October 7, 2015 at 12:46 pm
This is a follow-up article of Trading The Trend – Part 1. Make sure you read that first before reading this one. In Part 1 we discussed the different types of trends and methods how to determine which way the market is trending. In this article, Part 2, we take a look at how you can spot the end of a trend or a possible trend reversal.
We all know that at some point, all good things must come to an end; including a trend. Lacking the skill to identify trend reversals can cause unnecessary losses and missed opportunities. Being able to spot when a trend has ended will give you an enormous advantage over other traders. Let me explain with an example.
The market has been trending up for the last few hours, and you see a hint that the market has decided to change direction. Most traders who don’t know what to look for will still be on the lookout for buying opportunities. You, on the other hand, will know that the market has changed direction and will already be selling the market. While you are busy making money, the other traders are losing and confused about what is going on with the market. When they finally realize that the market has changed to a downtrend, it will be too late. You will see signs that the market wants to go up again, so you start buying when they start selling. Once again, the other traders are too late to the party. This situation happens every day.
What I am trying to say is that you need to be able to spot a new trend before other traders do. So how do you know when the market has changed direction? Let’s take a look at the three different methods to spot a trend and how a trend reversal will look like on each one.
This is by far the most accurate way to determine whether or not a trend has ended. We already know that an uptrend makes higher highs and higher lows. So when do you know if the market wants to change direction? It’s really quite simple. When the last higher low gets broken, and the market fails to make a higher high we know that the market will start ranging or develop into a downtrend.
Figure 1 – Higher Low Broken Down
The same is true when a downtrend reverses. When the last lower high gets broken, and the market fails to make a lower low, we know that the momentum has changed. When you see this happen, you can expect an uptrend to form, or the market will range before deciding where it wants to go next.
Figure 2 – Lower High Broken Up
Trend lines are a popular tool amongst traders when it comes to identifying trends. When you see that a trend line gets broken, you know that a reversal might occur. The only problem with trend lines is that drawing them can be subjective in some situations. Some might draw them differently than others. This can cause a problem when deciding whether or not the trend has really changed. They do however still work pretty well if the trend has clear points where to draw the trend line. The bigger the timeframe, the more important the trend line will be.
Figure 3 – Uptrend Line Broken South
Figure 4 – Downtrend Line Broken North
Moving averages act as dynamic trend lines. Some people like using them and others simply hate them. When the price goes through the 10- and 30-period moving average, it will cause the moving averages to cross. This moving average cross will signal a trend reversal in most cases. However, there is a reason I put this method last. You should be very careful when using this method as it could give false reversal signals. If you are unsure whether or not the trend has changed, rather wait for confirmation before taking any trades.
Figure 5 – 10period (red) crosses down through the 30period (green) moving average
Figure 6 – 10period (red) crosses up through the 30period (green) moving average
Now that we covered how you can identify a trend and how to spot a trend reversal, we can move on to Part 3 where I show you some trading examples.
October 8, 2015 at 10:55 am
I have been using trend lines the last couple of weeks with little success. Taking trades from the trend line is alright, but when the trend line breaks, I usually think that the trend has changed and I start taking opposite trades. Most of the time it will be a false break through the trend line and the market will carry on with the original trend. How can I avoid making this mistake in the future? How can I know when the market has genuinely changed direction and not just a fake out?
October 8, 2015 at 12:52 pm
Hey BinaryBanker 😉
This is something people have been asking since the beginning of time lol. There is no definite answer to that. If we knew if it was a false break or not, we would all be making BIG bucks would we not? There is no 100% solid way to confirm if the break was legit or a fake out. That is the reality.
Good news – We can stack the odds in our favor and make calculated predictions by using something called “confluence”. The more factors we have stated and pointing in the same direction the better. That is the best you can do regarding your issue. Have some patience and wait for confirmation of a break, rather than jumping as soon as it happens. Sit back and let the market show you the way.
Hope this helps mate!
October 8, 2015 at 1:46 pm
I love using moving averages in my trading. I find that they tend to work as dynamic support and resistance levels. What I also love about MA’s are that they keep me out of choppy markets which is a BIG plus point in my books.
October 9, 2015 at 1:23 pm
Thank you for coming back to me Dennis. I think my problem is that I don’t have enough patience, because I’m scared that I might miss out on a trading opportunity. From now on, I will try my best to wait for confirmation before doing anything and see how it goes.
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