the reader that a directional bias on a very small time frame such as a 5 minute candlestick chart isn’t really a directional bias and could simply be a blip or a correction. When the trend is different on different time frames the direction on the longer of the time frames usually wins, that is, the market price will usually reverse on the shorter of the time frames and start to move in the same direction as the price on the longer time frame.
How do we detect the trend?
On a price chart of a suitable time frame such as a 4 hour or daily candlestick chart an uptrend will present its self a series of higher high and higher lows, that is to say that while there will still be highs and lows each significant high will be a new high and each significant low will still be higher than the previous lows. Likewise, a downtrend will appear a series of lower highs and lower lows. Many traders also use technical indicators such as moving averages to tell them which way the trend is going, many traders find such indicators useful to help them filter out the noise but I believe that when it comes to telling the direction of the long term trend they are not really needed, if the direction of the trend is not immediately obvious to any trader looking at a medium or long term price chart then I would suggest that there is probably no significant trend at all. I would also warn the reader that looking for the trend in a long term price chart will only tell them what has already happened and there is no guarantee that the future will look like the past. Just because a strong trend has existed in the past does not mean that the market can’t turn around in the next five minutes. However trend following is based on probabilities, not certainties. And the theory behind trend following goes that if a trend has existed in the past up until the present then it is wiser to bet on that price movement continuing into the future than it is to bet against it.
Why do trends occur in the first place?
Trends occur in financial markets because of large macro economic forces and the Foreign Exchange (or Forex) market is one of the markets that are driven by these forces. Forces such as government/central bank policy, trade deficits and even commodity prices in some cases and such like, all these forces and many others will drive the value of a nation’s currency. The effects of these forces does not tend to change day to day and therefore once a trend begins as a result of these large economic forces it often continues for sometime. I would warn the reader that not all financial markets are driven by such forces – the stock market for example is driven on an intra day basis by the whims of speculators and does not therefore tend to trend well. The Forex market however is moved by these things especially the large currency pairs and therefore tends to trend pretty well.
A guest post by forextradingforbeginners.org.uk.
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