In conventional technical analysis the mantra is, “The trend is your friend .” In other words, identifying the trend is first and foremost in the analysis. This is so that the trades that are taken are always in the direction of the prevailing trend. This type of “trend following” strategy is fine provided there’s a strong trend and that the trend persists long enough to produce profits. The fact is, that although markets do tend to trend in the longer term, in the short term they spend a good portion of the time moving sideways. I have found that very few traders have the mental fortitude to sit through the range bound spells. Typically what happens is that traders become impatient and exit their trades, invariably, right before the next leg of the move gets underway.
In the charts below we can see that although these two markets ( the Euro and Copper) futures are in a clearly defined downtrend on a daily time frame, they spent weeks going sideways before resuming their downward slide. This may be surprising to some, but this is where the challenges that I mentioned before come into play.
In my experience, another challenge traders have implementing this trend following strategy is knowing when the trend has changed direction. In addition, identifying those periods where there isn’t a strong trend or there is a range bound market can also be a hurdle to consistent profitability.
Often times, when price exhibits the earliest signs of a trend change it’s too late for traders to find the lowest risk trades, primarily because there are many false fits and starts before a trend gains momentum. In conventional technical analysis, a trend change is demonstrated by price holding prior highs or lows and then changing the direction. In other words, if a downtrend is defined as a series of lower lows and lower highs, then price would have to reverse that pattern and start forming a series of higher highs and higher lows. This is how most traders learn to trade.
If you acquire the skill of learning to identify high quality levels of supply and demand you can actually anticipate where the trend is likely to reverse. This flies in the face of conventional thinking because everyone has been indoctrinated in the notion that trying to pick tops and bottoms is a fool’s game. However, it can be done if this skill is learned. And yes, it’s all about probabilities and not everyone can do it because although it seems simple, it’s actually very difficult.
In its most simplistic form, the idea is that smaller time frame trends tend to reverse at larger time supply and demand levels. Below we can see a couple of examples of this in two of the largest equity markets in world: the S&P 500 E-mini and The Dow Mini contracts.
The key is to identify the strongest supply and demand levels as this would suggest that in these zones is where we would have the most amount of unfilled orders; and by the time these levels are touched all of the buying (in a strong uptrend) or selling (in a strong downtrend) has been exhausted. Furthermore, these zones give a trader the lowest risk opportunities to enter a trend at its inception. Keep in mind that doing this consistently requires a lot of skill.
Written by Gabe Velazquez, Online Trading Academy Instructor. Gabe got his start in the markets as a broker trainee for Paine Webber, a mere 3 months before the market crash of 1987. He witnessed the gut wrenching fear of investors during that time period and the wild speculative euphoria of the late 90’s. That experience brought to light the importance risk management plays in trading and investing. In fact, it’s greatly influenced the way he trades today. He spent 15 years as a stock and commodities broker, conducting technical analysis seminars through-out Southern California. After many years of managing other people’s money, Gabe now concentrates full time on trading his own portfolio and teaching. Students will benefit from his first hand experience of daily involvement in the market. He brings with him an acute awareness and understanding of how the markets really work. Articulating this knowledge clearly, succinctly, and with enthusiasm is something students can appreciate. This gift for communicating was honed through many years of public speaking.He currently holds a series 7, 63, 9 and 10 (securities and options principals license.)