The Stages of a Forex Trend

A trend is a tendency for prices to move in a particular direction over a period. Trends can be long term, short term, upward, downward and even sideways. Success with forex market investments is tied to the investor's ability to identify trends and position themselves for profitable entry and exit points. This article examines the stages of a forex trend and how they affect investors. (For related reading, see Anticipate Trends to Find Profits.)
TUTORIAL: Technical Analysis & Technical Indicators

For the most part, an economy that is strong will also have a strong currency. Economic strength attracts investment, and investment creates demand for a currency. The demand for gold as an alternative to fiat currencies has led to a currency demand in those countries that produce gold such as Australia, South Africa and Canada. (For more, see How To Trade Currency And Commodity Correlations.)

Note how the economic factors, in this case, a demand for gold and the higher interest rates in Australia around 2009 to 2012, created a demand for the Australian currency. This type of demand will last until the exchange rate becomes too high and negatively affects Australian exports.

In addition, factors in other economies should be considered since no single currency can act in isolation of the rest of the world's economies.

The chart below (Figure 1) of the weekly AUD/USD shows the recent upward exchange rate trend in the Australian dollar against the U.S. dollar at the time. While the price (exchange rate) oscillated back and forth in a regression channel, providing some short-term trades in the opposite direction, the prevailing upward trend remained intact. (For more, see Forex: Should You Be Trading Trend or Range?)

Figure 1: Australian Dollar Vs. U.S. Dollar

Source: Wordon Brothers

In the chart below, the Canadian dollar strengthened against the U.S. dollar during the period 2009 to 2011. Canada is also a commodities-producing country, with a lot of natural resources. In the case of the Australian dollar chart, there is an upward-sloping growth path as the demand for Australian dollars increase. Since the Australian currency is the base currency and the U.S. dollar is the quote currency, the chart shows a strong upward-trending and strengthening Australian dollar.

On the other hand, in the case of the Canadian dollar against the U.S. dollar, the U.S. dollar is the base currency while the Canadian dollar is the quote currency. Thus the chart shows the U.S. dollar sloping downward as it weakened against the Canadian dollar. (For related reading, see Using Bollinger Band® "Bands" to Gauge Trends.)

Figure 2: U.S. Dollar Vs. Canadian Dollar

Source: Wordon Brothers

The conventional wisdom among traders is that "the trend is your friend." While this is good advice, we add a cautionary phrase: "The trend is your friend … until it ends."

Of course, the difficult questions to answer are whether a trend exists at all or just a sideways-trading range and where and when a trend will start and where and when it will end.

We first look at the question of where a trend could start and, once started, where to take part in the action. To answer these questions, we need technical analysis. To keep our analysis as simple as possible, we create a chart that uses a weekly time frame and uses only two indicators.

The first indicator is a simple 20-period moving average calculated on the closing prices. However, to add a cushion, we also add an additional 20-period simple moving average, but this time calculated on the price highs. Then, we add another 20-period simple moving average calculated on the price lows. The result is a moving average channel that reflects a dynamic price equilibrium. (For more, see "Deadly Flaws in Major Market Indicators.")

We use this channel to determine when prices are trending up and when prices are trending down. We assume that if prices break below the channel, there is a potential downtrend, and if they break above the channel, there is a potential uptrend.

Also notice that when a market trends in either direction, there is a tendency for prices to move away from the channel and to return to the channel as volatility increases and decreases, respectively. With volatility, prices always tend to revert to the mean over a period. This reversion to the mean provides either buying or selling opportunities depending on the direction of the trend.

In addition to the moving averages, we also add an RSI set to a two-period, instead of the usual 14-period, with the plot guides set to 90 and 10 instead of the usual 70 and 30. (For more, see Find Forex Profit With the RSI Roller Coaster.)

Figure 3: Daily EUR/USD

Source: Wordon Brothers

The chart shows some interesting opportunities. Each time the RSI reaches an extreme at the 90-plot guide, it provides a sell opportunity while the trend is downward and prices are below the channel. Each time the RSI reaches the 90-plot guide, the price has also moved back to the channel providing a new opportunity to sell in the direction of the trend.

Conversely, as the trend moves upward, prices revert to the channel at the same time as the RSI reaches the 10-plot guide providing new buying opportunities.

Trading in the above manner means trading only in the direction of the trend each time it corrects, thus providing a new opportunity to participate.

Many traders will look to trade reversals. A reversal point is always where a trend starts or ends. To find these potential reversal points, we look for price patterns (such as double or triple tops or bottoms), Fibonacci levels or trend lines. A reversal often occurs at a 127.2 or a 161.8 Fibonacci extension. Therefore, it is also useful to plot the Fibonacci lines on the weekly charts and then see the outcome on the daily chart as prices approach one of the Fib levels. (For more, read Make Money With the Fibonacci ABC Pattern.)

Some trends are stronger than others. In fact, some trends become so exuberant that prices form a j-shaped or parabolic curve.
On the next chart, we see an example of an irrational parabolic-shaped price curve of the World Silver Index. It is irrational because traders are pushing silver prices up, as the whole commodities complex is benefiting from strong fund flows into futures and ETFs without there being an equal and natural demand for the underlying product. This is a case of "musical chairs." When the music stops, the exit door narrows and late arriving traders suffer.

The "spinning top" candlestick on the weekly silver chart should be a strong warning sign to traders that the trend could be ending. (For more, read Advanced Candlestick Patterns.)

Figure 4: Weekly Silver Index

Source: Wordon Brothers

In the case of the Canadian and Australian dollars (Figures 1 and 2), the curve shape follows a more normal upward slope than the silver price. Traders should always be aware of the curve shapes since parabolic curves indicate a "bubble" mentality developing in the market.

A reader familiar with the Elliot Wave will observe that trending markets move in a five-step impulsive wave followed by a three-step ABC correction. Many investors prefer to count pivots, and they look for between 7 and 11 advancing pivots, particularly noting the pivot count as the price reaches a strong resistance level. (Learn how to set up a trading plan using this method. See Using Elliott Wave to Trade Forex Markets.)

It's impossible to predict the future, but we can calculate the potential success of a trade by stacking various factors in an effort to tilt the odds in our favor. Since all speculation is based on odds, not certainties, we should be mindful of risk and employ methods to manage the risk.

When placing a trade, it is essential to always place stops to limit losses in case the trade does not go as expected. Major market makers know where all the stops are and could, in certain circumstances (particularly in times of low liquidity) reach for the stops. Thus, an investor's stops should be in a place where there is enough room to prevent them from being taken out prematurely.

To best manage a stop policy in trending markets, use "volatility stops." The well-known Parabolic SAR indicator can also be used to trail the market and take profits once the stop is hit. In the chart below (Figure 5), the 50-period three ATR trailing volatility stops trail prices and provides exit points if the trend suddenly reverses.

Figure 5: Daily XSLV Index - with Volatility Stops

Source: Wordon Brothers

It is best to trade with the trend but to be alert as to when a trend is exhausted and a correction or reversal is in order. By observing and listening to market sentiment, following news announcements and using technical analysis to help time entries and exits, you should be able to develop your own personal rule-based system that is both profitable and simple to execute. (For more, read Seasonal Trends in the Forex Market.)