What is a trend drawdown

What is a trend drawdown

Trend drawdown is computed from pure price action and so is the best way to

determine the trend reliability. It simply tells you how deep the price went

against the current trend. You will appreciate this method in the next paragraph

“Protecting against volatility”.

Now, take a look at the chart below.

The blue line indicates the deepest move against the current trend. In this

example it is 233 pips. The whole move in this chart is 882 pips.

The trend drawdown is:

233 / 882 = cca 26%

Not bad. Conservative traders would prefer the trend drawdown to be below

20% as it is more reliable. The ‘big dogs’ prefer trends with drawdown even

below 15%. Such trends exist almost every day in at least one Forex chart.

Trends with drawdown below 10% are very rare, but when they appear, they

are gold mines – you can easily achieve a winning percentage above 90%.

The lower trend drawdown = the more reliable trend = the greater success rate

= the more consistent profit!

One more important note:

How many bars should we use to define the trend? We have used 200 bars in

the examples above. It is a compromise – not too much, not too little. If you

were to use only 20 bars, you would risk entering the short-term explosive

market movements which are not real trends as we have explained above. If

you were to use 500 bars, you would hardly find any currency chart with trend

drawdown below 20%. Before we show you how to systematically pick the best

trending pairs and time frames every day, let's look at how to use the trend

drawdown in the most important aspect of trading – using a Stop Loss!

Protecting against volatility

Look at the chart above. The trader who placed the Stop Loss right after

entering the market deserves great applause but the problem is, the Stop Loss

is too tight! Give the market enough space to breath or the Stop Loss will be hit

very quickly.

Some traders use a fixed number of pips, something like 50 pips or 100 pips...

this is bad! Stop Loss has to reflect the current market volatility. Ask yourself:

“when did the price go as deep as my Stop Loss?” If it has happened several

times in the current chart, why would you think your Stop Loss will not be hit

now?

The ideal Stop Loss should be greater than the trend drawdown.

Listen to the market, not to the pips. In the example above, the Stop Loss

should be at least 233 pips. Too much? Well, use a smaller lot size. If you trade

1 minilot and $233 is above your risk tolerance, then use microlots. Or don't

take the trade. The worst thing you can do is use a small pip value just because

you want a small risk. Actually, you would risk more because if you don't give

the market enough space to breath, the Stop Loss would likely be hit regardless

of how good your trading system (or reliable the trend) is.

You would do well if you would use the trend drawdown + 1 pip as the pip

value for the Stop loss (233 + 1 = 234 pips in the example). If you want to

increase the success rate but on the other side, increase the risk when

compared to the profit potential, your Stop Loss should be set at a much safer

1.5 x trend drawdown.

Stop Loss = 1.5 x trend drawdown = 1.5 x 233 pips = cca 350 pips

Some traders would prefer even 2 x trend drawdown = 466 pips. Such Stop

Loss would be safe enough from the wild market. It's all about statistics

Exercise

Now it's time for a little exercise. Here are two charts with obvious up and

down trends.

The maximum drawdown indicated by the blue line starts from the high at

78.66 and ends at the low at 78.18. The trend drawdown in pips is:

78.66 – 78.18 = 0.48 (48 pips)

Now let's calculate the percentage drawdown. The visible uptrend starts from

the low at 76.06 and the maximum high is at 79.50.

The overall move in the current chart is:

79.50 – 76.06 = 3.44 (344 pips)

The percentage drawdown is:

48 / 344 = cca 14%

No doubt, the trend with drawdown below 15% is solid. Place the Stop Loss at

least 49 pips below the initial entry point.

In the next chart, there is a downtrend.

The trend drawdown in pips is:

1.3065 – 1.2955 = 0.0110 (110 pips)

Now let's calculate the percentage drawdown. The visible downtrend starts

from the high at 1.3283 and the maximum low is at 1.2682. The overall move

in the current chart is:

1.3283 – 1.2682 = 0.0601 (601 pips)

The percentage drawdown is:

110 / 601 = cca 18%

The trend reliability is moderate. Place the Stop Loss at least 111 pips above

the entry point.

The ultimate solution

Discipline and patience are the two key points to succeed in the Forex market.

Stop hunting the market for every potential trade. Prepare before trading.

Scanning a few currency pairs on all time frames can take you about 15

minutes, but the consequences are invaluable. Pick only the best trending

currency pairs and time frames and ignore all other unpredictable movements

Trade less, profit more. A few guidelines:

1.    Trade only if the trend drawdown is below 20%, (preferably below 15%).

2.     If the trend drawdown is below 15%, you can be consistently profitable even with a simple trading system such as “Donchian 5 & 20”
 
3.   If the trend drawdown is below 10%, you have found a gold mine!

          You can simply enter the market in the trend direction with a 90% success rate.

The Forex Trendy ultimate solution scans 34 Forex pairs on all time frames for

you every second. It calculates the trend drawdown for each chart and shows

the most reliable trends sorted by reliability based on your preferences.

How to draw trend lines

Most traders think that drawing trend lines is all about connecting various highs

and lows. Without proper knowledge & experience, you would see them

everywhere, however not all trend lines should be considered. If you follow the

guidelines to drawing good trend lines, there is a high chance that the price will

respect your trend line and get repelled by it, or it will break through the trend

line resulting in a massive and profitable move. Let's start with some basics.

 

1. The upper trend line (blue) connects at least two lower highs, so it is

sloping down.

2. The lower trend line (blue) connects at least two higher lows, so it is

sloping up.

3. The red trend line in the chart is a little controversial when it comes to

discussion. It is obviously an upper trend line (connecting two highs),

but it is sloping up! Such a trend line alone is not valid unless we deal

with “Wedges” and “Flags” as you will see in the next pages.

Remember: an upper trend line is sloping down, while a lower trend line is

sloping up.

Examples: Good Trend Lines vs. Bad Trend Lines

When the price breaks through a strong trend line, it goes further, offering you

a great profit potential. You can draw many trend lines in one single chart, but

there are several guidelines to choose only the strongest trend lines:

1. Prefer trend lines with more than two touching points.

(Trend lines become stronger the more times they are tested).

2. The touching points should not be too close together.

3. Longer trend lines are stronger than shorter trend lines. Longer

trend lines are also seen on the upper time frames, so more traders are

aware of them.

In the example above the touching points are very close together forming an

unreliable trend line. There is no other touching point on the rest of the trend

line.

In the next example below, the two touching points are not so close together,

but the trend lines are too short. A good trend line should be at least 50

bars long. There exist much better upper and lower trend lines in this chart as

shown in the previous page.

Now let's see some good trend lines!

The trend line above has 3 touching points and can be considered as much

stronger than trend lines in the previous examples. The points are evenly

distributed and the trend line is long enough. All three guidelines are met

perfectly.

Now this trend line is a monster! It is long enough with 5 touching points. You

may notice that there are two groups of two points that are too close together,

but this is not a problem as long as the other points meet the guideline. Treat

a group of close points as one “big point”.

“Triangles, Flags, Wedges...”

Now that you know how to draw trend lines, you are one step away from

discovering the oldest market phenomenon: chart patterns. You are about to

learn incredibly reliable price formations that have time and time again provided

us with consistent profits.

The upper and lower trend lines are forming a triangle as seen in the next

chart. As the price is oscillating between the two bounding lines, the buyers and

sellers are in tug of war, and eventually the price will break through one of the

lines – nobody knows which one! In the next pages you will learn how to

participate in this explosive move.

Falling wedge is like triangle, but both trend lines slope down. Recall that the

bottom line alone would not be a valid trend line. You begin by drawing the

upper trend line and then you complete the wedge or triangle (it depends on

which line has more touching points).

One important note: the upper and bottom trend lines must converge so

that the price is being squeezed.

The flag pattern is encompassed by two parallel lines. The price is not squeezed

by the trend lines, but it is moving inside the channel formed by the trend lines.

Flags are usually seen as the market pauses after a big move before

continuing its main trend.

All the presented patterns above are in an uptrend. The uptrend does not need

to be perfect, the price before the pattern is just rising. Chart patterns after a

downtrend are similar. We will focus only on continuation patterns, that is,

buying in an uptrend and selling in a downtrend. You may hear about reversal

patterns, but trading against the trend requires a lot of experience. Many banks

have crashed and many fortunes were lost because of stubborn traders trying

to pick the tops and bottoms. Trend is your friend, so keep it simple!

How to trade chart patterns

Now it's time to reveal the definite strategy to enter an order, place your Stop

Loss and take a profit, so you don't need to watch the market and you don't let

your emotions control your trading.

The best way to enter the market is by

using “Stop Orders” and “Limit Orders”.

When the orders are placed, they are located on the broker's server, so you can

safely leave your trading platform. This brings you freedom from trying to spot

the best entry point.

The entry rule is simple:

1. If you trade a pattern in an uptrend, place a Buy Stop just above the

upper trend line. Where exactly? You may want to place it 5 pips

above the trend line to spot the real breakout. The advanced approach is

to reflect the market volatility as we will discuss it later.

2. Place a Stop Loss just below the lower trend line.

3. If you trade a pattern in a downtrend, you do just the opposite – place a

Sell Stop order below the lower trend line and a Stop Loss above the

upper trend line. More in the Exercise.

The interesting part is when to Take A Profit. Many traders enter the trade

blindly without any idea where to exit! Notice that the Stop Loss below the

trend line reflects the current market volatility. It is not (and never should be) a

fixed number of pips. The same should hold for the Take Profit. You cannot just

decide that 50 pips is enough and you would exit the position. 50 pips is very

different on minute time frame and daily time frame.

There are two great methods to find the Take Profit level:

1. Projection method – easy

2. Fibonacci method – using several Take Profit levels, a little complex,

    but better

Let's focus on the first one; The Projection Method.

1. Measure the greatest width of the pattern.

2. This pip value will be used for the Take Profit.

Use the same method for triangles, wedges, flags or single trend lines. As the

market breaks from the choppy zone, it normally travels at least the projected distance.

One note about the flags and wedges;

As the price travels between the boundary lines, it happens that the trend line

is not broken and the pattern becomes deeper, or even no more valid. In such a

case cancel the order and place a new one to reflect the current situation.

Sometimes the situation is not going as you had planned and the price breaks

through the other trend line. Then simply cancel the order and forget the

pattern. Rather not taking the trade than taking a bad trade is the key of

successful trading. There will be plenty of other opportunities!

Keep in mind that chart patterns can appear and disappear, or morph into

another patterns. An emerging pattern is not confirmed until the relevant trend

line is broken.

Exercise

First, let's look at the clean chart below. There are several significant highs and

lows that can be connected with a trend line. Before the choppy zone we see a

minor uptrend, so we are going to complete the pattern and place a buy order.

There is just one way to draw the two trend lines that meet the guidelines.

These trend lines are forming a triangle pattern.

1. Place a Buy Stop order just above the upper trend line.

2. Place a Stop Loss Order just below the lower trend line.

3. The distance of the highest high and the lowest low of the pattern is 93

pips, so this is the pip value for the Take Profit.

As the pattern continues to grow, you can replace the Buy Stop order a bit

lower to the trend line, but it's not necessary. Finally, the upper trend line is

broken, the Buy Stop order is executed and the Take Profit is hit!

 

Another example:

A minor downtrend is preceding some pattern. The lower trend line is obvious.

What about the upper trend line? It's not completely obvious; there are several

ways to complete the pattern into triangle, wedge or flag. We would prefer a

flag because triangle or wedge would be too wide and the Take Profit would be

too far (unless you use a more complex Fibonacci technique for several Take

Profit levels).

Now the well-known techniques are made in the opposite direction:

1. Sell Stop order below the lower trend line,

2. Stop Loss above the upper trend line,

3. Projected Take Profit.

The trend line is broken, the Sell Stop order is executed and we make money in

a downtrend until the Take Profit is hit. As we use a single Take Profit level, the

downtrend continues without us... let it go!

Recognizing chart patterns

Professional traders used to analyze chart after chart to find reliable patterns on

daily and even intraday time frames. Today, computing power comes into play.

Forex Trendy is a software solution able to recognize chart patterns on all

charts every second!

34 Forex pairs x 9 time frames = 306 charts!

It has an intelligent algorithm to recognize strong trend lines and discover the

most reliable chart patterns at the current time. You will learn more techniques

about chart patterns in the membership subscription:

• Using Fibonacci technique for multiple Take Profit levels

• Trading “pullbacks” by using Limit Orders for a better entry point

• How market volatility is used to filter false breakouts

• And more supertips!

 Click here to watch a video about automated chart pattern recognition