Of the many market sayings thrown around by traders, perhaps none is more overused and less understood than the old adage 'the trend is your friend'. All too often, the phrase is used after a trader has taken a counter-trend position and subsequently been stopped out at a loss. Remorse sets in at this point and most traders kick themselves not only for having lost on a counter-trend trade, but also for not having caught the latest move in the trend itself.

To avoid this all too common scenario, we will suggest using several technical tools to identify whether or not a trend is in place and then use additional indicators to help maximize trading profits. Having a strategy in place to identify trends is essential to successful trading in any market, but especially so in the case of the forex markets. Currencies have a greater tendency to move in trending fashion due to the longer-term macroeconomic elements that drive exchange rates, such as interest rate cycles or global trade imbalances. Currencies are also pre-disposed to short-term, intra-day trends due to international capital flows reacting in unison to day-to-day economic and political news.

Identifying the Trend
In its most basic sense, a trend is simply a prolonged market movement in one general direction, either up or down. From a traders' perspective, though, that simple definition is so broad as to be relatively meaningless. A more relevant definition of a trend would be one where a trend is defined as a predictable price response at levels of support/resistance that change over time. For example, in an uptrend the defining feature is that prices rebound when they near support levels, ultimately establishing new highs. In a downtrend, the opposite is true-price increases will reverse as they near resistance levels, and new lows will be reached. This definition reveals the first of the tools used to identify whether a trend is in place or not-trendline analysis to establish support and resistance levels.

Trendline analysis is often underestimated because it is perceived as overly subjective and retrospective in nature. While both criticisms have some truth, they overlook the reality that trendlines help focus attention on the underlying price pattern, filtering out the noise of the market. For this reason, trendline analysis should be the first step in determining the existence of a trend. If trendline analysis does not reveal a discernible trend, it's probably because there isn't one.

Trendline analysis is best employed starting with longer timeframes (daily or weekly charts) first and then carrying them forward into shorter timeframes (hourly or 4-hourly) where shorter-term levels of support and resistance can then be identified. This approach has the advantage of highlighting the most significant levels of support/resistance first and less important levels next. This helps reduce the chances of following a short-term trendline break while a major long-term level is lurking nearby.

Another technical tool that can be deployed to verify the existence of a trend is the directional movement indicator system (DMI), developed by J. Welles Wilder (see Wilder, New Concepts in Technical Trading Systems, c. 1978). Using the DMI removes the guesswork involved with spotting trends and can also provide confirmation of trends identified by trendline analysis. The DMI system is comprised of the ADX (average directional movement index) and the DI+ and DI- lines. The ADX is used to determine whether or not a market is trending (regardless if it's up or down), with a reading over 25 indicating a trending market and a reading below 20 indicating no trend. The ADX is also a measure of the strength of a trend--the higher the ADX, the stronger the trend. Using the ADX, traders can determine whether or not there is a trend and thus whether or not to use a trend following system.

As its name would suggest, the DMI system is best employed using both components. The DI+ and DI- lines are used as trade entry signals. A buy signal is generated when the DI+ line crosses up through the DI- line; a sell signal is generated when the DI- line crosses up through the DI+ line. (Wilder suggests using the "extreme point rule" to govern the DI+/DI- crossover signal. The rule states that when the DI+/- lines cross, traders should note the extreme point for that period in the direction of the crossover (the high if DI+ crosses up over DI-; the low if DI- crosses up over DI+). Only if that extreme point is breached in the subsequent period is a trade signal confirmed.

The ADX can then be used as an early indicator of the end/pause in a trend. When the ADX begins to move lower from its highest level, the trend is either pausing or ending, signaling it is time to exit the current position and wait for a fresh signal from the DI+/DI- crossover.

Let's look at recent long-term trend (chart 1) and put trendline analysis together with the DMI system to illustrate the utility of these tools when used in conjunction with each other. An aggressive trader might initiate a long position as the daily resistance line is breached on 11/12/03 (point A). A trader looking for confirmation might wait a day, when the DI+ crosses up through the DI- line, generating a buy signal. A conservative trader might wait for confirmation of the DI+/- crossover by waiting for the extreme point (high) to be exceeded, in line with Wilder's extreme point rule. This confirmation is given the following day (11/14/03). As the market begins to move higher, the support trendline drawn off the lows is tested, but holds, underscoring its validity to a nascent trend. Although the market has moved higher in line with the DI+/DI- crossover and trendline support, the ADX is still below 25 until 12/2/03 (point B), when a trend is finally confirmed. At this point, a trader should recognize that they are in a trending market and trend following systems can usefully be employed.

This brings us to the point of introducing some additional tools that can be used to maximize profit within a trending market. We have already suggested using the ADX as an early indicator of the end of a trend. Note that from point B, when it first registers above 25 indicating a trending market, the ADX continues to make new highs until 01/14/04 (point C) when it closes lower signaling a likely end to the uptrend and that it's time to exit the long position.

A second tool used to identify an exit point and possibly the end of a trend is the parabolic indicator. The parabolic indicator follows the price action but accelerates its own rate of increase over time and in response to the trend. The result is that the parabolic is continually closing in on the price, and only a steadily accelerating price rise (the essence of a trend) will prevent the price from falling below the parabolic, signaling an end to the trend. Chart 2 shows the parabolic indicator overlaid on the previous chart. Note that the parabolic gives an exit signal (point D) the day after the ADX experienced its first lower close.

The very basic trendlines that are drawn also could have signaled the end to the uptrend. Note that the price accelerates above the upper channel line in the final extension of the uptrend, tests back to the break and then goes on to make new highs. The subsequent price decline back below the upper channel line would then signal the end of the up-move. As well, another support line similar to the parabolic could also be drawn, and its breach would have been the earliest signal of the end of the upmove.

What About Short-term Trading?
The same tools outlined above can be used for short-term decision making, even in markets that are trading sideways, or so-called trendless markets. While the market may not be trending in a long-term sense, there are multiple smaller, short-term movements taking place that can be exploited. (One caveat must be noted, though: traders need to be aware of what is happening in the bigger picture. If shorter term ADX readings indicate a trending market, traders must be circumspect in initiating trades that are counter to the larger, daily trend.)

Let's then look at a short-term scenario using an hourly chart of the Australian dollar (chart 3). The first hint of a potential trading opportunity is the quick convergence of the DI+/DI- lines in the hour marked by point A. This is caused by the sharp bounce in price during that hour. The next hourly bar breaks through and closes above trendline resistance, precipitating DI+ crossing up through DI-. Following Wilder's extreme point rule, we wait for the previous high to be surpassed, which happens in the next hour at point B. At this point, we have several signals indicating a long position-the break of trendline resistance, crossover of DI+/DI-, extreme point rule satisfied, break of parabolic. As the market moves higher, the ADX begins to rise as well, peaking at point C and declining at point D, giving us our signal to exit the long. Basic trendline and parabolic supports are then broken several hours later setting the stage for the next potential move.

The next signal is given at point AA as the DI- crosses up through the DI+, generating a sell signal. This coincides with the price falling below recent hourly lows. The ADX begins to move up, indicating the possibility of a trend forming and eventually rises over 25 at point BB indicating a trend is in place and that the parabolic should be followed. Trendline and parabolic resistance are then breached and the ADX stalls at point CC, indicating an early, but profitable exit to the trade.

The Trend is Your Friend
Profiting from market trends is the essence of making the trend your friend. The first step to profiting from both short- and long-term trends is understanding what constitutes a trend and knowing how to identify them. The next step is employing a disciplined trading strategy that is specific to trends. A conscientious approach utilizing trendline analysis, the DMI system, and the parabolic indicator should help traders make more friends of market trends.

Authored by Brian Dolan & Kenneth Agostino

Originally published in Technical Analysis of Stocks and Commodities, September 2004
© 2004 GAIN Capital Group All rights reserved.