Let’s talk about trend trading and trend-following trading strategies, and how to implement a very, very simple trend-following strategy.
So I have added a long-term period moving average, so it’s a hundred-period moving average, which helps us define the long-term trend. During those trends, you can find re-entry opportunities using various trading approaches, different technical concepts. One of them is the very, very popular pullback trading approach. With the pullback trading approach, we are looking for so-called flags. Flags are temporary consolidations, temporary sideways phases during a trending market where the impulsive wave is currently coming to an end and the market is ranging. When we remind ourselves about a Dow theory, usually it looks something like this. You have an impulsive wave and a corrective wave, impulsive wave, corrective wave. So let’s assume we are in an overall downtrend. We have impulsive waves that go into the direction of the trend, and then we have corrective waves where the price is temporary moving, even sideways. Temporary up-trending phases may also happen.
Those are the flag patterns, or within those corrective phases we are looking for flags. You can find flags using horizontal support and resistance or trend lines. Not always will you be able to find them during trends, and some markets just don’t provide the technicals. But sometimes, and there are certain periods, certain markets, certain timeframes when patterns and flags will show up very nicely. Here you can see this is the Euro, US dollar on the one hour. You can use this pretty much on any timeframe. What you need to make sure is that the market is trading on one side of the moving average to show you that the market is really in a trending market. You could also use a top-down approach where you go to a higher timeframe. You determine a trend direction, and then you go to the lower timeframe to try to find those flags.
Here we have the first one. This is a horizontal flag. The market is just moving sideways without any direction. After this impulsive move, the sellers are currently pausing, and they’re taking a break. Then on the breakout, the down trend is resumed. This is regular market behavior. The Dow theory set it already and analyzed it and verified it decades ago that this is the regular market phase. You have downtrends, and within those downtrends you have impulsive and corrective waves. The wave analysis and the wave function is a natural behavior of any price chart. You will see that flags and pullbacks come in very different shapes. You can have horizontals, you can also have verticals. Here we have a tilted trend line. You can see that if we connect the lows, we have two touch points. It’s really, really important that when you draw a flag pattern you want to see that the level that you are drawing has multiple touch points.
Here, for example, the one before, there is no confluence. You just have one swing low, and you don’t have a second one. No matter how you draw it, you cannot find a good level with at least two touch points. That’s totally fine. You just need to let it pass, and you need to wait for your opportunity when there is a chance and when the technicals change again. You will see that this happens time and time again. You will see those phases where you have a sideways market with multiple touch points, and on the breakout, often a trend is resumed. Flags, as I said, happen in many different shapes. Here is a new down-trending phase, and you can see we connect the lows. You can either connect the lows here to get this trend line, or if you connect the other lows you can see that there would have been two options and both are valid flag patterns and continuation phases during a down-trending market.
We can follow the price action. We have another one, a very nice precise horizontal level. We have the breakout, the market comes back, provides a second, a pullback opportunity here into the previous structure, and then sells off again. Here you can see there is nothing. This is just one single point that has no other confluence, so we are not able to draw another flag pattern. Here at the bottom we would have another flag pattern, but the market never broke into a new low, and therefore the flag pattern was never triggered. You can see afterwards the market did roll over into a new trending phase. Now the market broke above the moving average. Here you may have been able to use a flag pattern like this to get into this bullish trending phase. So really important concepts, and a trader who knows how to draw and use flag chart patterns and understands the context in which they happen as a trend-following tool will often be able to improve his wave analysis and his trench trading understanding.
The market is coming here from an uptrend, trading above the moving average, to then trading below the moving average. Now we also again find multiple levels and multiple flag patterns moving to horizontal touch points that line up perfectly. You can see the market keeps making lower highs here as well. Here you can see another double bottom, two flag patterns or two swing lows that define your flag pattern, and move back into the moving average without breaking the moving average, another important pullback criteria. Then the market keeps selling off. Here we don’t have anything that aligns with this swing low, so there was no way to time a trade after or around this area. That’s totally fine. It won’t work always or it won’t always apply. That is why we have so many tools in our toolbox that we can choose the tools that we need when they are applicable.
Here you can see this also lines up. You can see a very nice trend pullback. The moving average is slightly broken, but the market never really makes a higher high. You can see if we draw our high here, you can see the market never really violates this high structure. This is a gap open on Monday. The market quickly falls back below the range and then continues to trend to the downside. Let’s take a look at a few more examples. Again, we are trading here below the moving average here in this area. You could probably use a horizontal level to define the flag pattern here. You have a very short-term breakout. The market then resumes or reverses on you. You need to cut your losses obviously very quickly. This is the premise for all trading strategies. Nothing will work 100 percent of the time, and that is really, really important that you don’t hold onto your trades. Learn to cut losses, and then the winners will be big enough to take care of the losses.
Here’s another flag pattern where you have a horizontal level that lines up perfectly. It gives you another opportunity to move lower. Here again, a double bottom, giving you the flag opportunity, pull back all the way into the moving average and then a break, retest of the structure, and then the market sells off. Here’s also a final one that then gives you the breakout into the final leg of this down-trending period, then to the upside, you can just repeat the same thing over and over again. Here it’s a little bit hard. This doesn’t really line up. You can see this is already a violation, so not really that good. There are certain market periods where you won’t be able to use this concept. For example, here those really don’t line up.
You don’t want to have a flag pattern where you combine the higher highs. In this case this doesn’t make for a good pullback phase, because if we are in an overall uptrend, we want to see such a market behavior up and down, up and down, up and down. What happens here is that the market keeps making higher highs. This is not really ideal, because it would then look something like this. You have height, and you have a small trend wave and this. This is not really ideal. This is not how the market generally moves during the Dow theory, or at least it doesn’t respect to Dow theory. We need to wait for the market to provide us a good flag opportunity, which then happened here. We have a double or triple high where the market then again respects the technicals on the horizontals,
a nice flag pattern that would have then provided you with another opportunity. Here into the highs you can see that the last up-trending leg we have multiple highs that line up, probably also this one here, and then the final leg of the trend. Word of caution: What is usually working best is that you look for flag patterns early on in new trends. The later you get into an existing trend, usually the likelihood of a follow-through is lower. So you want to get into new trends early on, and you probably want to stay away from the fourth or the fifth or later flag patterns. So you want to focus on getting in early the first or second to third one maybe. Those are usually the better opportunities. The longer a trend goes on, especially in [inaudible 0:09:39], the higher the likelihood that the market will reverse. This is how you can use the concept of flag patterns.
You can layer other confluence factors on top of that. You could use another moving average. You could use Fibonacci’s, for example, so you can measure the latest swing point. You can see when we draw to fib from here to here, you have a very nice retracement to the 50 level, to the 61.8. If you don’t want to wait for the market to reverse, and you want to get in earlier, you could also use Fibonacci’s as your confluence factor. That may also work. I did a recent video on my channel on Fibonacci’s and how to use Fibonacci retracements. Make sure to check that out as well. Let me know in the comments. If you like this video, if you want to learn more about pullback trading, trend-following trading, or what it is that you are really interested in, let me know in the comments below. I’m reading every single comment, so make sure to use that. Until next time.