In forex trading, trends play a significant role. Anticipating the movement of price is critical to your success in this market. While it can be difficult at times to identify short term trends, our analysis has found that long term trends are easier to define and exploit.
Before defining what we mean by a trend, we should first identify what we do not mean. Looking at the price on a chart, one sees plenty of “noise,” or random spikes and dips in the price movement.
One might think that since price moves up and down (or more often wiggles around) constantly, there cannot possibly be any discernible pattern to identify when making profit is possible; however, this assumption would be incorrect.
By recognizing these long-term trends, you can determine what is currently occurring in the market. Once you know that a trend exists, it is possible to trade in that direction until you have reached your desired goal or exiting for risk management purposes.
Identifying trends
There are many ways to identify these trends, but by far, the easiest way is with a basic moving average.
A simple 200 day SMA (which looks at closing prices over the past 200 days) will show where prices are typically traded based on historical data. If the price is above this line, then there is an uptrend, and if below the line, there’s a downtrend.
While indicators can help confirm what may already be evident on the price chart, trading against the trend is generally not a wise decision. It is because price tends to move in the direction for extended periods.
Trading against the movement can be hazardous and lead to substantial losses in short order.
It’s important to note that trends do not always continue in the same direction indefinitely. There will be times when price reverses course and moves back in the opposite direction.
At these times, it is possible to make profitable trades by taking advantage of this change in momentum.
However, it is still essential to ensure that your analysis confirms that an actual reversal has occurred and not just a short term correction within the overall trend.
Why use Trends
Trends can be quite helpful in determining what trades you should place, but they are even more helpful as a risk management tool.
A movement is not always right on target, which can lead to a loss of account size. If the market continues to move against your position, it’s possible to lose a substantial amount of money.
When dealing with long term trends, the exact opposite happens: instead of losing money on each trade over time, you gain it (or at least part of that increase).
While this may seem like an obvious plus, it’s important to remember that giving back some or all of those profits along the way is still possible using traditional stop-loss methods.
While we know how significant long term trends can be for traders attempting to succeed in the market, they can also measure and predict price movement.
This is done by identifying the average distance of a trend, which we define as the ratio between the height of a particular move and its length.
Using this formula, you can calculate the potential movement of an asset over any given period. This includes weeks, months or even years down the road.
Our traders see that a moving average has identified a 20 SMA (orange) with a bullish trend (upward sloping), along with a downward sloping 200 day SMA.
While their signal is to go long, our trader knows that it may be unwise to enter a position if the price turns around and heads back down suddenly.
Using the 200 day SMA as a guide, he decides that profitable entry will become available once again if this moving average also begins to trend downward (indicating a possible reversal).
