Forex Strategies #3 – The Correct Trend

This is part 3 of my 7-part series on trading strategies.  Click here for part 2: The Right Timing.

Forex Trading Strategies #3 – The Correct Trend

“Trend is your friend.”  You probably heard of this quote before, a supposedly valiant attempt to describe what most trading systems today are based on. But what is the “Trend,” and how can I be his friend?  Well, a quick search in google for the definition of “Trend” shows that:

A pattern of gradual change in a condition, output, or process, or an average or general tendency of a series of data points to move in a certain direction over time, represented by a line or curve on a graph. – Businessdictionary

Or, based on Google’s dictionary – A Trend is A general direction in which something is developing or changing…

So, to become a friend of the trend, You need first to identify what kind of a trend we are in today and then follow it…

Simple. Well, I wish trading is that simple because everyone looks at trends differently… here is an example:

If you call this a Downtrend and plan to SELL into the pair, then I guess you could be right… as you are seeing a drop of this pair from the 131.58 level down to the 130.47 (over 100 pips)… However, this is the 15-Minute chart… Let’s move to a higher time frame… (a 15-minute chart means that every candlestick represents 15 minutes, for more information on Candlesticks, please read my tutorial on Japanese Candlestick)

This is the same currency pair, but looking at the Daily Chart, which means that each candlestick represents a 24-hour trading period… and we can see that since the beginning of February 2012, GBPJPY has gained over 1300 pips at one point… even at the current level, it is still showing 1100 pips of gain… So shouldn’t we call this an Uptrend?

And, of course, this dilemma is not isolated to the GBPJPY pair. It is pretty much with EVERY CURRENCY pair; if you look at lower time-frames, you see one thing and another thing at higher time-frames… How can we identify Mr. Right Trend and be his friend?

Well, here’s a thought, how about we stop looking at charts? 

Let me be clear that I’m not advocating stopping using charts or indicators. Of course, they have their places in trading, quite indispensable, if I may add… but they suck at determining trends…

If you think you can predict what will happen next by looking at what happened before, then you are in a world of surprise… What we have is a lack of data, similar to the story of the blind men and the elephant… (skip down if you know the story – taken from Wikipedia)

…the story says that six blind men were asked to determine what an elephant looked like by feeling different parts of the elephant’s body. The blind man who feels a leg says the elephant is like a pillar; the one who feels the tail says the elephant is like a rope; the one who feels the trunk says the elephant is like a tree branch; the one who feels the ear says the elephant is like a hand fan; the one who feels the belly says the elephant is like a wall; and the one who feels the tusk says the elephant is like a solid pipe.

A king explains to them: “All of you are right. The reason every one of you is telling it differently is because each one of you touched the different part of the elephant. So, actually the elephant has all the features you mentioned.”

So what happens when you ask the King what is an elephant?  I think his answer would be along the lines of a gigantic creature with big ears, a long nose, huge tusks, and walks on four legs, among other things… the major differences between the blind men and the king are not only eyesight but the fact that the king can see the true form of what the elephant is…

I think if you make each of the six blind men walk around the elephant for an hour and then report back, we’ll get a very different story… but of course, that is beyond the scope of this article…

And that leads us back to the “Trend” and the question: What is its “true form”? 

At the risk of sounding too geeky, I think the trend is the effect of different driving forces of the market… much like when we see the waves of the ocean and feel the breeze of the wind, that is the end product of the changes of or effects of pressure, density, temperature, dimension, and gravitation forces… 

Similarly, to determine the trend, we need to determine the forces that move the market, which are the “causes” behind the “effect” known as the Trend.

Of course, theoretically, you can try to calculate every single event that affects the market to determine the trend, or you can focus on a few important factors that drive the trend…  Much like the theory that governs fluid dynamics, and since I’m not a mathematician, here’s an introduction from a professor at Stanford explaining the theory, and if you listen to her closely, you’ll see that not every factor affects the results, that sometimes it is just not necessary to include those events in your calculation…

So, in short, here are the two majors things I look at when determining the trend:

1. Market Perception
2. Risk Sentiment

Market Perception

There is a saying that when it comes to trading, perception is everything… But I believe that sometimes perception is even more powerful than the actual event.  That’s why “Buy on the rumor, Sell on the news” is thrown around almost daily.  So what is perception?  When the market believes something, it doesn’t matter if it is true, and the market will act on it…

“Buy on the rumor, Sell on the news”

If the market believes that the Federal Reserve will announce a rate hike, we will see USD getting bought off sharply… The market will position itself so much in advance (Buy on rumor) that at the actual announcement, traders may even SELL USD as the effects of the Rate Hike have already been priced in; thus, the term “Sell on the news.”  This is one of the strong reasons driving the trend, and if you can pay attention to what’s happening in the market today, it will help you stay on the right side of the trend…

For those hardcore Technical Analysts who wouldn’t consider anything else, here is a news flash for you: All major hedge funds, banks, and financial institutions pay close attention to fundamental news releases… there are TV stations dedicated to reporting financial news… And these are very smart people who graduated from top universities…  Need I say more?

Risk Sentiment

Emotions may sometimes drive the trend… When the market crashes or there are fears of a crash, traders will sell off on their riskier holdings to minimize loss, which can turn into a snowball effect…

The opposite is also true when the market is optimistic, and everything goes up because everyone and their cousins are trying to get a piece of the action… these are risk sentiments, or risk appetite/risk aversion sentiment.

In Forex, if you see a combination of safe-haven currencies gets stronger, it is probably risk aversion. For example, when you see USD, JPY, and CHF gaining across the board, then that is probably because traders are afraid and want the safe-haven status that these currencies provide…

On the other hand, when you see EUR, GBP, AUD, and NZD gaining across the board with USD and JPY weakening, it is probably risk appetite as traders demand more return on their investments… Usually, the higher the interest rate a currency provides, the higher the risk.

In conclusion, one can accurately determine the trend by looking at the market’s focus.  If the market focuses on an upcoming event, that event will be the driving factor.  You may ask what these upcoming news events are.  Well, you’ve come to the right website because this is what we are all about. We dedicate this site exclusively to helping you determine the upcoming trend…

If you want a few pointers to get started, I’d recommend starting with the weekly news calendar, which is posted prominently on the homepage of this site… It tells you what’s coming up, and you will soon see how the market revolves around these releases, time and again…

I hope this article helps you understand Forex better and points you to the right direction… To learn more about fundamental trading, check out some recommended books on my site…