Trend principles, tactics and new tools

As 2005 gets underway, we are at extremes in the currency markets. More specifically, the U.S. dollar has been in a long-term downtrend. The phrase "the trend is your friend" has certainly shown itself to be a good mantra for those who have sold into the extended dip. And while many traders swear

Beginning forex traders expectedly would follow-up that advice with a range of questions. How specifically do you trade with the trend? Where are the entry points? When do you get out? Are there principles to help the new trader trade with the trend? Can we build a strategic plan for trend trading in forex?

A prelude to shaping a trend trading strategy in forex is to first review intermarket conditions such as patterns in the U.S. dollar index (USDX) and gold. While each currency pair reflects specific trading of the dollar vs. that foreign currency, the USDX is a quick measure of global sentiment. Assessing gold trends also provides a leading indicator of global sentiment toward the dollar. When gold is breaking a previous sideways range or a downtrend, it offers a leading indicator of dollar sentient shifting.

The next step is selecting the time frame. Trends can be monthly, weekly, daily and even at the tick level. By scanning all of the time frames, you can quickly see the predominant trend direction. More important, countertrend waves can be identified. If the daily trend direction is diverging from the weekly or monthly, new trading opportunities can be shaped.

The next step is selecting a predominant trading direction. Finding a trade in either direction is always possible because forex prices are not linear and different laws of price action come into play across time frames. By pre-selecting a direction to trade, based on fundamentals or longer-term technical analysis, the focus becomes not what the trend is, but the best location for your next trade. For example, those expecting a major downtrend in the dollar in 2005 will focus on the best entry points for short trades until that major expectation changes.

Next, you need to focus on execution points. This is where the concept of "trading at the edge" comes into play. Trading at the edge is best understood as finding a probe of a key support. or resistance level. This requires some contrarian thinking.

It is a natural tendency to try to buy when a price is going up or try to sell when it is going down, but there are retracements and waves. Thus, if the currency pair is in a downtrend but is retracing to its five-minute trendline, a trader looking to sell will watch for a probe of this trendline. Waiting for a retracement to support or resistance also reduces the risks of being wrong because stop losses can be placed rather tightly.

Selecting the exit is one of the most challenging problems. Getting out too early after initial profits feels good, but improving the average pip gain per trade is key to long-term success. After all, trading is hard work, and for the same level of effort, increasing the gains per trade is a legitimate goal. On the other side of the same coin is getting out to prevent a serious loss.

Fortunately, a time-proven charting method is accessible to help with every stage of the trend trading process: three-price or three-line break charts.

In a three-line break chart, only the highs and lows are shown. If a new high is reached in a selected time frame, a new rectangle is added above, and if a new low is reached a new rectangle is drawn below. We see that for the pound, there was a series of consecutive new highs with a few periods of reversals in the accompanying weekly chart. The trend is up, but where and when do you enter that trade? The intra-hour trend sequences helps us find a more precise location (see inset). Looking at the 30-minute three-line break patterns, we see that the trend aligns with the weekly trend direction with some reversals. This gives the trader the choice of entering into the trend by buying after a reversal occurs or entering at any point but with a stop three lines below.

In 2005 trend trading offers opportunities, and with three-line break charts the trend may become even more friendlier to profits.