by Sam Evans, Online Trading Academy
In my article from two weeks ago, I explored some objective uses of the technical indicator, “What’s My Average?”. If you are a regular reader of this piece, you’ll know that everything we do at Online Trading Academy begins with our core strategy. While technical indicators do have a use in trading and analysis, everything must begin with understanding the nature of price and the dynamics of supply and demand. Any market speculator, who is attempting to generate consistent profits from the currency markets, needs to really be able to recognize what a picture of supply and demand looks like on a price chart before applying anything else.
Please don’t get me wrong. Like I have said on numerous occasions I do not have a problem with conventional technical analysis. I think some people believe I’m a hater of anything that isn’t to do with raw price action! In reality though, this couldn’t be further from the truth. I just encourage my students to start with understanding how institutional supply and demand really works and only then do I show them how they can bring other tools into the arsenal, in order to help increase the odds of their success.
Following on from the pace I set with moving averages, this week I’d like to explore another one of the conventional greats: the Trendline. As you can see from the title of this article, using trendlines do come with their own challenges which I’d like to explore. While the trendline is one of the most popular and aged technical tools around, it’s also not surprising to me when I meet so many people who struggle to use them. While the tool attempts to provide an unemotional way to build rules for a trading plan and allow you to manage and enter a trade with greater precision, the biggest issue I have found that my students have with the trendline is the level of subjectivity that they can cause. If you do not have hard and disciplined rules for how exactly you will incorporate the trendline into your analysis, it is very easy to find discrepancies along the way. The first of which is in the nature of actually drawing them on your chart.
To expand upon this point, let’s think about the practicalities behind the trendline. You need to have a trend already in place before you can attempt to actually draw the trendline. This simple fact alone means that when you are drawing the trendline either in an up or down market, you will always be doing this after price has already been going up or going down. This then creates the problem of buying late in the upward trend or selling late in the down trend. The sooner you can establish the trend the better because the profit potential will be greater. If you draw the trendline too late in the game, one runs the risk of shooting for a far smaller reward. Take a look at the chart below for example:
On this daily chart of the EURUSD currency pair, we can see that in early July and in early September we established two very clear pivot lows. Joining these two touches together extended our trendline out into the future to give us a clue as to where we could expect the next bounce and buying opportunity. This was hit in the later part of October. However, price then proceeded to break through violently to the downside, resulting in the redundancy of our trendline. We got the third touch but it was this touch that also turned out to be way too late for a successful buying opportunity. So how could we have overcome this? Take a look at the next example:
This is the same chart as I showed you before, only this time with two further additions. Firstly I have drawn a parallel trend line above the lower line, creating a price channel. Secondly, I have shown two areas of demand. The demand areas give us ideal buying opportunities because we would’ve been buying after a drop in price and also at a level where objectively demand was greater than supply. This fact alone, means our risk is at its lowest and our profit potential will be at its highest. These examples also give us much earlier entries into the already established trend. In fact it is the first one that also produces the second point in establishing the trend line.
So why have I drawn in the channel as well? Well the channel becomes nothing more than a simple guide. When in the trend, I always want to make the most of it and while I can use my opposing supply zones for profit targets, I would also like to run the trade for as long as possible. This is where the price channel can be useful. Can you see how the upward trend in the Forex pair respected the upper line of the price channel along the way? Using this line as a guide, I can get a good idea where would be a smart place to take my profits or at least to trail my stop, thus maximising my profits potential.
A technique like this should only be used when a price channel is objectively apparent on a chart itself. Supply and Demand levels will always be my primary reason for entering and exiting a trade, but the trendline channel just gives me a little bit of icing on the cake if I’m looking to really get a little bit more out of the opportunities that I take. If I was to give you one piece of advice about using trendlines in your market speculating, it would be for you to be as consistent and objective as possible. One trader may draw their line very differently to another and that is why it can be challenging when you’re drawing diagonal lines on a price chart to maintain that level of consistency at all times.
One of the big reasons why I love supply and demand levels, is because they are hard to argue about as they’re always on a horizontal plane not the diagonal, which makes things a lot cleaner for a simple guy like me. Just remember that if you’re going to use any kind of technical analysis in your own market activity, you always need a primary reason for entering the trade which is based on price and price alone in the first place. All other tools and techniques must be secondary to this. Stick with the rule and you definitely can be walking along the path of objectivity.
Have a great day and take care…