Building the Best Forex Trading Strategy EverFour (4) Methods for Identifying and Following the Master Price Trend

‘The trend is your friend, learn to recognize and to follow your friend’

In this analysis, we are going to investigate 4 different methods for identifying the master trend in a price chart. But first of all, we are going to refer to the 3 different market phases and then how to apply the appropriate timeframes.

The 3 Different Market Phases

There are three basic market phases, common for all Financial Markets:

(a) Consolidation Period (The markets moves sideways within a certain Range or else a Price Channel)

(b) Going Up / Uptrend

(c) Going Down / Downtrend

The 3 phases can also be described as:

(i) Consolidating Period (ranging)

(ii) Trending (up or down)

(iii) Trend Reversing (up or down)

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Master Trend and Timeframes

There is a master trend for almost every timeframe you trade. Most probably, this trend will not be visible directly in the timeframe you trade. You need to search for the master trend 2 timeframes above your entry chart (MetaTrader). For example:

  • Trading the M5 chart → use the M30/H1 charts for identifying the trend
  • Trading the H1 chart → use the H4/D1 charts for identifying the trend
  • Trading the D1 chart → use the W1/M1 charts for identifying the trend

The Essence for Top-Down Researching

The wise way to analyze any market trend is starting on the highest timeframe by going down (Top-Down Analysis). This approach will provide you a wide understanding of the current market conditions and the true market depth.

Therefore, if your execution timeframe is H1, start researching the D1 and then the H4 timeframe to identify any trends and opportunities. The execution timeframe H1 will be useful in determining the ideal time to enter the market. Avoid to start your analysis on the lowest timeframe by going up (Bottom-Up Analysis).

 

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Major Methods for Trend Identification

There are many ways to analyze the master trend. These are four (4) widely used methods for that purpose.

 

(1) Identifying the Formation of Price Channels

  • Method: Later-Stage Trend Identification
  • Timeframes: All
  • Reliability: 5/5
  • Applicability: 2/5 (requires several price hits)

Long-term price trends tend to evolve within certain price channels. Price channels consist a pair of two parallel trendlines and can be ascending, descending, or horizontal. If the price touches the boundaries (external trendlines) of those channels usually strong buyers and sellers become active.

USDX -When the price touches the boundaries (external trendlines) of those channels usually strong buyers and sellers become active

Price channels and trend lines are two of the most important aspects of technical analysis, no matter if you trade Forex, Equities, or Commodities.

The 3 Types of Price Channels

As it was mentioned before, financial assets tend to move within a price channel. The angle of the price channel defines if there is a master trend, or if the market is consolidating, as follows:

(i) If the market moves within an Ascending Price Channel the trend is bullish

(ii) If the market moves within a Descending Price Channel the trend is bearish

(iii) If the market moves within a Horizontal Price Channel there is no master trend and the market is consolidating

The Features of a Strong Price Channel

These are some key features of a strong price channel:

(1) The price channel is visible in both the D1 and H4 charts. Preferably, it can be seen also in the H1 chart.

(2) The price channel is characterized by a strong and balanced ascending (/) or descending angle (\).

(3) The slope of the price channel is neither feeble (<30 degrees) nor too steep (<50 degrees).

(4) The price has already made multiple hits on or close the boundaries of the channel (3-4 minimum price hits on each side). Less than 3 price hits can signify the potential for the formation of a price channel but not an existing price channel.

(5) The price hits on the H4 chart must be within 40-50 pips of the price channel’s top/bottom

(6) Some price action may be observed outside the channel but most of it must occur inside the channel. Even entire bars/candles are acceptable outside the channel, but not more than 2-3 bars/candles. After 1-3 bars the price action must return within the channel. Ideally, candlestick formations (Japanese) will appear at this point, confirming the price reversal. In the case of a descending price channel, we should expect candlestick patterns such as the Doji, the Hammer, the Shooting Star, etc. In the case of an ascending price channel, we should expect candlestick patterns such as the Evening Star, the Hanging Man, the Harami, etc.

(7) The price channel may contain 1-3 internal trendlines. These trendlines will be parallel to the two boundaries (external trendlines) of the channel.

(8) There might be multiple price channels in the same chart, and these price channels may co-exist for long periods of time.  The price action is often able to respect multiple different trends but eventually most of these trends will become obsolete and only one trend will prevail (there can only be one at the end).

 

(2) Observing the Sequence of Highs & Lows

  • Method: Mid-Stage Trend Identification
  • Timeframes: All
  • Reliability: 2/5
  • Applicability: 4/5

This is the most classic method for spotting a trend. The great advantage of this approach is that you can do it visually, without the need of an indicator or any complicated technique.

The Existence of a Trend

  • An uptrend, when there are is a sequence of higher highs and higher lows. In other words, the market forms a new higher low and then a new higher high.
  • A downtrend, when there are is a sequence of lower lows and lower highs. In other words, the market forms a new lower high and then a new lower low.

The End of a Trend

(i) An uptrend ends when the market is unable to form a new higher high, and after a while, the market forms a new lower low.

(ii) A downtrend ends when the market is unable to form a new lower low, and after a while, the market forms a new higher high.

(iii) If (i) and (ii) occur two times in a row, then the market has entered a consolidation period and it is expected to range.

 

(3) The ADX Indicator (Average Directional Index)

  • Method: Early-Stage Trend Identification
  • Timeframes: M30 and above
  • Reliability: 3/5
  • Applicability: 4/5

The ADX was introduced by J. Welles Wilder in 1978 {New Concepts in Technical Trading Systems} as an indicator of measuring the trend strength in a series of price data.

Introduction to ADX

The ADX includes three lines:

(a) the ADX line that measures the strength of the trend

(b) the +DI line (green) which presents the bullish strength

(c) the -DI line (red) which presents the bearish strength

The ADX can be used for three purposes:

  • Determining the direction of the trend
  • Determining the strength of the trend
  • Signaling price reversals

The +DI line (GREEN) shows the bullish strength and the -DI line (RED) shows the bearish strength

Using the ADX

A strong trend occurs when the ADX is above 25, there is no clear trend when the ADX falls below 20.

  • When the green (+D) line is on top of the red (+D) line, ADX signals an uptrend
  • When the red (-D) line is on top of the green (-D) line, ADX signals a downtrend
  • When the two lines (+D, -D) are found close to its other, the price is ranging

Trading Signals:

-A bullish signal can occur when +DI moves higher than -DI, but only when the master trend is also bullish.

-A bearish signal can occur when -DI moves higher than +D and at the same time the master trend is bearish.

Notes:

  • The ADX indicator can be easily combined with moving averages
  • The ADX indicator can be combined with MACD and RSI for entry confirmation
  • The ADX can be used in multiple timeframes {it is more reliable on M30 and above}

 

 

 

(4) Moving Averages (MAs) & Moving Averages Line-Up

  • Method: Early-Stage Trend Identification (Price Crossovers)
  • Timeframes: M30 and above
  • Reliability: 1/5
  • Applicability: 4/5

Moving averages are among the most popular trend-identification tools, especially among equity traders.

Using a single Moving-Average to Determine the Trend

When trading equities, you can tell the trend simply by identifying if the market is above or below the 200-day MA. The same method can be used when trading any other financial market, but it isn’t of course equally reliable.

Notes:

  • You can use Simple MAs (SMAs) or Exponential MAs (EMAs), EMAs are considered more reliable
  • The most important Moving Averages include the 50 periods, the 100 periods, the 144 periods, and the 200 periods.
  • You can use MAs in any timeframe (M5 and above)
  • The length of the periods of the MAs should be aligned to the timeframe used. As a general rule, for shorter timeframes use longer-period MAs, and for longer timeframes use shorter-period MAs
  • The Price crossover to MAs can be used as a signaling machine but it isn’t reliable
  • You can combine MAs with tens of other technical analysis tools

Moving Averages Line-up

An alternative method for identifying the trend is combining three (3) different MAs and observing their line-up.

Example:

By combining the 21 EMA, the 100 EMA, and the 200 EMA:

(i) When the Price is above 21(EMA), 21(EMA) is above 100(EMA), and 100(EMA) is above 200(EMA) you have an ideal uptrend.

(ii) When the Price is below 21(EMA), 21(EMA) is below 100(EMA), and 100(EMA) is below 200(EMA) you have an ideal downtrend.

(iii) When the three moving average are hitting each other, there is no trend and the market is consolidating.

An alternative method for identifying the trend is combining three (3) different MAs and observing their line-up

Notes:

  • The spacing between the moving averages is important. The more space between the moving averages, the stronger the price momentum.
  • Experience has shown that you can’t rely any research solely on Moving Averages and their combinations

 

Summary and Conclusions

From all the above four (4) methods, the best method for identifying and trading the trend is the 1st method (Price Channels). Financial assets tend to move within channels. Price channels are not only helpful in determining the master trend, but they can provide also ideal entry / exit points, close to their boundaries. The combination of a Price Channel with chart patterns ( Learn more) and candlestick patterns can prove even more reliable. Some traders combine price channels with Harmonic Patterns ( Learn about Harmonic Patterns). You can use and trade price channels in all timeframes but you need to wait for 3-4 price hits on each boundary, in order to be sure.

Observing the sequence of Highs & Lows is useful for confirming your short-term decisions (entries). You can combine this methodology with any other method or system and that creates value. You can use Highs & Lows Sequence in all timeframes.

The ADX indicator is also a useful tool, not only for identifying the trend but also as a signaling machine at the point of crossovers between +DA and –DA. You can use ADX crossovers in all timeframes above M30.

The Moving Average Method is only useful if you trade equities. There is no point in trying to identify the trend of a currency pair based solely on Moving Averages or Moving Averages Line-Up.

Whatever method you choose to apply the key is to focus on the right timeframe. The best timeframes to build your trending system are the H1, H4, and D1. The trend in very short timeframes is irrelevant because of the market noise. Whatever is your execution timeframe, you can identify the trend by researching the next two timeframes (i.e. H1→H4 and D1). Finally, the wise way to analyze any market trend is starting on the highest timeframe by going down (Top-Down Analysis).

 

■ Four (4) Methods for Identifying the Market Trend

George Protonotarios, Financial Analyst

» George at Linkedin

(c) November 2016


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