Forex trading will take forever
Recognize trends and understand other primary indicators
Trend detection is crucial for the success of a trading plan. Many investment strategies try to profit from trending markets. The point is to get in at the beginning of a new trend and hold your position until there is evidence of an end to the trend.
Technical analysts use a number of tools to help you with this process. Some tools determine the current trend; others can help predict a trend reversal. These tools include chart patterns as well as indicators and research. However, in order to use these effectively, you first need to know what a trend is.
What exactly is a trend?
In simple terms, a trend is the general direction in which a price tends to go. A stricter definition is used in technical analysis. A look at the past price development provides information about the general direction of a price. However, it is not so easy to infer how this affects the current situation. A precise definition can be helpful here.
An upward trend
An uptrend occurs when price follows a series of higher highs (or spikes) and higher lows. Figure 1.1 provides a theoretical illustration of this. An uptrend is considered intact as long as the price declines after the uptrends end at higher levels than previous lows.
Figure 1.3 shows an example from practice in which an uptrend has a steady course of higher highs and higher lows. Towards the end of the chart it can technically be seen that the uptrend is intact.
A downward trend
A downtrend occurs when price follows a series of lower highs (or peaks) and lower lows. Figure 1.2 provides a theoretical illustration of this. A downtrend is considered intact as long as the price rallies (increases) against the prevailing downtrend end at lower levels than previous increases (see Figure 1.2).
The chart in Figure 1.4 shows a downward trending market, followed by an upward trending market. No trend lasts forever, and if the price development in the market indicates an impending trend reversal, a different approach is required.
Support and resistance
supportAs the term suggests, a price level or price range on the chart below the current market price at which the buying interest is strong enough to overcome the selling pressure. As a result, prices will come to an end and prices will turn upwards.
The highs and lows of trend lines are also known as resistance and support levels, respectively. Identifying these levels is one of the most important skills in technical analysis.
resistance is the opposite of support. The term describes a price level or a price range above the current market price at which the selling pressure may gain the upper hand over the buying interest, which, contrary to an upward trend, leads to price declines. However, an existing previous high does not mean that subsequent rallies will definitely end at or below this high, but that resistance is generally to be expected.
Practical rules for identifying support and resistance
Identifying support and resistance requires identifying critical prices that define the trend (or range) and that are more prominent than other prices. There are guidelines and rules for determining the appropriateness and strength of a price level, regardless of whether it is a support or a resistance. This includes:
- Proven course level: a level at or near which a price has been "tested" (traded) several times and which is therefore more conscious of the market participants. For example, traders may not sell when they hit a low if they have not had good experiences with them in the past.
- volume: In view of the point above, market participants also take into account whether large volumes were traded at or near a certain level.
- Latest trading history: the more recent transactions have occurred at a certain level, the more important the importance of this level in the analysis of the market price.
- Round numbers: For mainly psychological reasons, traders (and people in general) remember "round numbers" better.
Trading strategies with support and resistance
Support and resistance are best suited for entering and exiting positions in conjunction with efficient risk management. Some practical examples would be:
- Take profit orders. Profits are realized on a position at this price level. That is, if the price approaches support (from above), short traders may realize profits on their positions. On the other hand, if a price approaches resistance (from below), long traders may realize profits.
- Establishing a new position close to an unbroken level. If the price approaches the support level, a technically active investor would place limit buy orders close to and above a defined support, but close to and just below the resistance level.
- Establishing a new position when breaching a level. If a support is broken, then one could take a short position in the technical expectation that prices will move back to the next (lower) support level. If, on the other hand, a resistance is broken, then a buy might be a good option in the expectation that the prices will rise to the next (higher) resistance, if there is one.
- Establishing stop-loss orders. Breaking through a level can also be used to limit losses. Breaking a support or resistance level can be used not only for new positions, but also to minimize losses. A losing position should be liquidated immediately. The signal required for this is breaking the support or resistance level.
Once there is a breakthrough, the functions of support and resistance levels are reversed. This is an essential aspect of identifying support and resistance: as soon as a level (whether support or resistance level) is breached, the technical characteristics of that level are reversed. That is, a broken support becomes a resistance, while a broken resistance becomes a support. This can be seen in Figure 2.4.
Technical analysis in sideways channels
One of the most useful engineering patterns is the sideways channel, or span. It enables a simple, mechanical strategy to be used as follows:
The first step is to identify the support and resistance that will limit current and recent price action observed. Then buy and sell orders can be placed accordingly, close to or above the support level or close to or just below the resistance level. It is then advisable to add stop-loss orders (i.e. exit orders) to the buy (or sell) orders.
Here is a simple example of a trading plan with planned risk limitation (i.e. the difference between our orders and the exit) for a targeted return. Two possible scenarios can emerge from this plan:
If the trading plan outlined in Figure 3.2 is used and a sell position is entered, one of two events occurs. These are shown in Figures 3.3 and 3.4. Figure 3.3 shows the ideal scenario. At the high end of the range, a short (i.e. sell) position was taken near the high and resistance level, while a stop-loss order was placed on the other side of the resistance.
From the point of sale, the price goes back to the lower end of the range, which leads to the triggering of a take profit order (near the support) and a liquidation of the position at a profit.
Figure 3.4 shows the scenario to be avoided, but for which it is necessary to prepare. At the high end of the range, a short (i.e. sell) position was taken near the high and resistance level, while a stop-loss order was placed on the other side of the resistance. From the point of sale, the price rises to the upper end of the range and breaks it instead of falling. In doing so, he triggers the stop-loss order. This position will therefore be liquidated at a loss. Note: Please note that this is just a very simple outline of a possible trading plan. You should always learn and practice accordingly in this area.
- This is a theoretical example of a trading plan based on the identification of support and resistance:
- the use of buy and sell orders with reference to point 1), and
- the use of stop-loss orders to limit risk and protect performance. Figures 3.3 and 3.4 show the schematic method applied to an actual (but historical) trading plan and market.
Draft of the plan - a practical example
In this example, a support has been broken and the price has fallen to a much lower level. Over time, the price has recovered to just below the old support level, which has now reversed and should become a resistance level
There are two possibilities. The first is to short sell just below resistance with a stop-loss order on the other side in anticipation of a decline. The second is to wait and see if there is a technical break (where price breaks resistance) and a buy order just above the break with a stop loss order just below the old resistance (which should act as support from now on) could be entered into.
Some additional important patterns to look out for:
The pattern in Figure 3.6 is known as the “Double Top” (M formation).This is a range pattern with two striking resistance tests, followed by a decline in price to the support level of the defined channel, which is then broken. More important than the name of this pattern is the fact that an essential, identified level (in this case the support) has been cut or breached. There are variants of such patterns. For example, if there are three major tests to the upside (i.e. resistance) followed by a decline that breaks the channel's support, it is called a “triple top”.
A pattern is confirmed once the support or resistance level is broken. Otherwise, it is just a likely or tentative pattern.
CMC Market is a purely executive service provider. The documents (with or without a statement) are for general informational purposes only and do not take into account your personal circumstances and goals. The information in this document does not constitute (and should not be understood as such) financial, investment, asset or other advice on which one should rely. An opinion expressed in these materials should in no way be understood as a recommendation by CMC Markets or the author as to the suitability of a particular investment, security, transaction or investment strategy for a particular person.
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