Trends in the currency markets are one of the most important and basic elements to trading. Incorrect recognition or interpretation of trends can have a devastating effect on traders. Like a slow moving trading, the equity can be easily depleted without knowing what happened until the last dollar disappears from your trading capital. Trends, however seem to carry an element of subjectivity and are well represented by the many confusing articles that seem to claim to be the authority on trends. So how does one define a trend and why is it important to figure out the trend first?
Why you need a trend (when trading)
A trend is defined as “a general direction in which something is developing or changing”. In the context of the currency markets, trends are nothing but the general direction in which price is developing or evolving. Obvious by the above definition, it makes logical sense to trade in the direction of the trend rather than trade against it. After all, which is easier? Going with the flow or against it? Going with the flow offers minimum resistance and is based on riding with the larger momentum. Perhaps this can be well explained by the analogy of a surfer. The best surfers tend to catch the wave and ride it. Going against the wave or the trend can be tough, disastrous.
A trend, in the currency markets therefore is essential as it tells the trader the general direction of the markets and therefore points the trader to trade in the direction of the trend. But the next question that comes to mind is how to identify this trend.
Identifying trends in the forex markets
This subject has given rise to many different definitions. Some range from the very simple concepts of looking at the direction of price on the charts where an uptrend is recognized when price rises from the lower left of the corner of your screen to the upper right and vice versa. The problem with this simple definition is that the true meaning of trend is lost. Those who have read the Dow Theory would know that trends are not constant and are in fact made up of primary, secondary and minor trends. Therefore, when speaking of trends, the time frame is of utmost importance. Just because you see an uptrend on your screen doesn’t qualify it to be an uptrend, especially if you are looking at 5 minute chart.
With all of the subjectivity involved, it often can be difficult for traders to figure out the true trend. Sure, there are ways to identify trend based on indicators such as the moving average or the MACD, but considering that these are lagging indicators and the fact that they are derived out of price, doesn’t it make sense to build an objective approach to identifying trends directly from price itself?
Identify trends with the 4-week rule
In this article on identifying trends, we make use of a simple, well known rule developed by Richard Donchian, known for his famous Donchian 4-week rule. Based on this rule, Donchian suggested to buy when a week high is broken and to sell when a 4 week low is broken. This is perhaps the most simplest of trading strategies, which has led to other famous experiments such as the Turtle Traders. Besides this, the 4-week rule can be applied to identify trends as well.
To build this objective framework of trends, we look to the 4-week high/low from the weekly charts. The 4-week high/low is one of the common indicators that are available in most charting packages and they can also be easily identified visually.
The chart below shows the 4-week high/low rule on EURUSD weekly charts.
By now it should be starting to get clearer for the trader to understand where we are heading to… that’s right, support and resistance. Without getting too much into the details, most of which can be read here on Support and Resistance, we define the criteria for the trends as follows:
- Up trend is where there are more higher highs and higher lows
- Down trend is where there are more lower highs and lower lows
Referring back to the main EURUSD weekly charts, we can see how what seemed like an uptrend to the right is in fact a correction to the uptrend with the downtrend actually in play.
But first… going by traditional knowledge of trends, the chart might show that an uptrend is in play as the last lower high at 1.34853 (which was resistance) turned to support. Therefore the average trader might be looking to take long positions. Sure, the long positions might work out in the short term trading time frame. But if you were a swing trader, things would look different.
Now look at the same chart as we move forward. Do you still believe this was an uptrend?
If the above chart doesn’t convince you, here’s the final deal using the Fibonacci retracement.
The above chart shows clearly how what would have looked like an uptrend was in fact a mere correction. While most traders would have been taking about an ‘uptrend’ in EURUSD was a correction to the larger downtrend in play.
Identifying trends with the 4-week rule: Putting it together
The 4- week rule is simple and objective and offers a trader, insights into the market which traditional text about trends often mistake it for something else. It if firstly shows the exact place of price within the larger trend by simply using past high/lows as support and resistance levels.
Here are the rules:
- Plot 4 week high/low on the weekly charts for any currency pair
- Look for lower highs and lower lows for a down trend and higher highs and higher lows in an uptrend
- As long as past high and low do not turn to low and high, the previous trend is still intact. If in doubt, use the Fibonacci retracement tool to measure the highest high and lowest low for added assurance.
- Once the main trend is identified, you can then scale down to the H4 or daily charts and take on trades that are in tandem with the main trend
- The same approach can be built on daily charts using a 20-day high/low to be used for trading off H1 or H4 charts