Detecting a trend is an important part of predicting direction in a currency pair. Tomorrow’s prices usually follow or continue today’s trend. There will, of course, be reversals and ranging behavior within the trend but it is easier to trade with a known trend than to predict when it changes. The task of the forex trader is to detect variations or waves of sentiment. The trader needs to ask: is there a shape to changes in sentiment and can it be detected? To answer this question, we can turn to price break charts (also called three-line break charts). In recent months, Bloomberg Professional stations added these charts. They also are available in many retail charting programs such as eSignal and ProRealTime.
Price break charts show only a new high close or a new low close. For example, if a trader using a candlestick chart of a daytime interval converts it to a three-line price break chart, he would see the price action from a different vantage point. The price break chart would only show consecutive new day high closes, or consecutive new day low closes. If no new high or new low is reached, then no additional bar would appear. But when the price reverses, it shows a new column only if the price reverses three previous highs (downward reversal) or three previous lows (see “Call me when it happens”). This is why it is called a three-line break chart. The conditions for a bullish and bearish reversal are easily identified.
Three-line break charts enable significant insights into the shape of sentiment in the price action. A trader can detect the prevailing sentiment, how strong it is, whether a change in sentiment has occurred and project where the next trend reversal will occur. Several examples of using the three-line break as an indicator occurred in the GBP/USD pair in 2009 (see “Show me the move”).
The year started with a series of three consecutive new lows. It then reversed to a distance of four new consecutive highs. The sequence reversed back to four new consecutive lows followed by three consecutive new highs. In April, we see a very significant sentiment event, a flip-flop. This is a new downward reversal followed immediately by an upward reversal. In other words, market sentiment did not continue into a series. When a flip-flop occurs, it is rarely followed by another immediate reversal and therefore is a signal that the trend direction after the flip-flop will continue for a longer distance. This is exactly what occurred. The GBP/USD flipped from a low of 1.4252 on March 30 to a high of 1.5002 on April 15.
Also in the pound, we see a long sequence of 20 new consecutive day highs that occurred between May 1 and June 11, taking it from 1.4490 to 1.6598. While the ultimate length of the sequence is not predicable, what was clear to the trader was that the previous highest uptrend sequence before the long run up was five new consecutive highs. When a previous sequence of highs or lows is broken by a new sequence, this is an alert that the sentiment is becoming stronger than ever.
After the 20 new consecutive highs were achieved, GBP/USD no longer had the energy to repeat this sequence. It entered into a series of smaller consecutive new daily highs, and reversals into consecutive new lows. GBP/USD ended with a reversal up with two consecutive new daily highs.
Price break charts can be used for any time frame. Scalpers could use a one-minute price break to spot what is the intra-hour prevailing sentiment. While price break charts do not predict the duration, or the distance of a new trend, they reveal the strength of the prevailing sentiment. That can be enough to get an edge for the scalper or the long-term trader.
Abe Cofnas is the author of the forthcoming book “Sentiment Indicators” (Bloomberg Press). He can be reached at abecofnas@gmail.com