How to Do Accurate Forex Trend Line Analysis

Accurate Forex Trend Line Analysis – Trendline analysis is one of the most simple, yet effective, ways for forex traders to establish the direction of a trend, and to establish support and resistance levels on currency price charts. It is my number one favourite and fuss-free way of telling the trend direction of any currency pair.

 

What a trendline does is to show you the price movements of the past, where people have bought or sold, and to give you an indication of where the market action could go next.

While some may dismiss or underestimate the power of trendline analysis as being retrospective and overly subjective in nature, trendlines can be very useful in helping you gauge the crowd in action, and which price levels were of concern to traders, and could be of concern in the future.

Most important of all, it represents the underlying trend, and cuts out the noise of the market. Other than telling you the direction of the current trend, the trendlines also serve as areas where you could buy during an uptrend, or sell during a downtrend.

It can even indicate points where you could buy and sell when prices oscillate in a trendline channel, where one trendline connects the highs of market action on one side, and another connects the lows on the other side.

 

A trendline is a dynamic line of support during an uptrend and a dynamic line of resistance during a downtrend. It slopes with the passing of time as buyers and sellers transact currencies at different prices.

By using a trendline, you can tell which direction the currency prices are heading. If it is sloping upward, then the trend is up. If it is sloping downward, then a downtrend is in place.

As the market moves in a series of waves, with periods of expansion and contraction, tops and bottoms will form, and along these points, trendlines are drawn. Trendlines can be horizontal in a trading range, or ascending in an uptrend,or descending in a downtrend. (See Figure 1)

Figure 1: examples of trendlines

 

It is easy to find trendlines of any type on any time frame. On this 60-min chart of EUR/USD, you can see a downtrend defined by a down trendline, then a trading range marked by horizontal trendlines, followed by an uptrend defined by an up trendline. ‘TLs’ stand for trendlines on the chart.

 

 

Trendlines do not just appear out of nowhere; you actually have to draw them into existence. For an up trendline, you draw a line connecting a series of lows, which get gradually higher.

Your line need not necessarily connect all the bottoms of the uptrend, as long as it connects a minimum of two (preferably three) bottom points. This becomes your up trendline, with the trendline acting as support. (See Figure 2)

Figure 2: drawing an up trendline

 

The up trendline shown here connects a few bottom points to form a straightedge line that slopes upward, forming a support line.

 

When drawing a down trendline, you draw a line connecting a series of highs, which get lower with time and, again, your line may not necessarily touch all the tops of the downtrend, as long as it connects a minimum of two (preferably three) rally points. This forms your down trendline, with the trendline acting as resistance.

You should track the low points of an uptrend, and the high points of a downtrend as these are areas where a predictable price response has taken place.

One thing about trendlines is that they tend to start from either an extreme low for an uptrend, or an extreme high for a downtrend and you can only determine these points in retrospect. While there is no doubt that applying trendlines to price charts can be quite subjective, it does not render them useless, in fact they are very practical technical tools.

 

When it comes to drawing trendlines, you may find yourself pondering whether to connect highs, lows or closing prices. Based on my own experience, I find it more useful to connect the highs or lows, rather than to construct trendlines using closing  prices.

Besides that, there are also other reasons to support why connecting highs or lows is better. Since the global currency market operates for 24 hours a day, for five and a half days a week, it can be quite inaccurate to track the opening and closing currency prices of the day as the day begins and ends at different times according to each time-zone.

For example, the Asian session opens and closes before the US market is open, so if you are to track the closing price, which closing price are you going to use? The Asian close or the US close? Some traders use GMT (Greenwich Mean Time), some American traders use EST (Eastern Standard Time), whereas others may
prefer to use their local times on the price charts.

Another reason why it is better to use high or low prices is due to the fact that these are extreme price points of a day, and these points are where there is the most resistance or support of the day, hence reflecting the market psychology better.

 

 

As mentioned earlier, there are generally four stages of a trend: starting with the uncertainty of a new trend, then progressing into a fully charged trend, then slowing down its speed as it matures and, finally, the crumbling and ending of a trend.

Adopting a high probability Trend Riding Strategy requires you to enter a trend at an appropriate timing, which will usually occur during a pull-back or a temporary pause in the trend before it resumes again.

Preferably, you will want to join the trend somewhere between Stages 2 and 3, where there is still room for more price movement in the prevailing trend direction for your profit capture. Your entry into a trend must not be near its end as that will lower the probability of success of the trade.

Before you jump hastily onto a trend, it is best to first assess its strength at the given time. There are several ways of measuring the strength of a trend, and they are through the study of price action and through signals given by various indicators and oscillators.

 

There are some ways to gauge the strength of a trend according to the price chart:

1. Trendline Gradient;
2. Correction or consolidation before the resumption of the main trend.

These are examined in more detail below.

 

One obvious tell-tale visual sign of the strength of a trend lies in the gradient of a trendline. A rule of thumb is that the steeper a trendline, the higher the chances of a trendline break, which will result in either a slower pace of price movement in the direction of the underlying trend or a trend reversal.

A steep trendline in an uptrend, for example, indicates the extreme enthusiasm of buyers as they bid up prices in a big magnitude move, and there are often no clear support levels on the charts.

Such buying sprees tend to run out of steam quickly as all those who want to buy have already bought, and there is not enough influx of new buyers (see Figure 3). The reverse is true of a steep trendline in a downtrend, which indicates the extreme enthusiasm of sellers as they take every opportunity to sell.

Figure 3: example of steep trendline breaking

 

The steep up trendline on this daily chart of USD/CAD would not have been a good place to ride the uptrend as it would be difficult to sustain that enthusiastic level of buying interest for a long time. The lack of new USD/CAD bulls near the end of the trendline prevented the uptrend from continuing.

 

For the Trend Riding Strategy, it is best not to join in the trend when the trendline looks too steep as steep trendlines tend to give way to a less steep trendline or could end with a sharp reversal, and that may cause your trades to get stopped out unless you are willing to risk a lot for potentially very little, since the trend strength seems to be waning.

 

The second way you can measure the strength of a trend is by examining the correction or consolidation period before the main trend continues. A trend cannot go on forever, without traders closing part or all of their positions for profit-taking.

Hence, a trend is bound to experience a price pull-back of some sort even if it is in the midst of a strong uptrend or downtrend. A trend is assumed to be robust if corrections are short and consolidation periods are narrow.

Short corrections occur when prices do not retrace too much, and bounce off above a previous support in an uptrend or below a previous resistance level in a downtrend (see Figure 4).

A short correction in an uptrend indicates that buyers of a currency pair have overwhelmed sellers or it could simply be that sellers are disinterested. In a downtrend, a short correction could indicate that bulls are no match for the aggressive bears.Whatever the reason is, this is a positive sign for the underlying trend.

Narrow consolidation periods are another strong continuation sign for the main trend. These consolidation periods may look like rectangles or flags (small rectangles) on currency price charts, and the magnitude of the corrective move is generally small (see Figure 4 again).

Figure 4: example of corrections

 

The downtrend seen on this daily chart of NZD/USD is an example of a strong trend, based on the observations that a corrective move bounced a good distance away from a previous resistance level, and that consolidation moves during the downtrend were quite small in magnitude.

 

In an uptrend, such narrow rectangles represent a slight battle between bulls and bears of a currency pair, buying pressure is typically sufficient to prevent a deeper correction of prices.

Narrow rectangles in a downtrend, on the other hand, show that selling pressure at resistance is adequate in preventing prices from retracing too much.

Although prices could break out of the rectangles in an opposite direction to the underlying trend, signalling a possible trend reversal in formation, the prevailing trend should be assumed to exist unless there is a sudden change in market sentiment or there are signs of trend reversal through technical indications.

When applying the Trend Riding Strategy, I suggest that you do not trade trends that seem likely to be in stage 4 as the probability of capturing profits can be quite low.

 

 

Before you evaluate the strength of a trend, you should already know the direction of the prevailing trend according to trendlines or moving averages. The main aim of evaluating the strength of a trend is to maximise your entry timing into an existing trend with the objective of a high-probability trade success. Other than looking at the currency price actions on the charts, you can make use of some technical tools to measure trend strength as well as to confirm the trend direction.

 

The Average Directional Index (ADX) is a popular indicator which many traders use to detect direction of trend and the trend strength. However, I find it to be extremely lagging and thus not so useful when it comes to applying it to price charts (See Figure 5).

The ADX is used to determine whether a market is trending, with values above 30 signifying a strong trend, and values below 20 indicating no trend or a trading range. As a measure of trend strength, the higher the ADX reading, the stronger the trend.

This indicator does not distinguish between a bullish or bearish trend. As long as the reading is above 30, it means that either a strong uptrend or a strong downtrend could be in place.

Figure 5: Average Directional Index

 

This daily chart of USD/JPY illustrates that the strong uptrend that formed between July and October 2006 was not reflected at all on the ADX indicator (which lies in a separate window below the price chart) as the reading for this period was below 20, indicating the absence of a trend.

As I find theADX to be extremely slow in reacting, and unable to indicate anything about the trend direction, I prefer to look at two other indicators, which are known as oscillators, to gauge trend strength as well as to confirm the trend direction.

 

The Stochastic is a very popular oscillator which was developed by George Lane in the late 1950s. The Stochastic is a momentum indicator that compares closing prices relative to high-low range over a specific time period.

Stochastics are measured and represented by two different lines, %K and %D, and are plotted on a scale ranging from 0 to 100. Readings above 80 represent strong upward movement, while readings below 20 represent strong downward movements.

Once you have determined the direction of the trend using trendlines or moving averages, you should confirm it with the slope of the Slow Stochastic which indicates the momentum. In an uptrend, you should be looking for the Stochastic to slope strongly upward, whereas in a downtrend, the Stochastic should be sloping strongly downward, in accordance to the direction of the trend (see Figure 6).

In order to gauge the strength of a trend, when prices are making new highs or lows, the Stochastics should be making new highs or lows as well, and if it does so, you are relatively certain that the prevailing trend will continue. If the Stochastics are not doing the same, then that may signal a possible trend reversal.

Figure 6: Stochastic

 

As AUD/USD rallied in an uptrend, Slow Stochastic sloped upward accordingly, and as AUD/USD declined in a downtrend, Slow Stochastic sloped downward accordingly as well.

 

An alternative to using the Stochastics is the moving average convergence/divergence (MACD) histogram. The MACD histogram is useful for anticipating changes in trend. Similarly, you should be looking for MACD histogram to slope upward during an uptrend, and for it to slope downward during a downtrend.

When prices are moving higher or moving lower, the histogram should become bigger as the speed of the price movement accelerates, and the histogram should contract as price movement decelerates.

That is, if a currency pair is rallying with strength, the histogram should be positive and growing larger (see Figure 7). If a currency pair is declining strongly, the histogram should be negative and growing larger. That is how traders can make use of MACD histogram to gauge the strength of a price move.

Figure 7: MACD

 

The initial phase of EUR/USD decline caused the MACD histogram to enlarge in size, illustrating that the speed of decline was fast and furious.

But in the later phase of downtrend, the histogram became smaller, reflecting the slow speed of price decline. The histogram enlarged again when EUR/USD rallied with gusto, but when the bullish momentum slowed down, the histogram decreased in size too.

Now that you have become acquainted with the tools of identifying the trend direction and measuring of trend strength, I will show you some of the basic effective steps to riding the trend.

 

 

To ride a trend successfully, you should get confirmation from the price action or technical signals that a trend is in place, and should avoid getting into trends which are already near the ending stage. There is no need for you to predict what the market is going to do, because you can never know that for sure, but the next best thing is perhaps to just go along with what the market is doing, and trend ridingallows you to achieve that.

Trading a trendline bounce can be a very profitable, yet simple, strategy for joining an existing trend as it provides a relatively low-risk entry point for traders. Here are the steps of this strategy:

1. First determine how long you wish to ride the trend for because that will influence the time frame of the trend you will ride on.
2. Make sure that the current market sentiment agrees with the technicals. If not,
3. Note the gradient of the trendline in both time frames and the number of times it has been tested.
4. Confirm trend direction and trend strength with oscillators.
5. Enter a limit entry or market entry order based on the hourly or daily trendline, depending on your preferred time horizon.
6. Place stop-loss orders at least 20 pips on the other side of the trendline.

I will now go through these steps with you with a more detailed explanation of what to look out for when adopting this strategy.

 

Since many people like to day trade the forex market, I will highlight two suitable time frames for this trading horizon: the daily and hourly time frames. Even if you trade intraday, it is necessary for you to use at least the hourly chart to plan your trade even though you may be using the 5-minute or 15-minute chart to monitor your trade.

In my opinion, it is essential for day traders to know the trend direction on the daily chart as this enables them to trade knowing the overall technical picture.

 

The forex market is mainly driven by the players’ perceptions of fundamental news, and technicals usually follow the market sentiment. Hence, you should look for the market sentiment to be supportive of the trade, in the direction of the prevailing trend.

If the market sentiment appears to be shifting, and the prevailing trend seems to be threatened, you should give the trendline bounce a miss. However, if the sentiment agrees, you can proceed with the rest of the strategy as outlined.

 

As mentioned earlier, for the Trend Riding Strategy I prefer to stay out of joining a trend that is on a very steep trendline (See Figure 8), but that really is up to you, depending on your own risk appetite and trading style.

Figure 8: avoid trends with steep gradients

 

The up trendlines drawn on this daily chart of EUR/CHF were not suitable for trading trendline bounces due to their steep gradient.

 

Ideally, either Stochastics or MACD histogram should be sloping upward when trading an upside bounce (off an up trendline), or sloping downward when trading a downside bounce (off a down trendline).

However, this condition is not a prerequisite as these oscillators may lag if the momentum is not accelerating, but if you can get additional confirmation from the oscillators then the probability of success will be higher.

 

The problem with placing a limit entry order is that sometimes the price may not reach your limit to open your position, and you could end up with an “either my price or none” situation, missing out on the opportunity to trade a trendline bounce.

One way of securing your place on the trend bounce is to initiate your trade a few pips before the price-trendline touch (see the following chart).
Figure 9: trendline bounce

 

The letters A and C on this 60-min chart of EUR/JPY indicate where the price did not touch the trendline exactly, while B indicates where the price hadmoved slightly beyond the trendline. All these three instances are examples of successful trendline bounces.

 

Having tight stops is the worst enemy of this strategy. It is very common for currency prices to exceed and pierce the trendline, even a daily one, by 10-15 pips or more in a very fast-paced move, and then just as quickly retreat back into the main price territory on the action side of the trendline.

This move is often orchestrated by institutional players to hit the accumulation of stops beyond the trendline so as to sweep money off weak hands into their own pockets. Of course, sometimes the prices may pierce 20 plus pips through the trendline, and then make a U-turn back into the old territory, resuming the underlying trend.

Note: There is no one-size-fits-all stop loss level that is the “best”, as that will depend on how long you intend to hold your position for and your lot size.

 

Summary

The idea of riding a trend is age-old, and there is nothing sexy about it. However, timing your entry into an existing trend can be the trickiest part of this strategy. One effective way of riding the trend is to sneak in during a trend pull-back, which you can do by trading trendline bounces, in the direction of the underlying trend.

The nature of the forex market makes trading bounces during an uptrend or downtrend a breeze as there are no uptick rules or restrictions on shorting a currency pair.

Always keep in mind that when you trade, the direction should be in line with the current market sentiment, and if not, it is better to pass up the bounce.