Staying with the right side of the market, by Sandy Jadeja.

Traders and investors starting to trade the markets will be told, “Trade with the trend”, “the trend is your friend” and “never buck the trend”.

But both newbies and seasoned professionals sometimes fail to stick to the rules and end up in messy situations, often leading to disastrous results. In this two-part article we will discuss trends, current examples of trends and how to stay on the right side of the market using available tools whilst keeping it simple.

If any trader stayed on the right side of the market, so to speak, wouldn’t it be easy to make money? After all, there are only three main directions that markets trade: up, down and sideways. Yet millions of people who trade the markets fail to become successful, simply because they are on the wrong side of the trend or their entry point was wrong relative to the trend.

Identifying what you want to achieve
How do we identify the dominant trend and then pick the right entry point? The real questions start with what you are trying to achieve. What time period are you trading?
Are you a short-, intermediate- or long-term trader? Do you want to capture a small part of the trend or a large part of it?

For long-term success, a trading plan is critical. Within the plan we should identify what we are trying to achieve.

Types of trends
There are many types of trends. The simplest way to identify a trend is to look at a chart and compare its right and left sides. In figure 1 we see the right side of this particular market is higher than the left. This market is moving up, and we want to trade on the long side.

Figure 1: Chart of an uptrend

Figure 2 shows a market that has been declining. Price levels are falling, and, more importantly, there are lower highs and lower lows. Thus, a rising market has higher highs and higher lows, while a falling market has lower highs and lower lows. This simple observation is the key foundation to identifying a trend.

Figure 2: Chart of a downtrend

Moving averages for trend trading
It is obvious what the trend is after it has occurred – and by then the financial media will also probably be talking about this particular market. So how do we, as traders, capitalise on a profitable opportunity before the rest of the world hears about it?

Charting software packages provide many technical indicators. The simple moving average is a basic tool. A moving average gives the average price of X periods. In this example we will use a 20 period simple moving average (see figure 3).

Figure 3: Adding a moving average indicator

Figure 3 shows that crude oil mostly traded below the 20 period moving average whilst also making a series of lower highs and lower lows. Using this information, we would be interested in trading with the trend by taking only short positions within the market and ignoring buy signals.

More specifically, a sell setup will occur when the market trades at or above the 20 period moving average line and then closes below the line. The price bar would also have to close below its opening price. In other words, the market would need to close in negative territory on the day it traded at the moving average line.

In figure 4 we can see the first sell short setup occurred when the market traded at the moving average line and the following day it closed in negative territory. You could place a stop order at the high of the entry bar in case the trade turned out to be wrong. The second entry occurred where the market traded through the 20 period moving average line and closed below its opening price, initiating a sell setup. Here, too, you would put a stop order at the high of the bar. The third setup took place when, after a few days of trading above the 20 period moving average line, the market finally came back below it and closed in negative territory, providing a sell signal.

Figure 4: Sell setups

This method is simple and easy to apply. However, it does not work every time.

Exiting for a profit
Once a trade has been initiated and a stop order is in place, the next part of the process is trade management. According to our trading plan, we choose either to exit at a pre-determined profit target or to allow the trade room to work out to its maximum profit potential.

To exit in this particular strategy we can apply the reverse process to entering. Every time we have a sell signal to enter a short position we wait for the market to close above the 20 period moving average line and exit for either a profit or a loss. We would not take a long position, because the market is in a downtrend and all buy signals would be ignored until the trend changes direction.

Figure 5: Closing a position

The same principle would be reversed for buy setups. This process can be used for any market in any time span.

Measuring the strength of a trend
Once a trend has been established, a trader might want to determine its strength. The Average Directional Index (ADX) indicator is a popular tool for this.

Created by J. Welles Wilder, this indicator measures the strength of the trend, up or down. A reading of 35 or above on the ADX suggests the trend is strong.

Figure 6 shows crude oil has been in an uptrend. In setup 1 the ADX rose above the 35 line and continued to rise in a strong move that also saw crude oil trade higher. In setup 2 there is another good move higher, but notice how a weak ADX reading on setups 3 and 4 preceded a weak uptrend.

Figure 6: ADX indicator

It is important to remember that a rising ADX does not mean a rising market. It simply means a strong trend.

Avoiding a disaster
A problem with trend trading is that we have to wait for a trend to start in order to see that we have a higher high with a higher low, or the opposite.

This means that capturing tops and bottoms is out of the question and one is looking to ride a trend for as long as it continues. Crude oil, for example, was in an uptrend from 2003 to 2007. But the turmoil in the financial markets has brought major downtrends from 2007 to the present, with stocks across many sectors declining sharply in price.

At present, the FTSE 100 Index shows no trend. Instead there is a range-bound market, which can be very difficult to trade. But if we know that the trend before the consolidation was down, it makes sense to say that when the trend resumes there may be a strong chance of another downside move.

Figure 7: FTSE 100 – Trading range

This is not to say that the FTSE 100 will go lower for sure – only that there remains a ‘possibility’ of a trend continuation if we see a breakdown of the current trading range. If, on the other hand, the FTSE 100 stabilises at current levels and then breaks above the channel we say a ‘trend reversal’ has taken place.

Once a trend has ended, the real test for a trader is to continue to trade without being biased or emotionally attached to the market.

It is very easy to be bullish in a bear market and bearish in a bull market. As long as you have correctly identified the trend, the road ahead should be profitable.

Trend trading patterns
Once a trend starts, it is unlikely to go up or down in a straight line. Within trends, there are various patterns. Some are trend continuation patterns and others are trend reversal patterns. There are also consolidation patterns and breakdown patterns.

Recently the markets have become more volatile. There have been some sizeable moves and plenty of action for the bulls and the bears. We should not fear the large moves as long as we are on the right side of the market. Using simple techniques that almost anyone can master we can look to make a handsome profit from the markets.

As the year 2009 has kicked off with stock indices and the commodities as well as certain currencies losing ground, it is imperative to stay on guard for upcoming opportunities. Most importantly, we should always try to keep trading simple, easy to understand and, of course, manage risk prudently.

There are likely to be many trading setups with easy-to-recognise patterns as the year progresses. In the next issue we will look at patterns in more detail and at applying what we have learnt across different markets, including indices, stocks, commodities and currencies. We will also take a look at alternative trend methods including monthly trends offering predictive powers.

Sandy Jadeja is Chief Market Strategist and Head of Global Training at ODL Securities Ltd. Sandy can be contacted at This e-mail address is being protected from spambots. You need JavaScript enabled to view it

This article was originally published in the Mar/Apr 09 issue of YourTradingEdge magazine (www.YTEmagazine.com). All rights reserved. © Copyright 2009, MarketSource International Pty Ltd. If you are not a subscriber, click here to subscribe, or to purchase this issue as a single back issue, click here.