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How to Build a Strategy, Part 4:  Grading Trends

How to Build a Strategy, Part 4: Grading Trends

James Stanley, Contributor

Whether a trader is building a strategy to trade ranges, breakouts, or trends – it is often beneficial to be able to grade how ‘strong’ the trend(s) may be.

For traders looking to trade ranges or breakouts – well they generally want the trend, if any, to be quiet to non-existent. After all, if the currency pair is already making new highs and new lows – the trader would be too late to trade the breakout. The range probably wouldn’t be operative in that condition either since price has been repeatedly setting new levels of support and/or resistance.

The 3 primary market conditions

For those traders looking to employ trending strategies, they usually want to buy up-trends cheaply – or sell down-trends expensive.

Use the ‘Longer’ Time Frame in the Analysis to Grade the Trend

As we looked at in The Time Frames of Trading, traders will often employ multiple time-frames in their analysis in an effort to get a ‘bigger picture’ view of the market they are trading.

Using multiple time-frames gives the trader the advantage of taking a step back to get a bids-eye-view of the market, and that is precisely what the longer of the two time-frames employed can do.

The longer time-frame can provide this ‘big-picture-view’ so that when we dial down to the shorter timeframe to plot our trade, we know what the general market environment has been doing.

Chart created by James Stanley

As we discussed in The Time Frames of Trading, traders can use longer time-frames to grade trends. The table below lists some suggested multi-timeframe setups. So, as you see below, if you are using the hourly chart to enter trades, the 4-hour chart may offer an analysis of the trend. If you are using the 4 hour chart to place trades, the Daily chart will often offer this same type of information.

Multiple Time-Frame Analysis Intervals; prepared by James Stanley

Grading Trends

There are quite a few ways to grade trends, and many of those ways have pros and cons. One of the more popular indicators for grading trends is the 200 period Simple Moving Average, which is often considered to be one of the more common technical indicators in usage today.

The 200 period moving average is plotted on the chart, and traders will often consider the trend to be up if price is trading above the 200; while considering the trend to be ‘down’ while price is trading below the 200 period Moving Average.

Chart created by James Stanley

In the chart above, you can see one of the primary benefits of this type of analysis: It’s simple. A trader merely needs to observe prices location to a moving average to say that the trend is up or down.

But this type of analysis may not offer us what we want, which is to focus on and analyze ‘trends,’ with an idea for how ‘strong’ the trend may have been.

As a matter of fact, this type of analysis may even be misleading. Let’s take a closer look at the portion of the chart above that we had denoted as the ‘up-trend.’

Chart created by James Stanley

As you can see, the 200 period Simple Moving Average will not always be able to offer valid trend analysis. The same can be said for all other moving averages as well, because, quite simply, any moving average is going to be lagging the market (since moving averages are built on past prices).

Since most indicators are lagging the markets, many traders have then attempted to grade trends as simplistically as possible; under the presumption that stripping away indicators from the analysis may provide more-timely trend-identification, by using only current price to analyze momentum. The concept of Price Action analyzes at individual candles without the necessity of indicators.

In An Introduction to Price Action we looked at a common way that traders can grade trends without any indicators at all.

During up-trends, price will often make successive ‘higher-highs,’ while also printing ‘higher-lows.’ The chart below will illustrate in more detail:

Chart created by James Stanley

And, on the flip-side, down-trends will often show ‘lower-lows’ and ‘lower-highs.’

Chart created by James Stanley

Match the Approach to the Environment

While this may sound intuitive and simple, in practice it is more difficult.

If one is witnessing (on the longer-term chart) a succession of higher-highs and higher-lows; or repeated lower-lows and lower-highs – then we are seeing a trend.

This trend may have developed for any number of reasons, but traders will generally want to look to employ the age-old mantra of ‘buy-low,’ and ‘sell-high’ in these environments.

Chart created by James Stanley

While the market may move from a trending environment to a ranging environment, money management can usually be used to help mitigate the losses that may occur. If a trader is looking to buy an uptrend, and enters at a ‘low’ price around support – placing a stop underneath that support; a quick change of condition into a range (thereby pulling price lower) – would only expose the trader to their tight stop underneath support.

If, however, the market is ranging – traders can take a different approach as there are now 2 possibilities that may take place.

  1. The range holds – and price stays bound within support and resistance.
  2. The range breaks – and support/resistance yield to an extended move.

Chart created by James Stanley

Neither of these can be easily predicted – which is why traders need to strategize their approach when trading range-bound markets; deciding before-hand whether or not they want to look for breaks of support and resistance (and thus placing entry orders around these levels), or a continuation of range-bound prices.

--- Written by James B. Stanley

You can follow James on Twitter @JStanleyFX.

To join James Stanley’s distribution list, please click here.

How to Build a Strategy, Part 1: Market Conditions

How to Build a Strategy, Part 2: The Time Frames of Trading

How to Build a Strategy, Part 3: Support and Resistance

Trading Psychological Whole Numbers

Attacking News Events with Price Action

How to Trade Panic

Forex Trader’s Guide to Price Action

DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.