In the last episode I introduced the topic of trends, and today we will look further into this topic, and learn some useful techniques that you can implement in your price action day trading.
So we know that the markets move in waves – up for a while and down for a while, up and down, up and down. I call that movement “up waves” and “down waves”.
This fact, this behavior gives us a few different ways to gauge the market’s strength and determine if the market is likely to continue trending in the same direction. Meaning, continue an uptrend or continue a downtrend, or if the market is losing strength and perhaps going to stall or reverse.
In order to be a successful trader, you will need to know when to buy and sell. That is obvious. And pretty ridiculous for me to point out. But if you think about how you are going to produce a profit: when you buy at a certain price and sell at a higher price. Or, when you sell short and then buy to cover at a lower price. In order to do that you are going to have to identify a trend one way or another.
Because a trend is a series of price points that get successively higher or lower, you will need to find out when that behavior occurs. When you have found an established trend, then you can either determine that the trend is going to continue or that it is going to stall, move sideways, or reverse. And then you can profit by following that trend or countertrade it.
In hindsight, it is easy to see when the market has trended in one direction or the other, or if the market trended sideways. But with some experience, you will also be able to determine whether the market is trending in real time when analyzing live charts. For this, you need to develop your own judgment, but there are also ways to identify trends systematically and quantitatively.
There are some techniques that you can use to determine if the market is trending. One way, that is suitable for beginners starting out, is to add a number of horizontal lines to each major price point in the chart. You can simply use every fourth the price levels that Ninjatrader gives you. Then if the price moves through a number of lines upwards or downward you can easily tell if the market is trending or not. I think 3 lines is suitable for identifying intraday trends on a 5-minute chart.
If the market reverses and starts moving in the other direction, then you should still consider the original trend to be intact. The first trend is intact until the price has crossed 2 lines. Then we cannot be sure if the market will continue upwards or downwards, but if it crosses the third line, then you have a new trend.
If the market stays between two lines for a longer period of time, just chopping around between two or even three lines, then you have a sideways trend. Until you have 3 consecutive line breaks, without a pullback of more than 2 line breaks, then the sideways trend is intact
Another way to determine the trend is to use trend lines. We have two different methods to draw trend lines and I will go through the first one today. This method of drawing trend lines was introduced by Richard D. Wyckoff in the 1930s (“The Richard D. Wyckoff Method of Trading and Investing in Stocks”)
If we are in an up trend, find two consecutive lows, two down waves, and draw a straight line through those lows. This straight line can be extended into the future, into the unknown. This will form a support line. You can also add a resistance line to the chart, so that you can form a channel.
A good reason to use channels is that you have an upper boundary, that will help you determine when the up wave is likely to end and a down wave will form.
To draw the resistance line you will find the highest high between the lows you used to draw the support line. Then draw a similar line through this high point. It is important that you draw the trend line in the same angle as the support line you drew through the lows.
The easiest way to draw this is to use Ninjatrader, select the support line, copy and paste it into the chart, right click the line, select-copy, then right click the chart and select paste. You can also use the short command CTRL+C and CTRL+V. Then you will get the new resistance line and you can click and drag this trend line to make it run through the highest high between the lows in the trend. Now you will see a trading channel.
Trends are more likely to continue than to end. Strength or weakness in a stock or another type of security is more likely to continue than to reverse. The reason for this is that prices are a direct result of the forces of supply and demand. The demand for a stock, demand for some futures contract is not temporary, it is not a one-off occurrence. It is usually more long term. It is not like a thousand traders wake up one morning and all decide to buy Apple, or buy the Euro. The demand for any contract is more long term.
So when you have drawn your trendlines, your trend channel, then you should trade with that trend until it ends. The trend ends when it breaks the lower trend line, the support line.
Trendlines are never going to be perfect, so don’t take anything for granted. Sometimes you will have situations when the price breaks the line, but then immediately moves back inside the channel. Sometimes, you wall have the market respecting the trend line for a long period of time, and sometimes that market will not care about your trend line at all. So you should consider trend lines to be one of the tools in your tool box – you will need more tools in order to be successful in your day trading.
The general idea behind trend lines is the same fact that markets move in waves – fluctuations up and down. When a trend is formed you will have price action that looks like stair steps, stronger up moves, a little bit weaker and shorter down moves. When this happens in a longer sequence, you will get the stair steps of higher lows, or lower highs.
How do you know if the trend is strong or not? For this purpose I use something I call the 50% line. When the market has made an upwave, from a low point to a high point where it starts to pull back. I measure the distance it has traveled and draw a 50% line at that price level. I use a tool in Ninjatrader like this. As the market moves from a low to a high and starts pulling back, I want the pullback to end before reaching the 50% line. If the pullback ends before the 50% line, then the market is strong, the trend is strong.
If the pullback goes past the 50% line, then there is some weakness in the market, the trend is not so strong at the moment and it could well start moving sideways or even reverse.
That’s it for today’s episode. Please make sure to subscribe to our Youtube channel https://www.youtube.com/daytradetowin, and then browse our website to see our day trading strategies that are all based on price action.