The myth of market trend

The myth of market trend

Trend following has been the best style of trading for the past 30 years. There

were times when traders made fortunes just by following the trend or following

a simple system based on two moving averages crossover. The “buy and hold”

strategy that was so popular by traders about a decade ago is dead today.

Look at the EUR/USD chart from January 2001 until July 2008. The uptrend was

pretty strong most of the time. If you pushed the “Buy” button, you would win

most of the time even with a poor trading system. The consistent rise of the

euro over the dollar was giving you a clear sense of the overall trend.

Since July 2008, it looks like everything has changed. The trend direction is

unclear, nobody knows what is going to happen next and people are seriously

preparing for the coming collapse of the single European currency. By the way,

for us (Forex traders) it would be nothing but another opportunity to make a

profit, so keep smiling.

Does it all mean that markets are not trending today? Of course they are

trending! Trends exist and they can be traded up and down for profit. There will

always be short-term trends in any market, the only question is when! So, the

big question is…”how do we find the best trending market and not miss the

opportunity of taking trading signals in the direction of a strong trend?” You will

find a definite answer soon.

The belief that trend following is an outdated trading technique is only partially

true. It is true that there is hardly any market with clear overall trend direction.

You could follow the temporary trend only if you are able to determine the

trend correctly. This is the point where so many traders fail. A pair moving up

on a 30-minute time frame can act exactly contrary on an hourly time-frame.

Even if you find a rare coincidence – a currency pair moving in the same

direction on all time frames – you still need to know “how well” the market

is trending to avoid very short-term trends. The solution is smart and simple.

How to increase the profitability of any system

Before you discover the most simple and effective method to determine the

trend, let's see what it’s good for. All the trend following systems are based on

one common approach:

“Buy the dips in an uptrend and sell the rallies in a downtrend.”

 

Let's reveal one simple trading system that actually made a fortune for one

famous trader and his investors. The system “Donchian 5 & 20” is named after

him. Here is the set-up.

 

In the chart above, you see two indicators – the blue line and the red line. The

blue line is the indicator SMA 5 (stands for simple moving average with period

5) and the red line is SMA 20 (simple moving average with period 20).

Donchian's idea was very simple:

1. Buy when the blue line crosses the red line upwards

2. Sell when the blue line crosses the red line downwards

Even a 5-year old child could do this! Actually, there is nothing special about

this system. All trend following systems are like this. Some systems are more

advanced, with more sophisticated indicators, but the common approach is to

buy the dips and sell the rallies.

If everyone could do this, then what's the money making secret?

 

The answer is that Donchian used this system in strong bull markets. Yes,

trending markets! This important note is the key to consistent profits as

illustrated in the chart below.

 

The first trade was profitable because it was made in the direction of the strong

trend. The next trades lead to losses as the market was turning up and down

without a clear direction. Profits made in the first trade would be taken back in

a series of losses.

How Donchian dealt with it was smart. He ignored all trading signals when the

red line was not going up on at least a 45 degree angle. He wouldn't take any

losing trades after the first trade because the red line is not trending at all. It is

in a so called choppy zone. So why was Donchian able to make a fortune from

such a simple system while others could not? Because others would throw this

system away as not profitable! The only “trick” was to follow a good trend and

not taking any other trades.

What is the lesson from this story?

If you know how to determine the market trend correctly, it could make a

difference between losing or break-even and winning. Donchian used a simple

moving average to determine the trend and filter trading signals.

1. When the market was trending, he turned his system on.

2. When the market was in choppy zone, he turned his system off and

ignored any trading signals.

How to determine the trend

Some people learn from their mistakes, but smart people learn from other

people's mistakes. So let's start with examples of a wrong but very common

approach to market trend analysis.

What you see in this chart is explosive price movement that is usually the result

of a news release. All brokers, platforms and various currency tools are

indicating a “strong uptrend”, tempting people to jump in and make a profit.

What happens next is, at best, a choppy zone, or a hard fall.

What is actually in the chart are a few consecutive long green candlesticks. This is not a real trend, but immediate price action, tempting traders to initiate

trades and experience a costly and painful exercise. To avoid falling into this

trap, you need to focus on longer trends. This is what a real trend looks like:

The price is consistently rising with no sudden changes or explosive

movements. You can expect that this trend will continue and you should take

only bullish signals. Obviously the trend won't last forever and you can even

have bad luck by entering the market at the end of the trend, but the odds

work for you. It simply cannot be better. There are 100s of free or proprietary

indicators to identify the trend but believe or not, no indicator is better than the

human eye. As Albert Einstein said:

“Make things as simple as possible, but not simpler.”

Now let's reveal the easy but the most effective method to identify the trend.

1. Zoom the chart in/out to show about 200 bars. Notice that 200 bars on

daily chart (or 200 trading days) correspond to 1 year.

2. Connect the lower left corner with the upper right corner. If the line

overlaps with the price bars several times (the more times, the better),

you have found a reliable uptrend. See the example below.

3. Connect the upper left corner with the lower right corner. If the line

overlaps with the price bars, you have found a reliable downtrend.

As you see, the market is like a sea wave and it keeps on going up and down.

Sometimes the dips are too deep to consider it a reliable uptrend, or the rallies

are too high to consider it a reliable downtrend. Knowing the “trend reliability”

is the key to discover the real and reliable trend. So, how do we determine if

the trend is reliable, or whether it is better to stay off? The best way is to forget

any lagging indicators, but to use pure price action.