I’m sure you’ve heard of the famous saying that the “trend is your friend”.
That’s why you often hear that you should “trade with the trend”.
But while it sounds so simple…
It’s not actually so because how do you “trade with the trend” if you’re not sure what is the trend?
For example, if you’ve identified that the 1-hour chart is in an uptrend…
But the 4-hour chart is in a downtrend…
How do you decide whether it’s an uptrend or downtrend for your trading?
In this post, I will put an end to all this confusion for you.
I’ll share with you exactly how to identify the real direction of the trend for your trading purposes…
I’ll also share with you exactly how I identify a trend…
And finally, I’ll share with you exactly how to put everything together so you know whether you should go Long, Short or stay out of the market altogether.
How to Identify A Trend
So in order to identify a trend, you need to first understand how a trend is formed.
For a trend to form, it always forms wave patterns.
You see, if a market goes up, it can’t go straight up forever.
The market has to take a “breather” before going up again.
Hence it forms these wave-like patterns in the market forming Higher Highs and Higher Lows like this:
Similarly, if a market goes down, it never goes straight down forever.
It also has to form wave patterns of Lower Lows and Lower Highs like this:
This is how you generally identify whether a trend is up or down.
However, this is not enough to really establish whether it’s an uptrend or downtrend.
Here’s what I mean – take a look at this chart below:
The chart above is on the USDCHF.
You can see that it is forming Lower Lows and Lower Highs.
So this is considered a downtrend right?
Let me now show you the full picture of this chart:
From the chart above, you can see that the earlier Lower Low and Lower High wave pattern you saw is from the highlighted blue box.
Although there was the wave pattern of Lower Lows and Lower Highs, when you see the big picture, it’s clearly in an uptrend.
So the Lower Low and Lower High wave pattern was just a part of the bigger uptrend wave.
Now, this can start to get confusing because if you zoom out even further…
This uptrend you see above might just be part of an even bigger downtrend wave pattern.
So to prevent you from driving yourself insane, we need to use a filter.
And that filter is using Moving Averages.
Using Moving Averages to Filter
Moving Averages calculate the average of the last number of bars as determined by you.
So if you use a 20-period Moving Average, it calculates the average value of the past 20 bars.
If you use a 100-period Moving Average, it calculates the average value of the past 100 bars.
And with every new bar, it has a new average.
To give us an indication as to whether the market is in an uptrend or downtrend, we want to use two different Moving Averages with different values.
In general, if the shorter period Moving Average is above the longer period Moving Average, the momentum of the market is up.
And if the shorter period Moving Average is below the longer period Moving Average, the momentum of the market is down.
But how do you decide what values to use for our Moving Averages?
This is very subjective and dependent on the trader.
Some traders like to use shorter periods like the 10-period and 20-period Moving Average…
While some traders like to use longer periods like the 100-period and 200-period Moving Average.
So the question is…
“What’s the best Moving Average combination to use?”
The answer is…
There isn’t one.
It comes down to your trading style.
In general, a shorter Moving Average period will be more sensitive to market movements.
While a longer Moving Average period will be less sensitive to market movements.
Here’s the same chart I’ve used above but with the 10-period and 20-period Exponential Moving Average (EMA):
You can see in the chart above that the 10 EMA and 20 EMA sticks closer to the market.
It’s also more sensitive to the market’s movement as you can see that the 10 EMA crossed below the 20 EMA where the market started to form Lower Lows and Lower Highs.
Now, here’s the same chart but with the 100 EMA and 200 EMA:
From the chart above, you can see how far away both the EMAs are compared to the previous chart.
And in this chart, the 100 EMA is always above the 200 EMA, indicating that the momentum is up.
So in the first chart, you have the market indicating that when the Lower Lows and Lower Highs wave pattern was formed, the market is in a downtrend.
But in the second chart, you have the market indicating that the Lower Lows and Lower Highs wave pattern is part of a bigger uptrend.
So which is correct?
The answer is that they are both correct in their own way.
It ultimately comes down to your trading methodology on how you trade them.
What I personally like to use is the 20 EMA and 50 EMA to indicate whether the trend is up or down.
So if the market is forming Higher Highs and Higher Lows and the 20 EMA is above the 50 EMA, I consider that an uptrend.
And if the market is forming Lower Lows and Lower Highs and the 20 EMA is below the 50 EMA, I consider that a downtrend.
But here’s the catch…
Just because I determine that the market on the chart is in an uptrend, it doesn’t mean I will go Long.
Similarly, if I determine that the market on the chart is in a downtrend, it doesn’t mean I will go Short.
That’s because I want to trade in the direction of the bigger trend.
And that’s where I will use one more filter.
And that is…
Using A Higher Timeframe
You see, if the 1-hour chart is in an uptrend showing that the market is forming Higher Highs and Higher Lows and the 20 EMA is above the 50 EMA…
It doesn’t mean that the 4-hour chart is in an uptrend.
Take a look at this 1-hour chart below:
You can see on the right-hand side of the chart that the market started to break about the previous swing high and form Higher Highs and Higher Lows.
At the same time, the 20 EMA has just crossed above the 50 EMA and the market is trading above both EMAs.
So on the 1-hour chart, the market has started its uptrend.
But take a look at the 4-hour chart below:
On the right-hand side of the chart, you can see that although the market started to go up…
The 20 EMA is still below the 50 EMA indicating that the market is still in a downtrend.
So is the market in an uptrend or a downtrend?
The answer is you take the bigger timeframe as the reference.
In this case, we want to use the 4-hour chart as a reference for the bigger trend.
And the reason is that you always want to trade with the bigger trend.
Because with the bigger trend, you’re able to get a bigger risk-to-reward ratio.
But how do you determine what is the higher timeframe?
It depends on the main timeframe you’re trading on.
So for example, if you’re trading on the 15-minutes chart, then the higher timeframe could be the 1-hour chart.
And if you’re trading the 1-hour chart, then the higher timeframe could be the 4-hour chart.
And if you’re trading the 4-hour chart, then the higher timeframe could be the daily chart.
Putting It All Together
Now, let’s put all these together to show you how it works with your trading strategy.
Let’s say your trading strategy is to trade with the trend…
How do you decide when to go Long and when to go Short?
Let me walk you through how I make that decision.
So first of all, here are the criteria for me to take a Long pullback trade:
- Start with the 1-hour timeframe. The market must be making Higher Highs and Higher Lows above both EMAs and the 20 EMA must be above the 50 EMA.
- Wait for the market to do a pullback to either of the EMAs.
- See the Stochastic Oscillator if there is a Hidden Divergence.
- If there is, take a look at the 4-hour timeframe. The 20 EMA must be above the 50 EMA at that point. The market has to also be trading above the 50 EMA.
- If the above criteria are met, go Long.
Now let’s look at a trading example to show you what I look at on the chart.
So first of all, what I will do is look at the 1-hour chart and see if there is any potential setup.
In the chart above, I’ve identified that the 1-hour chart is in a downtrend.
It’s making Lower Lows and Lower Highs.
At the same time, the 20 EMA is also below the 50 EMA.
So I’m only looking for potential Short pullback trades.
On the right-hand side of the chart, the market has pulled back to the 20 EMA and found some resistance there.
At this point, I look at my Stochastic Oscillator to see if it’s showing a Hidden Divergence.
As you can see, the market is forming a Lower High but the Stochastic Oscillator is showing a Higher High.
There is a Hidden Divergence here.
But before I plan my trade, I will take a look at the 4-hour chart to see if the 20 EMA is below the 50 EMA, and also if the market is trading below the 50 EMA.
So what I’ll do now is take a look at the 4-hour chart:
From the 4-hour chart, I can clearly see that the market is in a strong downtrend as it has been trading well below the 20 EMA.
For the 4-hour chart, I do not look at the Stochastic Oscillator.
What I’m looking for is whether the 20 EMA is above or below the 50 EMA…
And whether the market is trading below the 50 EMA.
As long as both conditions are met, I will look to enter into a trade on the 1-hour chart.
And I don’t care if the market has been going down for some time or not.
Some traders will worry whether the market has been “overextended” and hence not take a trade.
I’m not bothered by that because when the market trends, an uptrend can continue to go up and a downtrend can continue to go down.
Let’s take a look at another example.
This time I’m looking to trade Lower Lows in an uptrend.
For this trade, what I’m looking for is for the market to form Lower Lows in an uptrend…
And for the Stochastic Oscillator to show a Higher Low for a Regular Divergence.
Similarly, I want the 20 EMA to be above the 50 EMA on both the 1-hour and 4-hour chart.
However, the market does not have to be above the 5o EMA on the 1-hour chart.
So I start off by looking at the 1-hour chart:
On the right-hand side of the chart, I can see that the 20 EMA is above the 50 EMA.
The market has also formed a Lower Low.
And the Stochastic Oscillator is showing a Higher Low for a Regular Divergence.
At this point, I can see a potential Long trade.
However, I want to see if the 4-hour chart is showing an uptrend as well.
So I quickly take a look at the 4-hour chart and I see this:
As you can see on the right-hand side of the chart, the market is actually in a downtrend.
The market has actually formed a Lower High on the 4-hour chart…
And the 20 EMA is below the 50 EMA with the market trading below the 50 EMA.
What this means to me is that the market isn’t in sync.
The 1-hour chart is in an uptrend, but the 4-hour chart is in a downtrend.
So what do you do in this situation?
I stay away.
That means I don’t get into a trade even if the 1-hour chart shows a valid setup.
And the reason is that I don’t want to go against the bigger trend.
At this point, I simply look at other currency pairs.
There are many opportunities in the market and I don’t feel the need to force a trade where I don’t have the best chance of it working out.
And you should do the same.
Here’s a summary of what you have learned in this post:
- For a trend to happen, the market moves in wave patterns.
- In an uptrend, the market will make Higher Highs and Higher Lows.
- In a downtrend, the market will make Lower Lows and Lowe Hights.
- To further define the trend, we want to add two filters
- Two Moving Averages
- A Higher Time Frame
- If the shorter period Moving Average is above the longer period Moving average, the market is generally in an uptrend.
- If the shorter period Moving Average is below the longer period Moving average, the market is generally in a downtrend.
- To enter into a trade for our setup, we want to confirm the trend of the higher timeframe.
- If the shorter period Moving Average is above the longer Moving Average on the higher timeframe, we only want to trade Long setups.
- If the shorter period Moving Average is below the longer Moving Average on the higher timeframe, we only want to trade Short setups.
- And if the higher timeframe and shorter timeframe are showing different trends, the market is not in sync and that means to stay out of the market.
While there are many different ways to identify the trend, the one that I’ve shared in this post will generally work well for all trading setups.
Ultimately, it comes down to finding one that works for you.
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