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Trading with the trend is trading with the flow.
When the prevailing trend is up, why would you want to look for short entries when buying might result in much smoother trades?
Many amateur traders, even when facing a very obivous trend can’t stop trying to predict reversals and burn their fingers going counter-trend, whereas they could have made so much more money by simply joining the trend.
But even if you are not a trend-following trader, you can combine the concept of trading with the trend and with momentum with your regular trading approach. Knowing where the price is going and which side of the market is stronger is an important trading skill.
To be able to correctly read price action, trends and trend direction, we will now introduce the most effective ways to analyze a chart.
In our Forex trading course, you will learn even more about this way of reading and trading price.
Intro: The different market phases
Before we learn how to identify the trend, we should first be clear what we are looking for.
It may sound too simplistic first, but stick with me for now and you will soon see the power of this analysis approach.
Markets can do one of three things: go up, go down, or move sideways.
Of course, how fast (or how slow) and how long the individual periods last changes all the time, but price can only do one of those three things.
The picture below shows you the three possible scenarios and how the market keep alternating between the phases. We will shortly see how all price patterns and chart formations are also made up of those moves.
Reading trends the simple way: The Line Graph
Most traders only use bars and candles when it comes to observing charts, but they completely forget about a very effective and simple tool that allows them to look through all the clutter and noise: the line graph.
The purpose of bars and candles is to provide detailed information about what is happening on your charts, but is this really necessary when it comes to identifying the overall trend? Probably not.
A trader should zoom out from time to time (at least once a week) and also switch to the line graph to get a better and clearer picture of what is currently happening. And since our only goal here is to identify the trend direction and become aware of the overall situation, the line graph is a perfect starting point.
The market rythm: Highs and lows
This is my personal favorite way of analyzing charts and although it sounds very simple, it is usually everything you need to understand any price chart.
Conventional technical analysis says that during an uptrend you have higher highs, because buyers are in the majority and push price higher, and lows are also higher because buyers keep buying the dips earlier and earlier.
It works the same during a downtrend: lows are lower when the seller surplus moves price lower and highs are lower because sellers sell earlier and buyers are not as interested.
Chart example: Head and shoulders vs highs and lows
Highs and lows define all market patterns and chart formations. Below we see a Head and Shoulders pattern and this pattern is, of course, also made up of highs and lows. This pattern beatifully shows how transitioning highs and lows describe the shifting power between buyers and sellers.
We just need to follow the highs and lows to understand what the market is telling us.
Try it out and you will be able to describe all market patterns anc conventional chart formations using highs and lows.
3. Moving averages
Moving averages are undoubtedly among the most popular trading tools and they are great to identify the market direction as well. However, there are a few things to be aware of when it comes to analyzing trend direction with moving averages.
- The length of the moving average highly impacts when you get a signal when markets turn.
- A small (fast) moving average might give a lot of early and false signals because it reacts too soon to minor price movements. On the other hand, a fast moving average can get you out early when the trend is about to change.
- A slow moving average might provide signals too late. Or, it can help you ride trends longer when it filters out the noise.
In the screenshot below we used the 50 EMA which is a mid-term moving average. You can see that during an uptrend, price always stayed well above the moving average and once price has crossed the moving average, it entered a range. In a range, price does not pay too much attention to moving averages because they fall in the middle of the range, hence average.
If you want to use moving averages as a filter, you can apply the 50 MA to the daily timeframe and then only look for trades in the direction of the daily MA on the lower timeframes.
4. Channels and trend lines
Channels and trend lines are another way of identifying the direction of a trend and they can also help you understand range markets much better.
Whereas moving averages and the analysis of highs and lows can also be used during early trend stages, trendlines are better suited for later trend stages because you need at least 2 touch-points (better 3) to draw a trendline.
I mainly use trendlines to identify changes of established trends; when you have a strong trend and suddenly the trendline breaks, it can signal the transition into a new trend. Trendlines during ranges are ideal when it comes to finding breakout scenarios when price enters the trending mode again. Also, trendlines can be combined with moving averages nicely because of the complimentary characteristics.
If you want to learn more about trendlines, take a few minutes and watch our video here: learn how to draw trendlines.
5. How to use the ADX indicator
The ADX is an indicator that you could use to determine the direction of the trend and for the strength as well. The ADX indicator comes with three lines: the ADX line that tells you the strength of the trend (we deleted this line in our example, since we only want to analyze the direction of the trend), the +DI line which shows the bullish strength (green line) and the -DI line which shows the bearish strength (red line).
As you can see in the screenshot below, the ADX signals an uptrend when the green line is on top of the red line, and it signals a downtrend when the red line is higher than the green line. When price is ranging, the two DI lines are very close together and hover around the middle.
The ADX can be combined with moving averages nicely and you can see that once the DI lines cross, price also crosses the moving average. In the video below we explain how to use the ADX in more detail with the other concepts.
If you like this introduction to reading charts and you want to take your tradint to the next level, take a look at our advanced Forex and Futures trading course.
You will learn our professional and profitable trading strategies and also get our best setups every week.
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