Part II. Indicators’ Application for Estimating of Trending Market

Indicators’ Application for Estimating of Trending Market - Forex School
Commander in Pips: We know that when market falls in trend it usually creates higher highs and higher lows in an uptrend and lower highs/lower lows in a downtrend and the market usually moves in one direction. Let’s see how different indicators could be used for estimation of trending environment. Still, to be absolutely honest, I look at this skeptically, because any indicator is derivative from price action and using of price action itself to estimate trending sentiment looks to me to be much better. Still, many educational resources tell you to us some indicators for identifying a trending environment. Usually ADX, MA and Bollinger Bands are used. Also we will look at a bit of a different approach by using MACD and Displaced MA (DMA). So, we will start from ADX indicator, as on chart #1 

Chart #1 | EUR/USD 60-min chart and ADX (10) EUR/USD 60-min chart and ADX (10) - Forex School

For example, you may apply not single close, but two or three closes above or below and so on. The point is that the overall strategy doesn’t change.


But here I want to note a very important feature of any MA: 

1. MA is a lagging trend indicator. It means that first, it based on some preceding price action, and, second – it needs some time to react on this price action; 

2. This lead us to next conclusion – since an MA lags after the market and when the market changes direction fast and often compared to the MA period, it leads to whipsaw price action. Appling an MA for trading in these circumstances could lead to losses.

Pipruit: I know! I know! I remember that!
Commander in Pips: ? ...Is there a fire somewhere? 

How we can identify a trend with ADX? - Forex School

Pipruit:
 I mean, I remember Average Directional Index…
Commander in Pips: Oh, right, I understand. So, if you have such good memory, tell me about it. How we can identify a trend with ADX?

Pipruit: Right. We know that ADX could move in 0-100 range, but it does not show the direction of the trend – only the power. If ADX moves above 25 then it tells that market is gaining power and turning into trending environment – the greater ADX value the stronger the trend.
Commander in Pips: That is correct, but ADX still has some disadvantages. First is, as you say, it does not show the direction of the trend. Second, ADX is a lagging indicator. Also, its interpretation in real time is not so simple a task. Still, on chart #1 we see that ADX nicely holds the trend action on EUR/USD. All the time ADX stands above 25 (red dot line). 

The next indicator that could be used is a combination of different Moving Averages.

Triple Moving Average 

This is a relatively old method of identification of a trending market. For that purpose you should use three MAs with different periods: short-term, medium-term and long-term. For short-term usually 5-8 periods are used, medium-term 17-21 period, long-term 50-65 period. Anyway you have to test different periods before adding them in your trading arsenal. This is just an example, how they could be applied. 

Chart #2 | EUR/USD 5-min chart and 7;25;55 SMA EUR/USD 5-min chart and 7;25;55 SMA - Forex School

On chart #2 we see, how three different MAs compressed with each other on top and then have started to spread out, coming farther from each other. When the short term MA (in our case this is 7-period) moves below medium term MA (25) and the medium term, in turn, moves below the long-term (55) and they start to fan out – this is an indication of down trend. 

Also, take a look how the trend holds in the rectangle – although there were some crossings of different MA, we should exit only when the 7-period will move above the 25 period, and the 25 will move above the 55-period MA – just like in the circle on the bottom of chart #2. The opposite is true for uptrend: 

Chart #3 | EUR/USD 5-min chart and 7;25;55 SMA Chart #3 is a continuation of chart #2 - Forex School
On chart #3 is a continuation of chart #2 – an upward trend has started right in the circle, as on bottom of chart #2 and it also shown on chart #3 – see, the MAs contracted into a tight node and then start to fan out – 7 period above 25 and 25-period above 55. The trend has finished when we see opposite crossing and so on. 

Pipruit: Well, that reminds me some trading methods from the MA application chapter. As I remember, applying MA’s leads to lagging and whipsaw price action that could turn to losses in a ranging environment – something like on the chart #3 to the right from “exit” point. Although here we can exit dry from the water and will not take a loss on whipsaw action, in other cases it easily could happen.

Commander in Pips: Yes, you’re right. Any method has its own disadvantages. But here we have to offer you different approaches, including this old one with MAs. May be somebody will find it useful as an additional tool in his/her trading system.

Pipruit: I see. What’s next?

Commander in Pips: Next is Bollinger Bands, but I personally do not like very much using this indicator for estimation of trending market. Still there is solid logic for its application for that purpose. Bollinger Bands What do you remember about BB?

Pipruit: Well, I remember that there is some kind of statistical foundation of its work, something with normal distribution law…

Commander in Pips: Right. Although there is a question, is FX price normally distributed or not? We will not dive in this swamp currently, but focus on the logic of using BB for indication of a trend. As we’ve said previously, a good trend is a relatively rare event and most of the time the market spends in some range. In general, market ranging is 70-80% of time or even greater. So, ranging is a normal condition for prices. 

Now let’s take a look at chart #4. What normal distribution tells us - 68% of the time the market should spend between bands of BB that use 1 standard deviation. That is the green bands on the chart. 95% of the time the market should stay between red lines that are 2 standard deviations from average price. Hence, when the market stands between the green bands – there is no trend, because the market does not come out even from 1 deviation from average price, and as we’ve said this is a normal ranging environment. 

When market suddenly explodes and moves in the range between green and red lower bands, then we can suggest that probably a downtrend has started, because th market holds in a non-typical range.

Pipruit: And why this range is non-typical?

Commander in Pips: Because the probability is that market could stand here is just 13.5%: (95-68)/2 = 13.5%. So, what do we get? The market stands in the range (between the bands), where it could stay only with a low probability, but it still stands here. That could happen only when the market environment is changing.

The same is true for uptrend: 

Chart #4 | EUR/USD 5-min chart and 20-period Bollinger Bands EUR/USD 5-min chart and 20-period Bollinger Bands - Forex School
Pipruit: Sounds logical. Other words you mean that although the market has a low probability to stay here – it still stays because some power forces it. And this power is the power of sellers, right?

Commander in Pips: That’s correct. It’s like a spring. When you press it, it comes in unnatural condition and holds there while you force on it. As soon as you release it – it returns back in calm condition. So, calm condition of the market is when market is ranging and holds between green bands (1 std. deviation). When some power appears – the market shifts into an unnatural condition – between the red and green bands. Although probability tells us that the market has only a 14% chance to stay here – it still stays, since the power of sellers forces it to do it. And that’s our signal.

Pipruit: Cool! 

Commander in Pips: The same is with uptrend: 

Chart #5 | EUR/USD 5-min chart and 20-period Bollinger Bands Why this range is non-typical? - Forex School
Pipruit: And what is our signal to enter?

Commander in Pips: Well, I do not to tell definitely about the “signal”, since this hardly could be used as separate trading tool. But as a necessary condition, the market should show some regular closes between the red and green lines. This will tell us that those closes were not just an occasion.

Pipruit: Well, although it sounds logical and has a solid math foundation, I guess in practice it will be hard work to do. Even looking on charts #4 and #5 we see many situations that could lead us to loss, even when the market shows 2-3 closes in the Buy or Sell zones…

Commander in Pips: Right, but as you’re already know, any strategy is a question of probability. What does it mean? Will profit from successful trades beat loss from fake and unsuccessful trades or not? If they will, then this strategy is relatively acceptable. That’s why you should try it on a demo account first to make a final judgment about testing it with real money or not. Still, if you like so much different indicators for trend estimation, I will give you another way that is not spread wide. It based on a combination of short-period DMA and the MACD indicator.

DMA and MACD cooperation

In general, this is just a beginner’s thought on this topic. More closely we will discuss it, when we will talk about multiple time frame trading. Also we need a Fib retracement tool along with MACD and DMA. The idea of this method is simple. First, we need identify the thrusting move on the market. For that purpose we will use 3x3 DMA.

Second, when the initial thrust will stop and the market will turn to retracement, we need MACD/MACDP and our Fib tool to estimate potential levels, where we can enter in the direction of the thrust. In fact, this method is not for possession of a trend, but to catch the nearest continuation of an initial thrusting move, that could be part of a trend later. When and if you’ll catch it – then you may act as you want, move your stop to breakeven and may wait for rather extended targets, or, take the nearest one. There are no forbidden choices. Once your stop is at breakeven, you have a riskless trade… 1. 

Identify the trend. Here we use simple 3x3 DMA. We will call move as “thrust” if market shows at least 8-10 bars with close in direction of thrust, no closes beyond 3x3 DMA. Preferable, if market even does not touch 3x3 DMA, like on chart #6:

Chart #6 | 60-min EUR/USD thrust identification with 3x3 DMA 60-min EUR/USD thrust identification with 3x3 DMA - Forex School

See, we have excellent thrust down. The number of black candles is obviously greater than 8-10. There is no even single close above 3x3 DMA. Even more, the market has touched it only once, but during all the other time there is a good separation between the MA and price. Other words, the thrust down is perfect.


Pipruit: And we need definitely thrust? Why we can’t just have bearish trend, based on MACD, for instance?
Commander in Pips: Because the foundation of this approach is existing momentum, that price gets during a thrusting move. Even, when conditions have changed, the market tries to continue move in the direction of the thrust mechanically. It will do it even more, if conditions have not changed.

Pipruit: But why?

Commander in Pips: This is happening because a reversal point, where market should theoretically stop, many traders treat as retracement, and those who were late at the starting point of the thrust want to join it at retracement. Even if the environment has changed and the market really is reversing, in most cases the move shows some continuation in the thrust direction due to the momentum that it has accumulated during this thrusting move. Some traders call this a “momentum trade”.

Pipruit: I see. So what’s next?​

Commander in Pips:
 2. Estimating potential level of retracement, from which market could start a momentum continuation. For that purpose we need Fib retracement tool, as on chart #7:

Chart #7 | 60-min EUR/USD retracement after initial thrust down 60-min EUR/USD retracement after initial thrust down - Forex School

Here we see that market has tested 50%, retraced, and then broke it up. Also, the trend has turned bullish. That’s not in our favor. We need a bear trend to enter short. That’s why in this particular example, all that we can do is to wait. When the market reestablishes a bear trend, we can then enter on shallow retracement. 


3. Wait for when trend will reestablish in the direction of the initial thrust. Estimate the target. Wait for the nearest shallow retracement and enter. As on chart #8: 

See, our target is 0.618 Fib extension from initial thrust and followed retracement. We do not try to predict, where this retracement will end. All that we have to do first is wait for reestablishing of a bear trend. That has happened after strong bars down. And second, - wait for the nearest shallow retracement from that continuation move. It comes very soon. We enter at 0.382, but there was a chance to enter from 50%. You can see that market has reached the target.

Chart #8 | 60-min EUR/USD entry point and target 60-min EUR/USD entry point and target - Forex School
Pipruit: Well, Sir. This way is much easier to apply than BB and some others you’ve taught me. But still, a lot of questions are rising. 

1. Can we enter not after the trend reestablishing, but right from the Fib level? 

2. Why do we place stop above the swing high. May be we can place it, say above, 0.618 retracement level? 

3. Can we use other targets? 
Commander in Pips: Good questions, son. 

1. This could be done, but this is more risky way. You can apply it, if some upward AB=CD pattern makes an Agreement with some Fib resistance. Second, if the market reverses from, say, a 0.382 resistance and MACD holds a bear trend. But here you need some reversal patterns on the 5-min chart to justify entering. I’ve pointed out the safest way how to approach to such situations. All other ways are possible, but they demand some experience and other confirmation signs from the market; 

2. It’s possible. But you want give the market some room to breathe. You have to keep a balance between absolute risk value and effectiveness of stop placing, just not to be stopped out occasionally. The way how we place the stop here is logical, since if the market will return right back and trigger our stop it will tell us that there is something wrong with continuation, or that the market intends to show AB=CD retracement. You also need some explanation, why you intend to place stop just above 0.618. If market will trigger it, will it mean that further down move probably will not happen? Hardly. At least while you have no additional tools to use for clear clarification of down move cancellation, you should be careful. 

3. You may use any other. We use the nearest, as we’ve said – 0.618 extension of the thrust. This is a bit early to talk about it. But to choose a target you need to know the direction of higher trends. In our example this is daily trend. Since we do not know anything about it – we use the nearest target.

Comments

M
mmtto
12 years ago,
Registered user
Hi Sive,

I have 2 questions related to the lesson entitled "DMA and MACD cooperation".

1) On Chart #8: when you say enter short at nearest retracement (38.2% resistance), how do you enter? by placing a sell limit order slightly below 38.2%? or you will need additional confirmation besides bearish trend before you pull the trigger?

2) Quote:"1. This could be done, but this is more risky way. You can apply it, if some upward AB=CD pattern makes an Agreement with some Fib resistance. Second, if the market reverses from, say, a 0.382 resistance and MACD holds a bear trend. But here you need some reversal patterns on the 5-min chart to justify entering......." I underlined my doubt. Do we still need reversal pattern on 5min chart when hourly MACD is already in bearish trend?

Thank you.
S
Sive Morten
12 years ago,
Registered user
> Hi Sive,

I have 2 questions related to the lesson entitled "DMA and MACD cooperation".

1) On Chart #8: when you say enter short at nearest retracement (38.2% resistance), how do you enter? by pl..

Hi mmtto,
nice questions buddy.
1. It depends on what is your context time frame. Here we have 60-min chart. If you trade at daily and use 60-min to enter - then you may place just order slightly below 0.382 and after that monitor that hourly trend remains bearish.

2. Here is the answer is you use 60-min chart as a context. In this case you need confirmation that 0.382 level will hold. Let's say, you see that 60-min trend holds bearish during retracement, but you do not know - will market proceed to 0.5 or may be even to 0.618. Because hourly trend still can hold bearish as well. For that purpose you drop your time frame and watch for sell signals or patters on 5-15 min chart that coincides with hourly Fib resistance levels. If you see, say, 15-min 1.618 butterfly "sell" right in agreement with 0.5 hourly resistance and hourly trend is still bearish - you can pull the trigger.
M
mmtto
12 years ago,
Registered user
Thank you Sive for your swift reply. Your help is greatly appreciated.

Does the chapter on Multiple Time Frame Trading cover the subject on Context of Trade?

Thank you.
S
Sive Morten
12 years ago,
Registered user
> Thank you Sive for your swift reply. Your help is greatly appreciated.

Does the chapter on Multiple Time Frame Trading cover the subject on Context of Trade?

Thank you.

Yes, there will be chapter dedicated to multiple time frames. but it will be released a bit later.
H
Hamza Samiullah
6 years ago,
Registered user
Good work
O
One-fm
5 years ago,
Registered user
Nice explanation

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