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Embedded Trends:  A Strategy to Optimize Your Entry

Embedded Trends: A Strategy to Optimize Your Entry

2012-03-30 04:20:00
Richard Krivo, Trading Instructor
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Some traders will notice that a currency pair is moving up or down on a chart and decide to buy it or sell it simply on that basis alone. While that strategy may work on occasion, a higher probability strategy for timing an entry is to look at how a currency pair has been moving across several time frames. By looking at more than one time frame, a trader will become acutely aware of how the pair is moving and how they can use that movement to their advantage. This is known as Multiple Time Frame Analysis.

Here’s a quick overview…

If a trader is using three time frames, let’s say for example the Daily to determine the trend, and the 4 hour and the 1 hour in their analysis, it would benefit the trader to wait until the smaller time frames are in agreement or alignment with the larger Daily time frame.

Take a look at my (and I use the term loosely) “drawing” below for a visual on this concept

Embedded_Trends_A_Strategy_to_Optimize_Your_Entry_body_MTFA_Cycles_downtrend_with_Stops.png, Embedded Trends:  A Strategy to Optimize Your Entry

The black lines represent the Daily trend. Within the Daily trend to the downside we see the red channel lines which represent the 4 hour trend. Within the 4 hour trend we see the green arrows which comprise the 1 hour trend. So the 4 hour trend and the 1 hour trend are “embedded” within the Daily trend. And embedded within the 4 hour trend is the 1 hour trend.

Trends, within trends, within trends.

For an ideal entry, we would like to see all three trends or trading cycles aligned and headed in the same direction at roughly the same time.

For example…

What if a trader had opened a short position, in the direction of the overall trend at the red asterisk on the diagram above and placed their stop above the entry at the red line? Right…they would have been stopped out as the 4 hour and the 1 hour trends retraced. The Daily trend may have been going down but since the 4 hour and 1 hour trends were just beginning a retracement the trade did not work out.

Now, what if a trader had shorted the pair at the green asterisk with a stop at the green line just above their entry? They would not have been stopped out and in fact would be in a profitable trade as price action moved in their favor. They entered the trade at a more opportune time…when the 4 hour and the 1 hour time frames had completed their retracement and were moving back in the direction of the Daily trend.

This is what we mean when we say “fine tuning” the entry.

Let’s take a look at a pair that currently demonstrates these embedded trends in action…the AUDCAD.

On the Daily chart of this pair below we can see that the pair has a bearish (downside) bias. The pair is trading below the 200 SMA (Simple Moving Average) and has been building lower highs and lower lows on the chart for about a month.

We will use the MACD indicator to “fine tune” our entry…

MACD is in a bearish posture given that both the MACD line (red) and the Signal Line (blue) are below the Zero Line. (The Zero Line is the horizontal line separating the upper and lower green histogram bars.) In addition, the MACD has just crossed over the Signal Line to the downside.

Also, at the time of this chart, the AUD is among the weaker currencies and CADis among the stronger.

Based on this information, the higher probability direction to trade this pair is clearly to the downside…we want to sell it.

Embedded_Trends_A_Strategy_to_Optimize_Your_Entry_body_mtfa_macd_3_29_1.png, Embedded Trends:  A Strategy to Optimize Your Entry

Taking a look at the 4 hour chart below we see that price action is also moving to the downside in this time frame as well. MACD also indicates that bearish momentum is present in this time frame. Again both the MACD Line and the Signal Line are below the Zero Line and both are at a strong downward angle with good separation between the two.

Since our entry signal, a bearish MACD crossover, has already taken place on this chart, we would not enter based on this chart. We are looking for an entry that is a “fresh move” to the downside based on renewed bearish momentum.

Embedded_Trends_A_Strategy_to_Optimize_Your_Entry_body_mtfa_macd_3_29_2.png, Embedded Trends:  A Strategy to Optimize Your Entry

As we check out the 1 hour chart below we can see that the MACD line is poised for a bearish crossover of the Signal Line…the area within the black circle. This is the signal we have been looking for! When/if that crossover occurs, that would be our entry signal to short the pair. Our stop would go above the most recent bullish retracement as marked.

Embedded_Trends_A_Strategy_to_Optimize_Your_Entry_body_mtfa_macd_3_29_3.png, Embedded Trends:  A Strategy to Optimize Your Entry

This is precisely how we would go about using Multiple Time Frame Analysis to “stalk” a currency pair across several time frames to optimize our entry as the smaller time frames come into alignment with the larger time frame.

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

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