In 2008, the global financial markets had one of the worst years in decades. The S&P 500 declined by 40%, DAX by 41%, and Nikkei by more than 40%. This was during the global financial meltdown, which was caused by the deregulation of the financial industry. This deregulation led to increased risk taking by the banks and the ultimate collapse of leading Wall Street firms like Lehman Brothers and Bear Stearns.
After the crisis ended, the S&P, DAX, Nikkei, and the Dow Jones Industrial Average (DJIA) have climbed by 256%, 200%, 174%, and 235% respectively. Investors who invested in stocks before the crisis have more than doubled their investments. This is a good example of how the trend can be your friend in the market.
Price action trading is all about identifying trends as early as possible and seizing opportunities. Technical analysis plays an important role in this as traders believe that past trading patterns can determine future movements.
Types of trends
Understanding trend types is essential. In an upward trend, the security makes higher highs and higher lows. When a security is in an upward trend, the goal of the trader is to buy low and exit the trade when the security reaches its peak. A good example of a long-term upward trend is that of the S&P, which moved from a low of $720 in 2009 and reached an all-time high of $2840 in 2018.
In a downward trend, the security makes lower highs and lower lows. An example of a downward trend is crude oil which moved from a high of $115 in June 2014 and reached a low of $27 in 2016. In a downward trend, the goal of the trader is to sell high and profit as the price moves lower.
In a sideways or horizontal trend, the supply and demand of a security is usually almost equal. This makes the price move in a horizontal direction. A good example of a horizontal trend is the S&P VIX, which traded within a narrow range of between $9 and $11 in 2017. When a security is in a narrow range, it is impossible to make a profit and so, traders wait for a breakout. In a wide horizontal trend, traders buy in the support levels and sell when the resistance level is reached.
How to identify a trend
With this type of trading, the challenge for traders is in identifying when a trend is forming and identifying a false breakout. A false breakout is when a breakout fails to move past a certain level. New inexperienced traders often make the mistake of initiating trades during these types of trends.
Technical indicators are essential when identifying a trend. Trend indicators like Bollinger Bands, Average Directional Index (ADX), Moving Averages, and Parabolic SAR are used to identify when a trend is forming.
A common way to identify a trend is to use the Double Exponential Moving Average (DEMA) on a chart. This is applied by adding two EMAs—one short-term and another longer-term—on a chart. An upward trend is identified when the shorter-term EMA crosses the longer-term EMA. A downward trend is identified when the longer-term EMA crosses the shorter-term EMA. The Exponential Moving Average is used because it is more responsive than the Simple Moving Average (SMA).
After applying the moving averages, you can confirm the formation of a trend by adding another trend indicator like the ADX. When the value of ADX is between 0 and 25, there is usually no trend or the trend is weak. When it is between 25 and 50, the trend is strong and when it is between 50 and 75, it is usually very strong. Above this, it is extremely strong.
To avoid a false break out, it is important to confirm this trend using the oscillator and volume indicators. Oscillator indicators like the RSI and Stochastics help you identify whether a security is overbought or oversold. When the RSI is above 70, the security is said to be overbought and when it is below 30, it is said to be oversold. When it is overbought, it is a signal to sell.
To further confirm the formation of a trend, you should use the volume indicators like the accumulation/distribution indicator. These indicators attempt to gauge the level of supply and demand in the market. If the security is in a strong upward trend, the accumulation/distribution line follows the price movements and vice versa. If the line is diverging, it might be an indication that the trend could change.
The timeframe of the chart is very important when using the price action strategy. This is because the charts of securities differ between different timeframes. For example, a security might have a strong upward trend in a daily chart and a strong downward trend in an hourly chart.
One way to avoid a mistake is to consider the type of trader you are. If you are a scalper, who benefits from tiny movements, you should use a chart that ranges from 5 minutes to 15 minutes. If you are a day trader who holds trades for a day, your charts should range from 30 minutes to 4 hours. If you are a swing trader who holds a trade for a few days, your charts should range from 1 hour to daily while if you are a long-term trader, you should focus on daily, weekly, and monthly charts.
What’s in summary
Investors who bought stocks at the end of the financial crisis have made money by timing it right. Equally, traders who bought cryptocurrencies in 2017 and shorted them in 2018 have made good money. These examples show the power of price action in the financial markets. To succeed in it, however, you need to take time to learn and practice using a demo account from your broker.