The Market Typically Pulls Back When Everyone Figures Out It’s a Trend

March 29th, 2013
in contributors

Online Trading Academy Article of the Week

by Gabe Velazquez, Online Trading Academy

The golden rule in most trading books is that you must trade in the direction of the prevailing trend in order to be successful. These same books also tell you that the biggest no-no is trying to pick tops and bottoms. On the surface it seems like pretty reasonable advice, however there are different ways to trade the trend, and if you are skilled enough, picking  tops and bottoms should be very feasible. In this article we will explore alternative “low-risk” entries that will allow us join the trend, and not fall prey to the high risk way of looking at the trend.

Conventional technical analysis teaches that one must always wait for trend confirmation. This can mean a trend line that can be connected at three points, or a moving average sloping higher confirming an uptrend. Price confirmation of trend can also be used by simply identifying a series of higher highs, or lower lows. This is all text book stuff that most of you already know, so why am I going over it you might be asking. The answer is that although we can use these tactics, if we utilize them in the wrong manner we will end up taking high risk trades, which will result in us losing some, if not all of our hard earned money.

Follow up:

The reality is that trends are formed by saw-tooth type patterns, and not straight forty five degree angle lines. These undulations tend to trap trend traders because they wait for too much confirmation. The likely reason this happens is because of how they are conditioned to trade trending type markets. An example of how this thinking is flawed would be that when a market is trending higher it’s safer to buy when it makes a higher peak. Conversely, lots of traders are trained by many conventional trading books to sell only when the market breaks to a new low. As we can see in the chart below, when the market is trending higher most of the new peaks are followed by counter-trend moves otherwise known as corrections. And therein lies the problem when buying after the new high price has printed. That is unless you’re willing to sit through big draw-downs waiting for the trend to resume.

Click to enlarge

Likewise, in a downtrend, when the market breaks to new lows, an upward move ensues. This is illustrated in the 240 minute chart of the Euro FX contract shown below. Traders waiting for a break in price before shorting will also encounter the same difficulty.

Click to enlarge

As stated before, in order to engage the trend in a lower risk manner we have to utilize a different tact than the conventional thinking espoused by the trading books. A lower risk approach to joining the trend would be to wait for the counter-trend moves into quality supply in order to sell short when in a downtrend, and buy pullbacks into quality demand when the market is in an uptrend. When I refer to quality levels, I mean levels that score high using our odds enhancers.

The bottom line is that trend following done in a low risk strategy format can be rewarding. In addition, have a set of specific criteria to define the time-frame in which we define the trend as well as when a trend has changed is also very important. The next step is to anticipate when the trend will change because by the time everyone has figured out that it’s a trend, it’s just about then, when the market will pullback.

Until next time, I hope everyone has a fabulous week.

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