In this article, we’re going to focus on what many traders consider to be the most attractive of the three conditions: Trends.
Why Trends?
Of the three possible market conditions, trends are often considered to be the most desirable for a few different reasons. Future price movements are unpredictable. Price action merely gives traders a clear and concise view of the market so that they can look to implement strong risk-reward ratios in their strategies.
This is why trading in trending environments can be so attractive. If the trend is to continue, the trader can reap three, four, or five times the initial risk that was used to enter the position… and if the trend isn’t going to continue, the trader can look to cut their losses quickly.
Further – trading trends via price action is a way to decrease ‘guess-work’ with fundamental analysis.
If fundamentals are improving for an economy, then traders will generally look to buy in anticipation that those fundamentals may, eventually, bring on higher rates in that economy.
As traders move prices higher with increasing demand, price action will show the up-trend with higher-highs and higher-lows; and if those rate expectations are to continue to increase and if the fundamental news is going to continue to improve, the rational expectation is that the trend will also continue to move higher.
Threading the Needle with Multiple Time Frame Analysis
Traders can use multiple time frame analysis to get two different vantage points of a market; with the primary goal being to enter trades and trigger positions in terms of the ‘bigger picture’ trend.
Rather than basing the entirety of a trader’s decisions on a single time frame, traders can look to a longer-term chart to determine the ‘general condition’ and trend of that market. In the 4-hour chart below, we’re looking at GBPUSD making continual higher-highs and higher-lows over the past year:
Up-trend in GBPUSD over the past year
As you can see in the above chart, GBPUSD has been on a tear since July
of 2013, putting in a +2200 pip up-trend; and this is shown via price
action with the continual higher-highs and higher-lows.
When a situation like this presents itself, the trader should look for
opportunities to go long so that if this +2200 pip trend can continue,
they can look to take part in the move.
The only question is whether or not a new ‘higher-low’ has actually been
made on this longer-term chart, and the answer to that will never be
known until it’s too late. But this is the advantage of price action;
the premise of whether or not this is going to be a ‘higher-low’ can
allow the trader to look for a risk-efficient entry.
Executing the Entry
As we said above, you’ll never know whether a higher-low has been set
until after price action has proven that the trend will continue: But
the hypothesis that a higher-low ‘may’ have been set is enough for
traders to assimilate risk management of a potential position.
In the below chart, we’ve moved down to the hourly time frame so that we
can more accurately plan an entry in the same market we had looked at
above.
The hourly chart presents greater granularity for plotting and planning the entry
Traders can watch the shorter-term chart to begin planning their
entries; and in the event of an up-trend, as was seen above, traders
want to wait for support to be set (the higher low) so that they can
look to buy with a stop just below that ‘higher-low.’
What allows this to Work – and why are Trends so desirable?
As we’ve said a few different times in this article, future price
movements are unpredictable; and the goal of price action analysis isn’t
to get a 100% accurate forecast of what will happen because nothing in
this world can offer that.
Rather, this is simply a way for traders to look to get the
probabilities of success on their side, if even just a little bit by
getting the most clear and concise view of a market.
Make no mistake about it; retracements can last for a prolonged period
of time. Case-in-point, check out the down-trending channels in the same
GBPUSD chart we looked at just a moment ago:
Traders can wait for higher highs and lows to show on entry chart before triggering position
What allows trend trading via price action to work so effectively for
some traders is the fact that if and when they’re on the right side of
the trade, they can reap far more than they had to risk to get into the
position.
This could be a risk-reward ratio of 1-to-2, 1-to-3, or 1-to-4. Traders
can look to ‘scale-out’ of positions as trades move further in their
favor; even adding a break-even stop to ensure against taking a loss in
the position should prices happen to turn around.
If a trader is able to average out of their positions with a 1-to-2
risk-to-reward ratio, they need to be right approximately 33% of the
time to break-even; spreads or commissions not included. If a trader
wins $2 when they’re right, but loses only $1 when they’re wrong – well
if they win 40% of the time, they stand a legitimate chance at making a
profit: These traders don’t need to win 60 or 70% just to get a chance
to break-even on their strategy.