“If prices resemble an avalanche on a mountain path, retrace your steps and walk a smoother road” – Anonymous
Today I’m going to write a “biased” article. I’m going to write about one of the ingredients that has proven successful for me over the years, and that I believe is a timeless building block of market movement: directional momentum. The concept of directional momentum might help clarify some doubts our members have been having, regarding:
- when a trending phase is retracing vs. ending
- when a new trend is beginning
- when entries are “viable”
Let’s get started!
Select Your Trend Identification Time Frame
Many trading quotes talk about “trading the trend” or “the trend is your friend”. However, traders that aren’t too familiar with price ladders start asking questions like “what trend do I follow? The Weekly? The Monthly? The Daily?The 4H?The 1Min?”. There are probably as many answers as there are traders in the market, but for the scope of this article, attempt to wrap your head around two ideas:
- timeframes are irrelevant
- select one trend identification timeframe, that suits your time availability
These two statements contradict each other, on the surface. Like everything in the market, they need to be qualified and put into context.
Timeframes are irrelevant, to me, has 2 separate meanings:
- on one hand it means that the market “just is”. The transactions that happen every minute of every day create that squiggly line we call “price”. We then like to “gift-wrap” price into neat little boxes called “candles” or “bars” and we attribute significance to certain patterns. Traders frequently ask question such as “is this Doji valid” or “Is this a valid reversal candle”. Let me clarify that the candle itself means nothing. What the trader is actually asking is “is the market changing direction”. And we can go “inside” a daily candle and judge the market’s movements on a 1Min or tick chart even. It’s all the same information, just “gift-wrapped” in a different manner.
- on the other hand, “timeframes are irrelevant” means that various traders will have different agendas and operate different objectives which will require more or less background confirmation. Some traders will be deploying their bets off of a data-influenced move (which is intraday in nature). Other traders will be playing a central-bank influenced move (which can be longer lasting). Other traders will stick to trends.
This leads us to the next statement: select 1 trend identification time frame. Most retail traders are trading around a day-job (and that’s not a disadvantage by the way). It simply means that, compared to industry participants, retail traders have less experience and require, perhaps, a logical and simple structure that allows them to be efficient with their time and efforts.
Selecting one trend idenitification time frame, for example a Daily chart, allows traders to avoid confusion amongst time frames. Make a choice, and stick to it. A robust Daily chart is usually a good starting point.
AudCad has been a nice trendy vehicle of late and is a good example. The objective is to have a consistent starting point from which to gauge the potential momentum strength and directional bias of the pairs you are interested in trading.
At the core of any directional approach is the concept of momentum. Essentially you should be looking for higher high/higher low “stair steps” in an uptrend, and lower high/lower low steps in a downtrend. Going back to classic Dow Theory, in order to have “faith” in a new trend, you should witness at least 2/3 of these occurances on your trend identification chart before drilling down through the timeframe spectrum.
Now that we know how to define a “trending” market, what is required in order to initiate a fresh trade?
You require continued trendiness through prior highs (in an up trend) or prior lows (in a downtrend) as marked on your trend identification time frame. If the market fails to surpass a prior high (in an up trend) or a prior low (in a down trend), then you should be on guard watching what the price action was doing as it retraced. The borderline scenario would be a test of the previous swing low (in an up trend) or swing high (in a down trend), which however should hold in order to continue buying dips or selling rallies.
The last 3 months have seen steady increases with price maintaining higher swing highs & higher swing lows (the definition of an up trend). The last major swing low prior to that 1.0334 top was at 1.0130. That was the point that should not be violated on any retracement.
Price pulled back from 2017 highs, and as it pulled back (during March 21, 22, 23) you will be looking for trend resumption reference points. Remember, until 1.0130 is compromised, AudCad remains a “buy on dips”. Any kind of price action above this level can be considered a retracement, not a reversal.
Multiple Time Frame Momentum
Now that you have your trend identification time frame established (Daily chart) and you know what a trend looks like (higher highs & higher lows in an uptrend, and lower highs & lower lows in a downtrend) you can drop down through the timeframe cascade to mark the “trend resumption” points that alert you to a shift in market strength.
This is the key point. If your trend identification frame is flowing with ease, retracements can be seen either as consolidations or temporary reversals on your smaller time frames. So, all that is required is to pay attention to these smaller time frames, until they align themselves with the larger picture once more. This is the concept of directional momentum. Price is “pushing” on all time frames, in the same direction. Some also call this “self-similarity“.
The levels are the same whichever timeframe you choose, the important thing is that you have a clear directional bias given by the larger picture, which gives you clear levels that can assist in determining a change of trend from a retracement.
While following market movement like this is quite straightforward, I must stress the importance of not making life difficult for yourself. Let’s use a recent example: NzdUsd.
There is no clear, evident trend on this pair at the moment. Don’t make life difficult: avoid trading things that are not clearly moving in an established trend.
50-50 odds are not advantageous…make life as easy as possible.
Over To You
Could it be, that by following indicators you have been ignoring the basic building blocks that allow for simple and subtle analysis of market movements? Identifying a trending market, and when it’s stalling (i.e. retracing or losing momentum, which is visible on the lower timeframes) is the cornerstone of successful speculation. Trend and momentum are two essential concepts that every trader should understand inside out.
Try this kind of analysis out for yourself and see how you do. Like everything in trading, it will require some experimentation and practice, but perhaps it can help avoid some common pitfalls that traders encounter.
About the Author
Justin Paolini is a Forex trader and member of the team at www.fxrenew.com, a provider of Forex signals from ex-bank and hedge fund traders (get a free trial), or get FREE access to the Advanced Forex Course for Smart Traders. If you like his writing you can subscribe to the newsletter for free.