Over the last 2 years the market has been changing a lot and we saw across the board many currency pairs has started moving away from those nasty big range zone and have been shifted towards more clear trends. Trend trading can be as difficult as range trading if you don't understand the characteristic of this new type of environment, and you need new adequate rules to be able to profit in the market. In this regard my article is going to provide you with some core basics and unique rules that have been helping me to trend trading with a unique strategy.
A healty trading market is when we move step by step: Consolidation - Breakout type of move. As a general rule if a market is moving in a consolidation or a range trading box or a base, followed by a breakout and than repeat the process, than the market is doing what it should be doing (see Figure 1). One of the best hedge fund managers PT Jones has explained this process quite simple, and I'm quoting him here:
The basic premise of the system is that market move sharply, when they move. If there is a sudden range expansion in a market that has been trading narrowly, human nature is to try to fade that price move. When you get a range expansion, the market is sending you a very loud, clear signal that the market is getting ready to move in the direction of that expansion. PT Jones
Figure 1. USD/JPY Daily Chart. Trend Trading.
- Identifying a New Trend.
One of the best way to achieve a great Risk:Reward ratio is to be in a trade as close as possible to the starting point of the move. I've done a lot of research and found out that majority of the newly-developed trends have one thing in common: a broken trend-line from a previous trend. The degree and the gravity of the move, after we break a trend-line depends on the time frame, the length and the angle of the trend-line.
The angle of the trend-line can vary enough and it's quite important in projecting the velocity of the move after the trend-line breakout. Based on my observations and research I found that the lower the angle of the trend-line breaking, the more significant the move becomes. In order to be able to visually measure the trend-line angle you can draw imaginary lines above/below down-trend-lines/up-trend-lines (see Figure 2 gray lines).
Figure 2. USD/JPY Weekly Chart. Trend-line types.
I'm only working with two categories of trend-lines in order to keep it simple:
- Major trend-lines connecting the big Swing High/Low points (Big= "V" shape Top/Bottom);
- Intermediate trend-lines which connects the minor Swing High/Low points;
- Trend-line Hold vs. Breakout
Figure 3: EUR/USD 1h Chart
A key question we could ask ourselves is how do we know if the trend-line will hold or breakout. We could either wait for confirmation and let things unfold, in which case we're going to be late in the trade which ultimately will alter our RR, or we can observe a few key factors that can help us anticipate if the trend-line will either hold or not. From a technical perspective being aware of this factors should help traders asserting that probability of what is more likely to happen:
- Angle of the trend-line: As I've mentioned earlier the lower the angle of the trend-line breaking, the more significant the move becomes, conversely the steeper the angle of a trend-line, the less likely it is to hold.
- How many times the TL has been hit: The more times a trend-line get hit, the weaker it becomes and it's less likely to hold. Based on my research you should be looking for a breakout after the 3rd touch (see Figure 2). On lower time frame the intermediate TL can be hit as much as 5-6 times before a breakout.
- Confluence of Support/Resistance Levels: This is a requirement because it's increasing the probability of the trend-line to hold. Having confluence zones of support and resistance makes the pattern more powerful(see Figure 3).
- Trend-lines Anomaly:There are some occurrences when a trend-line is broken but without the momentum confirmation. A
valid trend-line breakout is always confirmed by the momentum as both of them go in tandem and the range expansion should go in the direction of the breakout. When we have a false breakout don’t disqualify a trend-line because it has been simply passed by a small fractional amount. You should patiently wait until the market turns below/above TL (see Figure 4).
Figure 4. EUR/USD 4h Chart.
- Departure Trend-line Setup
Everything we have discussed so far are key elements in order to understand the Departure Trend-line Setup that we're going to discuss next and which is the core part of this strategy. Like anything else in trading, missing pieces of information typically mean the difference of success or failure, so I'll suggest to read again the above section before going further.
The Departure Trend-line Setup has two features:
- Entry a trade on the premise the TL holds, which is the easiest one;
- Entry a trade on the premise that the TL breaks, this setups gives a better risk:reward ratio;
- The Spike Base Pattern
Figure 5. The Spike Base Pattern
You'll often see that after an initial big surge in price, either up or down the market will start trading inside a very narrow box, once you start noticing them you’ll see them quite often (see Figure 5). This pattern should be quite straight forward and has 2 key elements:
- A clear spike with a strong momentum in price.
- A pause in price in the form of an trading box.
(Image: no brainer trades, http://www.nobrainertrades.com/2011/05/liquidity-gaps-and-spike-removals.html)
Now that we have defined what a spike base pattern is and we know how to determine if a major move is underway, it's time to come back and integrate everything we learned so far into the Departure Trend-line Setup which has clear risk management strategy with defined entry and exit points. We're going to focus more on the second scenario where we enter a trade on the premise that the TL will break.
Figure 6. The Departure Trend-line Pattern
In Figure 6 we have gone one step further and combined the Spike Base Pattern into the Departure Trend-line Setup with the following characteristics:
- First we draw a trend-line between two clear points. As a rule of thumb you only draw a trend-line between points that have a clear price structure in the form of a "V" shape move. Look at all the instances (see notes 1,2) where we draw a trend-line between 2 points, we had a strong push down which was quickly reversed the next candle or in other instances it reversed with the same candle.
- Secondly we have the trend-line departure move when we move away from TL in a strong fashion way with big momentum to form the liquidity gap. This is the first signal the TL will soon break.
- Last thing we have the spike base pattern formed which gives us the entry and SL levels.
We use as entry point the breakout of the base and the SL the other end of the base. As target, based on the structure of the pattern we either use the starting point of TL (see Trade 1) or use projection which is the case of Trade 2, where we measure the first reaction from TL and project that measurement to the downside.
- Final Words