When a Trend is Trustworthy, and When It Isn’t
One of the first lessons we often receive as traders is “trade with the trend.” This is good advice, which I recommend following. But how can you tell when a trend is trustworthy, or strong? While it is good to trade in the same direction as a strong trend, if the trend is weakening or potentially reversing then the probability of scoring a winning trade begins to drop, and you may wish to avoid that trade or seek a smaller profit target.
A Simple Technique For Determining Strength
When a trend is very strong, a pullback should be smaller than the trending wave that preceded it. For example, during an uptrend, you’ll see a strong wave higher, followed by a pullback lower which is smaller in length than the prior up wave. When this isn’t the case, it warns the trend may be reversing.
The chart below shows a strong trend. The pullbacks lower are smaller than the prior up waves, showing that momentum is still to the upside. As long as you see price action like this, keep trading the buy signals as the odds are still on your side.
Figure 1. Pullbacks Smaller than Trending Moves – Strong Trend
A pullback should respect the starting point of the prior trending price wave. If it doesn’t, the trend is weakening and you may need a more conservative profit target on your long positions, or you may opt to skip the long trades altogether when this occurs.
In figure 2 the starting points of each up wave have been circled. Notice how the next pullback (after we have drawn the circle) stops dropping before reaching the last circle (start of prior up wave) and then the price moves higher again.
Figure 2. Price Respects Start of Prior Move – Strong Trend
Figure2 shows a strong trend, and we want to be trading buy signals in such conditions.
Figure 3 shows more of this trend, and finally there is a price move which doesn’t respect the starting point of a prior wave higher. Marked “Doesn’t Respect,” the price continues to fall below the starting of the prior up wave, and indicates the uptrend is severely weakened or over altogether.
Figure 3. No Respect – Up Trend Weakened or Finished
Once you see this sort of price action avoid taking buy signals, or at least be very cautious with taking longs. You may also begin to look for shorting/put opportunities. Once the downtrend begins, look for the same pattern to confirm a strong downtrend–pullbacks higher must respect the starting points of the trending waves lower.
By using the starting point of any wave during a trend, you can determine the strength of that trend. If the price doesn’t respect the start of the prior trending price wave, that means the pullback is as big or bigger than the trending wave, and that shouldn’t happen in a strong trend.
Under such conditions, “trade with the trend” is no longer sound advice, since the trend is likely about to change direction, or already has.
Considerations
Most traders will want to focus on the major price waves and pullbacks, such as those highlighted on the charts. Whether you trade on a 1-minute chart or a daily chart, you can use this technique for determining market strength. This technique will provide you with a very early warning signal that the trend has weakened and may be changing direction.
This is not the only input you can use to determine trend strength, but is a good one. This information can be combined with the information found in Should I Hold Through a Pullback, or Get Out? Part 1 and Part 2 to develop a more comprehensive trend following trading strategy.
Final Word
During a strong uptrend, a pullback should stop falling before the starting point of the prior wave higher. If it doesn’t stop, and falls through this starting point, it is an early warning sign that the uptrend is weakening or finished.
During a strong downtrend, a pullback should stop rising before the starting point of the prior wave lower. If it doesn’t stop, and rises through this starting point, it is an early warning sign that the downtrend is weakening or finished.
Use this technique, in combination with others, to trade with the trend, but also to realize when the trend is likely over.