Trading forex with the trend

August 31, 2012 07:00 PM

Trends are great profit-making opportunities. They are directional, but usually include ranges that provide you a chance to hop on board at numerous stages.

If forex traders have the potential to make the most money trading with the trend, the opposite is true. That is, traders have the potential to lose the most money, and lose it fast, trading against the trend. As a result, it makes sense to trade with the trend.

Even though trends are directional, they tend to move in a step-like progression. Large trend moves are followed by smaller corrections within the trend. For retail forex traders in a position, those corrections can be both painful and confusing. Corrections can increase uncertainty; uncertainty increases anxiety; anxiety increases fear; fear is a trader’s worst enemy. It is hard to trade well with heightened fear.

During the corrections, many retail forex traders get themselves turned around. Instead of waiting the corrections out and buying a dip on an uptrend, or selling a rally on a downtrend, the temptation is to sell a corrective low or buy a corrective high. In doing so, traders can get out of sync with the trend and find themselves in a cycle of repeatedly trading against the trend.

Fibonacci retracements are a technical tool that can give traders a much-needed framework for trading forex trends. They specifically can help traders stay on the trend when the trend is strong, and exit the trend if the clues suggest the trend is over. 

Makings of a trend

A trending market occurs when there is an imbalance. The imbalance is caused when the buyers are overwhelming the sellers in an uptrend, or the sellers are overwhelming the buyers in a downtrend. Typically, the imbalance originates from the forex market’s largest and most capitalized traders. They have the firepower to introduce imbalance to an otherwise balanced market.

Conversely, retail traders typically cannot cause a trending market. They can participate in a trend and benefit greatly from a trending market, but do not have the capital to move the market in a trending direction for a prolonged period of time. 

Because most retail traders do not see the actual large money flows that cause a trend to start and continue, they rely on technical tools as a proxy for measuring trend strength. This is where Fibonacci retracements come into play. 

Retracement zones

Strong trends do not move in a straight line, but take steps higher (or lower). A trend move consists of a fast and directional move higher (assuming an uptrend), followed by a smaller correction to the downside. The corrections typically are caused by traders who are anxious to take profit and counter-trend traders who are trying to pick a high extreme. The combination swings the market to the downside for a period of time. If the market is in a strong uptrend, typically there are measurable characteristics for the corrections within that broader trend. 

Most traders know that there are a variety of Fibonacci retracement levels that can be applied to trend moves as a way to measure corrections. These levels also can be used to measure the strength of the trend.

The first key retracement is the 23.6% level, followed by the 38.2%, 50%, 61.8%, 78.6% and 100%. Although charting purists say all are important, in trending markets experience shows that the 38.2% and the 50% levels are the most relevant. The area between these two Fibonacci levels can be termed the “Correction Zone.”

If the Correction Zone can hold after a trend move higher, it says two things about the uptrend: Buyers likely are well-capitalized traders who are supporting the market at the discounted retracement price, and the counter-trend sellers are not taking back control.

Conversely, if the market trends higher, then corrects below the Correction Zone, it says: Capitalized buyers who forced the market higher were not committed to the trend totally, and sellers (who also may be well capitalized) took back some control.

When this happens, faith in the trend’s strength diminishes. Also it may be time to exit the position and reevaluate the market. 

USD/JPY trend move

The USD/JPY trended to the upside from the beginning of February 2012 to the middle of March. “Beginning of the trend” (below) is the hourly chart that marks the start of this move. The pair was non-trending in a narrow range for nearly three trading days (from Jan. 31, 2012, to Feb. 3). Non-trending markets eventually will transition into trending markets, so often traders look for a breakout to signal the start of a trend. 

On Feb. 3, price breaks above trendline resistance and the 100-hour simple moving average (blue line at 76.20). Traders, looking for a break to trigger a trade, would buy here with a stop 12-15 pips lower. In the example, the technical break was indeed supported by strong buying, and the price moved sharply higher before pausing at the 76.793 level (59 pips from the breakout price). 

We can overlay the Fibonacci retracement levels and eye the Correction Zone for trend clues. In “Beginning of the trend,” that area comes in between 76.416 and 76.505. If the correction stays above the Correction Zone, the larger, more-capitalized traders are supporting the market and it will trend higher. We assume that sellers are not strong enough to push the market lower. As a result, they too can add fuel to the fire for another break to the upside as they cover their losing short positions. 

Because the Correction Zone defines risk at the Fibonacci levels, traders who missed the initial break higher, but who recognize the potential for a trend, can buy against the zone with a stop a few pips below the 50% retracement. Risk is defined and limited. 

Trend development

When the Correction Zone holds, it says something about the buyers and sellers. Specifically:

  1. Traders, who bought on the break at 76.20, had little risk initially and now have great trade location, with the potential for a trend-like move. This allows them to manage their stop loss with little risk of capital. A logical stop would be on a move below the 50% (say, at 76.35) or even at breakeven (76.20). 
  2. Traders who missed the break higher at 76.20 can buy against the 38.2% retracement level at 76.505. They do not have as great an entry location, but they still have limited risk (a stop loss can be set below the 50% retracement at 76.35).
  3. Traders can assume the move higher is being supported by well-capitalized traders. Buyers took control on the break, held the 38.2% retracement and are not showing signs of relinquishing control.
  4. Sellers could not take back control. Even the seller at the 76.793 high should not feel confident with a short position. Shorts are now trading against the trend.
  5. When buyers are confident and can define and limit risk, they are more likely to buy. When sellers are scared and face the possibility of a trend move against them, they are likely to join the buying at some point. The combination creates another buying imbalance. 

This is what happened in the case of this USD/JPY move, and the market made another trend move to a new high at 77.177. 

Trends that are strong will tend to repeat this pattern. In “Continuing the trend” (below), the chart shows the next move higher. The correction from the top at 77.179 is a stronger move as the price breaks below the defined trendline (incidentally, on an economic release). However, when the price moves toward the Correction Zone (green area between 76.608 and 76.743), buyers emerge once again and force the market higher. 

A new, stronger leg to the upside is established as more traders realize the positive trend signals (rebounding quickly above the 38.2% and reestablishing support along the trendline). That trend move ends 106 pips higher at 77.802. 

Big ranges

Strong trends tend to be fast. They also tend to have large ranges. Although in the case of our example the price has trended from the breakout point of 76.20 to 77.80 or 160 pips, still that is rather small for a strong trend move. Moreover, until the sellers can prove they can wrestle control back, the bullish trend remains intact. In our example, there is no real reason to exit. The corrections have held the Correction Zone.

“Broad view” (below) is an extended look at the period from Feb. 8 to Feb. 29, 2012. Along the way, there were five trend moves to the upside and five corrections of those trends. In each of the up moves, we measured the corrections of the smaller trend segments. This was to see if the capitalized traders still support the market and if the sellers can take back some control. This allows us to put the correction of the most recent leg higher in perspective.

On four of the corrections, the Corrective Zone held support (see small yellow circles). On the fifth trend move higher, the Corrective Zone did not hold (smaller red shaded area) and the correction lower was the most pronounced since the trend started. 

The move below the Correction Zone of the last leg higher was a clue that the market was more balanced. Sellers finally were able to exert some control over the buyers. The buyers also had the incentive to book profit. They likely contributed to the selling. The Fibonacci retracements gave traders the clue for exiting. 

Trends consist of big steps followed by smaller corrections. If the smaller corrections are able to stay within a Correction Zone as defined by the 38.2% and 50% Fibonacci retracement levels, traders can look to take another step in the trend’s direction. If the Correction Zone gives way, traders can use the clue to exit positions. Step through the trends by measuring Fibonacci retracements. You will stay on the side of the trend and ultimately make more money in the markets.

About the Author

Greg Michalowski is chief currency analyst at FXDD. He has more than 25 years of professional trading experience and is the author of “Attacking Currency Trends” (Wiley, 2011).