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Every trader wants to know how to identify trends and determine their relative strength. It’s what allows us to trade with momentum rather than against it, which in turn increases the odds of a favorable outcome.
Unfortunately, gauging the strength of a trend isn’t as straightforward a task as some would hope.
Let me rephrase that, the plethora of indicators and techniques that have flooded the financial world over the years have unnecessarily convoluted a relatively simple task.
But I digress…
Yes, it is a simple task. Is it easy? Well, that depends on the techniques and tools you decide to use.
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There are three very simple techniques that I will show you today that, with enough practice, will make determining trend strength a much more manageable task.
By the time you finish reading this lesson, you will have a firm understanding of trend characteristics as well as when to know whether to look for a continuation of the current trend or an imminent breakdown.
Let’s get started!
First and foremost, we need to know how to identify a trending market. Traders have complicated the topic for years, but it’s very simple, I promise.
A trending market is one that is making higher highs followed by higher lows or lower lows followed by lower highs.
If we transform that statement into its visual equivalent, we get the following illustration.
Pretty basic stuff, right?
But before you leave thinking you know about the concept of higher highs, higher lows, etc., there are some concepts later in the lesson that may not be familiar to you. In fact, I would bet that 90% of Forex traders don’t know to look for what I’m about to show you.
In other words, you may want to stick around.
Now comes the fun part – taking this very basic concept of highs and lows and turning it into actionable information.
For that, we turn to the most basic principle of technical analysis.
Let’s start things off by just visualizing where the highs and lows on a chart have formed over a period. In short, the relationship among highs and lows as they form over time.
All we are doing with this technique is observing where the extended swing highs and lows are within a given trend.
The GBPUSD daily chart below is a perfect example of how something as simple as watching how the highs and lows of a market interact with each other can signal a change in trend.
Notice how over the course of several months, GBPUSD carved out somewhat of a rounding top, which is a valid technical pattern. However, for purposes of this lesson, we’re only interested in using the swing highs and lows to identify a possible change in trend.
In the chart above, the first lower high was the first sign that the uptrend was beginning to fatigue. But it wasn’t until the first lower low that we had a telling indication that the current trend had reversed.
Keep in mind that trend changes won’t always be this obvious. But the signs are always there; you may just have to look a bit harder to find them in some instances.
At this point you may be thinking, this is great and all, but how/where do we enter short?
For that, we need the highs and lows to interact with a key level in a way that offers a favorable setup. In other words, we need to turn the price action you see in the chart above into actionable information.
Now that we have discussed how to use swing highs and lows to gauge the strength of a trend, let’s add a key level into the mix.
There is a common (and costly) misconception among traders in all markets where technical analysis is a traditional method of trading.
Someone at some point in time came up with the notion that support and resistance levels become stronger with each additional retest.
I hate to be the bearer of bad news, but that’s a complete and utter fallacy.
Multiple retests of the same level make that level more visible, they do not make it stronger.
And visible and strong are by no means synonymous.
Think about it, if this were true – that a level became stronger with each additional retest – it would theoretically never break. Because if it didn’t break on the third retest, why would it break on the sixth when it’s supposedly twice as strong?
It doesn’t add up.
So if we can agree that multiple retests of a given level do not make it stronger, we can naturally conclude that it makes the level weaker, right?
Well, not quite. While a market that continually revisits the same area can eventually break through, we don’t have enough data to conclude that it is likely.
For that, we turn to (you guessed it), highs and lows. More specifically, the relationship the highs and lows have with our key level.
The illustration below shows a trending market that is respecting a trend line, however, the distance between each retest has become shorter over time.
Note how the market tested this level as support on four separate occasions since its inception. What many traders tend to dismiss, however, is the shorter time span between each retest as the trend extended higher.
The likely outcome for this type of price action is as follows:
Why does this happen?
In short, it’s the market telling you that demand is drying up. When it comes to supply and demand, as prices move higher, demand naturally begins to run thin as traders a less willing to buy at higher prices.
At the same time, supply increases as market participants unwind their positions to book profits.
In the case of the illustrations above, that demand is drying up more quickly with each subsequent rally from trend line support. Thus, we get a market that begins spending more time trying to keep its head above water than making higher highs.
Of course, this concept also applies to a bearish trend where demand increases and supply decreases as prices drop.
The EURUSD daily chart below is a perfect real-world example of a currency pair that began testing support more rapidly over the course of 256 days.
Notice how each rally spent less time away from support as the trend became extended.
We all know what happened next. The breakdown you see in the chart above was the starting point of the massive 3,300-pip drop that transpired over the next 44 weeks.
If we want to get fancy, we can combine the two techniques we just discussed to further the conviction that a breakdown was imminent.
I will be the first to admit that the pair was not making lower highs before the technical break. However, the fact that a rising wedge formed indicates that each subsequent rally had less bullish conviction than the last.
Last but not least is when price action clusters near a key level. In some ways, this is a combination of the two techniques we just discussed.
I often call this “heavy” price action. The idea of heavy price action is something my members have become very familiar with over the years.
As the term implies, this is when a market begins to put constant pressure on a key level over a short period.
I suppose I should come up with a better word for it since the word heavy only applies to a pair that is putting pressure on a support level. That would make the opposite “light” price action, which doesn’t have the same ring to it.
(I’ll save that for a later discussion with my members.)
At any rate, the idea here is to watch how the market responds to support or resistance within a given period. A typical period would be a few days or maybe a full week if trading from the daily time frame.
If the market begins to cluster or group for an extended period at a key level, chances are the trend is about to break down and reverse.
The illustration below shows what this looks like for a market that is in an uptrend.
Notice how, toward the latter half of the trend above, the market began to cluster just above support. This type of price action leads to a breakdown more times than not.
The AUDJPY weekly chart below is a perfect example.
I can’t tell you how many times I’ve seen this happen at significant support levels. Unfortunately, those who haven’t done their homework find themselves entering in the direction of the trend just before it breaks down.
But don’t be fooled into thinking this technique is only useful on the weekly chart. It can, in fact, be extremely powerful on just about any time frame, even the 1-hour chart.
The annotated chart above is the same one I posted inside the member’s area on November 19, 2014.
Once again, notice how the price action became heavy toward the latter half of this ascending channel, a clear indication that the bullish momentum was not only tiring but that a break was imminent.
The AUDUSD 4-hour chart below paints a fairly bleak picture of what happened next. The result of the breakdown in the chart above was a 680 loss over the next 30 trading days.
While it’s still necessary to wait for a close above or below a key level before considering an entry, understanding how clustering price action can lead to a break will help you avoid being on the wrong side of a trending market.
Determining the strength of a trend doesn’t need to be a complex operation. Something as simple as the three techniques discussed above are all you need to gauge whether a trend is likely to continue or break down.
Keep in mind that all three techniques above are as useful in bearish markets as they are in bullish markets. The charts and patterns above were only used to maintain a consistent theme throughout the lesson, but the techniques discussed above can be utilized in any market and on any time frame.
The best thing any trader can do for themselves whether they are attempting to decipher trend strength or identify key levels is to get back to basics. Every market has its story to tell, and every story can be translated using swing highs and lows.
As I often say, your job as a trader is not to know what will happen next. Rather, your job is to gather the clues the market leaves behind and assemble them in a way that stacks the odds in your favor; and every possible clue is born from the natural ebb and flow of the market.
How do you currently determine the strength of a trending market? Will you be adding any of the three techniques above to your trading arsenal?
Share your opinion, leave some feedback or ask a question below and I’ll be sure to get back to you.
Justin Bennett is an internationally recognized Forex trader with 10+ years of experience. He's been interviewed by Stocks & Commodities Magazine as a featured trader for the month and is mentioned weekly by Forex Factory next to publications from CNN and Bloomberg. Justin created Daily Price Action in 2014 and has since grown the monthly readership to over 100,000 Forex traders and has personally mentored more than 3,000 students.Read more...
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