Trading Trends in Forex

As Greg Michalowski explains, being on the wrong side of the trend is one of the easiest ways of clearing your trading account

Although every trader knows that trends are your friend, you’d be surprised by how often traders trade against them. As a prime example, the overriding trend for the first four months of 2011 had been a lower US dollar. The EURUSD bottomed on January 10th at 1.2873, and the subsequent move higher has seen the price peak at 1.4901 – a 16% increase in the value of the EURO (and decrease in the value of the US dollar).

Despite the clear trend, statistics from the National Futures Association (NFA) show that the percentage of unprofitable traders at the major USA based retail forex brokers was 70% in the 1st quarter. Why? Well, when we combine the dollar’s trend with the NFA’s statistics, we can only come to one conclusion: that retail traders do not trade trends very well.

Make the Most Money or lose the Most Money with Trends

Trends are fast. Trends are directional. Trends tend to have low to high trading ranges that are greater than a non-trending range. These are the three main characteristics of a trending market.

As a result, traders can simply get on the trend and let the fast, directional momentum – with the extended range – take care of the profits. In short, traders have the wherewithal to make the most money trading with the trend.

What a lot of retail forex traders fail to realise is that the same fast, directional, extended trading range can be lethal to their trading account. That’s because if you want to lose the most money, in the shortest amount of time, the way to do it is to trade on the opposite side of the trend. Yet traders are still constantly looking for ways to sell the tops or buy the bottoms in the middle of a trend move, and the result is that they invariably “get caught” by the market. This ultimately is the reason for the disproportionate amount of retail forex traders being unprofitable.

Buy Low. Sell High. it’s the key to Making Money, Or is It?

It’s human nature to want to buy low and sell high – especially in trading. Most trading textbooks and courses emphasize this simple Wall Street axiom. In the world of equity trading, where retail traders predominantly buy, then sell, the buy low/sell high mentality is engrained in the minds of anyone trying to be profitable in the markets.

The forex market is different. In this market, going long (or short) on a currency pair (like the EURUSD) always involves buying one of the currencies in the pair low. The reasoning behind this is that when you trade forex, you are buying one currency and selling another at the same time. As a result, if a trader buys the EURUSD, the trader is saying the Euro (or EUR) is low and the US dollar (or USD) is high.

Conversely, if the trader sells the EURUSD, the trader is saying the EUR is high/the USD is low. In every currency trade, a trader buys what he thinks is a low priced currency and sells the dear one.

When markets are in a non-trending phase retail traders who follow this philosophy tend to be most successful. They buy low and sell high, and become mesmerized by their uncanny ability to succeed by trading in this fashion. Technical tools, such as the Relative Strength Index, create overbought and oversold levels that make trading seem even easier. When trade location isn’t so great, the trader will double up. As long as the market remains non-trending in a range it eventually reverses, providing the opportunity to breakeven or even make money. Life is good.

The Market Breaks and Trends

Then the market changes from non-trending to trending. At first the pattern tends to be similar, but then the currency pair starts from a lower level and starts to move higher. Let’s assume the trader buys the EURUSD at 1.3200 in the non trending area. By doing this the trader is buying the cheap EURO and selling the expensive US dollar. The price of the pair goes up and the trader sells, booking a profit. Life is still good.

Since the market is starting to trend, instead of rotating back down, the price goes higher. At the 1.34199 area the price starts to trend higher. Since the trader last sold at a lower level, and the price is now higher, what does it say about the EURO? What does it say about the dollar? At the higher price it says the EURO is dearer, and the US dollar is even cheaper. The trader – used to buying low, selling high – sells the EURO and buys the cheap US dollar when the price starts to dip.

The market may continue to dip for a very short time, but since trends are fast and directional it will continue to rise shortly thereafter. At the even higher price, the trader is not inclined to cut the loss but instead sells again. After all, in the non-trending market the market always came back down. Moreover, popular technical tools such as the Relative Strength Index (RSI) are likely telling the trader that the market is becoming overbought. The trader therefore ignores the fast and directional trend and instead still allows the buy low, sell high mantra to dictate their trader bias. He sells the Euro at a higher price and buys the dollar at an even cheaper level.

The price may again fall slightly, but because trends are fast and directional the correction is shallow. And when the trend continues to move back higher the trader inevitably gets caught again as the pattern continues for two more (trading against the trend) sales.

Eventually, fear takes over as the trend marches higher and the trader either closes the position out for a big loss, or is liquidated out of his position. The trader laments on how he got “killed” by the unexpected trend move, but in reality he ignored the reality of what was going on in the market and chose to trade against the trend.

Buy Low, Sell High, Buy Higher in Trending Markets

“Buy low, Sell high” works great in a non-trending market. But in a trending market like the EURUSD, traders have to re-train their thinking to a Buy low, Sell high, Buy higher model if they want to be profitable. In next month’s issue, I will continue to explore how traders can attack the currency trends and take advantage of fast and directional markets.