The value of a currency pair is constantly changing. It is, therefore, important to know when to buy or sell currencies and when to be on the sidelines.
To help you spot the next trend, we’ve put together a list of the most important ways to identify trends in forex.
These are the strategies and tools that you’ll be using most in your forex trading, so it’s essential that you have the right ones at your disposal.
Why trends are important to traders
Traders rely on trends because it helps them anticipate which direction the market is going. Some of the most successful forex traders are very good at identifying strong trends, and they use the trends to make trading decisions for short and long-term trades. A trend can be a downtrend, an uptrend, or a sideways trend, but identifying trends just as they are starting is a prerequisite for success in the forex market. But what really is a trend?
What is a trend?
In Forex, trend refers to a situation when currency pairs move in a certain direction for a short or long time. Traders focus on the pairs’ prices as quoted by the exchange rate, and they make trading decisions based on these quotes. To trade with trends, certain indicators are used, and one of the widely used indicators is called a moving average indicator. With this indicator, traders can track prices over a period of time from days to weeks. So a moving average that is climbing is interpreted as an upward trend, and a moving average that is falling is a downward trend.
How to identify trends in the market?
Different traders have different ways of identifying trends in the market, and that is what is fascinating about forex trading. However, there are popular ways traders identify trends. Some methods are guided by indicators, while others are a combination of several techniques. Let us look at the popular methods.
Moving Average
Moving Average is one of the surest ways to identify a trend in the market when analyzing the price movement of two currency pairs. A moving average crossover happens when a short-term price moving average of a currency pairs rises above or drops below a long-term moving average price. For instance, if you track the price of a currency pair for three days and the currency price rises or crosses above a 10 day moving average of the same currency pair, that is an indication that an uptrend has been established.
Price Action
Another way to identify trends is to track the prices of certain currency pairs. Currency prices are never static but change from time to time throughout the course of a trading day. So when tracking a currency, you are bound to see a high price or a low price. To identify trends based on price action, you need to review the price of the same currency pair for the previous day. This is where the higher high and lower low phenomenon comes in.
Pairs that rise above the price of the previous day are moving on an upward trend, but if it is lower than the price of the previous day, it is said to be a lower low. Thus, price action is a very effective way to analyze and identify trends in the market, which is why many traders have come to trust it. Its reliability has also influenced the saying, “the trend is your friend.”
Technique Combination
Some traders also combine different techniques to help them identify trends. If you recall, at the start of this section, we noted that many traders have their own way of identifying trends. Some traders do so by combining different tools and techniques to analyze current trends accurately. Price action and moving average can be combined to spot a trend. Also, several moving averages can be combined with cross-over moving averages to confirm an upward trend.
Trend Trading
Traders rely on trends partially when doing their market analysis, but there are traders who rely majorly on trends to do their trading. Those do use trends to trade solely are called trend traders. The art of trend trading involves making profit projections and opening trades after analyzing the direction of a currency pair’s price. Most traders who trade with trends enter the market in a long position if the currency pair is trending upward. However, if the price of the currency pair is going downwards, they mostly go short.
Trend trading is nothing new and has been practiced for a very long time. Here are some of the common strategies used by trend traders.
Common Trend Trading Strategies
Before we review some strategies used by trend traders, do note that important tools and techniques are involved. One fundamental tool used to hedge against risk is a stop loss in case a trend reversal occurs. If the trend moves up, the stop loss should be placed below the entry point; if it is a downtrend, it will be placed above the entry position.
One of the trend trading strategies used by trend traders is the moving average strategy. Since we have reviewed that in the previous paragraph, we will not rehash it here, but here are others.
Momentum Indicators
One strategy used by trend traders is a momentum strategy. This strategy relies on momentum indicators to spot upward trends based on their strength. One useful indicator to spot momentum is the RSI indicator. RSI requires experience on the part of the trader to use it perfectly. Some traders wait for the RSI to drop below a certain point before it rises again. Such a movement may indicate an upward trend and a signal to go long. Others may wait for RSI to rise above 70 and drop below a designated level before they exit the trade. Suffice to say that there is no golden rule when it comes to using momentum, which is what makes forex trading in general dynamic. Traders rely on their own interpretation and analysis of the market to make decisions.
Chart Patterns
Using chart patterns is another way to do trend trading. Combining charts with the drawing of trend lines can be an effective way to establish entry and exit points in the market. Experienced traders know where to draw a trend line to help them determine at which point the price will reverse. Other chart patterns they may look out for include triangles, flags, an aggressive rise in price, or a price drop.
What are the causes of trends?
Although it is very important to know how to identify trends, knowing why trends occur in the first place is very important. If you know why you will be in a better position to understand what causes them and how long the trend may last. Trends are caused by several factors. For example, when analyzing the price of a currency, these factors will influence the trend more than anything else
- Interest rate
- Inflation rate
- Employment/Unemployment
These factors will influence the currency’s value, and these effects will be noticed in the foreign exchange market as the price rises and falls. In addition, the country’s debt profile may also affect its currency and cause it to lose value. Furthermore, the demand for the currency is another factor too. Suppose the demand for the currency in the foreign exchange market is higher or lower than the supply and the situation lasts for a significant period. In that case, this may lead to a price movement in a particular direction for a certain time.
Another factor that causes trends is human emotion. This factor is not as fundamental as economic indicators, but it does create a trend. How so?
Humans are emotional beings and make decisions based on how they feel, even if their feelings are irrational. Emotions like greed, fear, and confidence can influence their trading decisions, and by extension, the price movement of a currency pair. For example, if many traders trading on a currency pair wake up to a new trading day and fear that the price will tank based on reports coming from major institutions and news agencies, they may all panic and begin to sell the currency so as not to sustain a loss. If so many traders do this, it may cause the price of the assets to move in a particular direction. If this is sustained for a particular period, a trend is established.
Confidence in the market can also influence traders to buy more of a particular currency pair to drive the trend upward. Since human emotion is fickle and very difficult to track, what experts do is identify the phenomenon that triggers traders to act in a certain way. Once they do that, they can predict how the market will react on a given day. Common triggers that influence trading behavior are
- Report/Announcement by the US Federal Reserve Bank
- Announcements by major Corporations
- Economic rating agencies
- Report/Announcement by central banks of major countries
- Internal and Global politics
- Oil prices and energy costs
Pros of following the trend
There are several advantages of following trends, which is why many traders rely on trends to make trading decisions. When combined with other strategies, it can be a recipe for success. Here are some of the pros of trend trading.
You will identify it early
When you follow the trend, it is much easier to Identify it on time before gaining momentum. Many traders don’t just dive right in when they sight a trend but wait to see if it gathers momentum or not. Some even wait to see whether it reverses before returning to its former direction before entering a trade. Following the trend helps you identify a price movement on time, and when you do, you can enjoy good profits off your trades.
Know when to enter and exit
The key to successful forex trading is to know when to enter and exit the market. Trend traders are very good at this. If you know when to enter and exit the market, you will know when to go long or short, and you will not be bothered by minor reversals and fluctuations because you know where the market is going. And better still, your entry and exit points do not need to be inch-perfect but within the margin of error.
Requires less time
Unlike scalpers who stay glued to their screens and open and close trades by the minute, following the trend does not require too much of your time. If you are good at identifying it, you can keep your trade open for as long as possible because you know where the market is going. However, this comes with its own risks, which is why trend trading is only recommended for expert traders.
Lower costs
Brokers charge traders for opening and closing trades. Trend traders enjoy low transactional costs because they do not open and close trades as much as day traders and scalpers do. By keeping a trade open for a very long time, the trader can make as much profit as possible if the market is in his favor and pay only a fraction of his earnings to the broker.
Exit the market early
One reason why many traders lose money from a winning position is because they do not know when to exit the market early. Even if the trade is in a losing position, they keep at it and lose more in the end. If you understand how trend develops and reverses, you will know how to cut your losses early or when to walk away with the profit you have made before the price reverses.
Cons of following the trend
Despite the pros of following the trend, there are disadvantages involved.
False breakouts
One risk many trend traders face daily is the risk of false breakouts. The price of a currency pair may seem to be moving in a particular direction only to reverse itself not too long after. False breakouts are one of the leading causes of losses in forex trading, and they occur a lot. In a single trading day, false breakouts may occur hundreds of times, especially if the market is very volatile. In extreme cases, as much as 80% of trades result in losses due to false breakouts.
Tool Lags
Tool Lags are another disadvantage when it comes to trend trading. To spot and exploit trends, you need trading tools and an active platform. However, slight delays may lead to losses. The tools on the platform like the RSI, Moving Average, and other indicators may work well, but if they are slow by a few seconds, they could place your investment at risk. This is why beginners are advised to only use advanced and efficient trading platforms.
Low hit rate
The problem with low hit rates is common with signal traders. If you receive the signal from the operator and don’t apply it early enough, you may either make only a fraction of the profit you would have made or suffer a loss.
Following the trend is not always easy
Riding the trend is not as easy as it seems due to false breakouts and unpredictable price reversal. You may have analyzed the trend, and your strategy is positive based on your judgment and the feedback from other indicators; however, unpredictable events like human activity may cause the market to go in an opposite direction. These factors make trend trading very complex.
Conclusion
Trend identification is very important if you want to be a successful forex trader, but it comes with practice and experience. Trend strategies have their strength and weakness, and no strategy is without its flaws. If you must follow trends, understand that there will be potential for losses. Also, note that you may not trade for an extended period if the trend is not in your favor. To be on the safe side, we recommend that you combine trend trading with other strategies for better results.