In Price Action Trading Strategy

In an effort to keep this site moving along I wanted to dig a little more into the trend following category today. There are few explanations I have ever read that leave me truly satisfied in terms of how to trade a trend properly. Over the years I have adapted my own methods to latching onto preexisting movements.

First and foremost, many of the materials written out there in reference to trend following tend to ignore the type of trading environment that is underway. And while most people might say something like, “well, the environment is a trend, dummy“, this kind of explanation is broad, vague and can mean any number of different things.

Trends move in stages, and depending on the driver and time at which you are observing the trend, have varying intensities that need to be handled differently.

In short form, I wanted to outline a handful of points that have bailed me out over the years and put into practice to this day.

Rule #1: Expect the continuation.

Yes, while I realize this is a very general statement, the truth is that most people do not. I could supply you with here with statistics that point to the retail bloodbath that ensues anytime an aggressive trend is underway, but I'll spare you.

Expectation of the obvious is something people tend to lack in this business, I suppose in part to the fact that he or she thinks that someone or something is always out to fool them, or some other counter-intuitive thought process. If you expect it, you can not only be prepared for the good, but the bad as well. Most trends will give up something on a pullback as opposed to none, regardless of the stage at which it is being traded. The exception to this statement are V tops and bottoms, which have their own characteristics.

Rule #2: Trends move in stages. 

Expecting the continuation of a trend works only as well as the point at which you are trading it. “Drive, Channel, Drive” or “Channel, Drive, Channel” are just two of the ways I'll use to describe the evolution of just about any trend. And even within these larger, more macro patterns you'll find substages on lower timeframes or tick intervals.

For instance, many trends complete with a small channel, which is essentially a triple tap following a sharp drive. This drive is what many people would consider “aggressive” behavior. And by the time this behavior comes to light, many daytraders are just starting to switch gears and think that prices are going to continue, when in fact they are witnessing nothing less than the grand finale.

 

Trend following environments

Rule #3: It is easier for a trend to continue vs. reverse.

Forget about your major support and resistance levels, order flow, etc. etc. in front of the freight train. They will all go bust if the stimulus is strong enough. And trying to “scalp” against these is like picking up pennies off of the train track. It is, for the most part, a useless exercise that almost always ends in ruin. Latching onto the preexisting movement is much easier and about 10X less painless.

Rule #4: The inception of leg #2 tends to drive the most confusion.

Trends can be cut up into “legs”, which essentially distinguishes drives, or sharp movements from one another. Leg #2 gets hairy for a lot of people because this is the leg that can either 1) fail and the previous trend continues or 2) continues, establishing a new trend.

In trends, leg #2 will fail and the preexisting movement will continue. Prices take an intraday pause, reverse, only to fail at more attractive prices for trend followers.These legs themselves can be cut up into two distinct movements and trading accordingly.

Failed 2nd leg in trend

Rule #5: Without anything to dictate otherwise, trends keep moving.

While not as aggressive as the inception, trends will indeed continue should no other counter-stimulus take over. This “rule” can be witnessed many times, over centuries, not just decades, and in most markets. For example, I subscribe to a newsletter written by a guy that most people would consider a “permabear”. Since 2010, I have been reading weekly about a range of indicators that always point to the death of the world equity markets. The problem with most of these “indicators” (which are a mix of fundamental correlations, volumes and technicals), is that people give a rat's rear end about them and are focused on a much bigger picture.

People have been there, done that. If it happened the last time (whatever it might be), it will likely not happen again. We learn from our “mistakes” and trade things in a different way, based on our past experiences.

This does not deter from simple supply and demand, however. If the demand is there, people will buy. If a lack thereof, people will sell. This much never changes.

Others? Please post them below. Needless to say this is a topic that is hard to exhaust.

 

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Showing 12 comments
  • Ryan Lemieux
    Reply

    Great article like usual and it’s exciting to see you writing again! In Rule #4, you mention that many people would mistake it for a flag, but don’t provide any detail of how to distinguish it from a failed 2nd leg. From my experience, it’s easy to identify that the bulls were rejected 3 times painting a triple tap pattern, as well as bulls clearly struggling to make new highs each time. Are there any other signs that might have indicated such?

    I’d love to see more articles drilling deeper into some of the points you made. It would even be nice to see an entire article covering various failed 2nd legs. Thanks again for your great work and keep writing!

    • Steve W.
      Reply

      Hi Ryan, I look for the drift of the flag itself, and whether or not, in a nutshell, new higher lows are being registered within the pattern itself (in the case of a downtrend turned uptrend). And when doing so, backup the timeframe and ensure I’m not being overzealous in terms of time (oftentimes the drift will appear to want to shed lower, as in this case, when in fact it is only in the middle of what ends up being the entire flag itself, which ends up drifting upward). Most of the time (and I am still using a downtrend, turning into an uptrend as an example) you’re going to see a rising wedge formation if price wants to keep heading higher), although it takes more time to complete, simply because a transition is underway. Any transition takes more time than a continuation.

      Individual bar patterns are also helpful, as weak bulls try to take control, hammers or “pin” bars are not uncommon, which quickly get devoured, and the trend keeps traveling lower. Those, in fact, are some of the best telltales. And by that I mean any “rejection” bar that gets eaten up.

  • Rolf
    Reply

    Hi Steve,
    great article. I believe that #2 is one of the most important lessons traders should take away here. Even if they can find a way to enter on a good trending move, way too many get scared out of their trades when they see price retracing a little. They either pull their Stop Loss orders too soon too close and get taken out by a minor retracement or exit manually because of the fear of giving back. Also, traders should start seeing the pullbacks in the ‘drive’ move, as you call them, as opportunities to add to a trade.

    Just my two cents 🙂 Keep it up and hope to read more from you again!

  • Brad F
    Reply

    Steve!

    Good to see you writing again. I have been working on refining my inside trend lines since reading one of your earlier posts. I have gained more insight and understanding through those in conjunction with price confluence/congestion areas than any indicator I ever slapped on a chart. It isn’t as easy for me as reading about it and then having that “Aha!” moment, but over time, I am finding price action is making more sense and I thank you for pointing out the importance of identifying inner trend lines.

    Keep up the posts!

    Cheers,
    Brad

    • Steve W.
      Reply

      Hi Brad,
      Nice to see you around! Inner trendlines are best looked at on the barriers, or just “outside” of price in the early days. Over time you can start working your way inward, but better to shoot for the more conservative measurement when just getting used to them.

  • rahim
    Reply

    Good work! keep it up!

  • Gabriel
    Reply

    Hi Steve,
    Glad to have a new article to read here. What’s your view on profit targets in trends. Are you looking for measured moves from a previous trend or something similar? Sometimes what I think is a ‘natural move’ gets way way overshot in a strong trend. Any other logical points to keep an eye on, or is gradually moving your stop up a better idea?

    • Steve W.
      Reply

      Hi Gabriel,
      In a nutshell, it’s all about the environment. After a breakout on any significant trendline, you are going to drive into a basic, measured move prior to failure. You can repeat this process over and over again scaling higher and viewing these on a more macro basis. Wait for prices to make one last final drive and seek out your exhaustion. If you are talking about much longer terms trends like our recent EURUSD move, then it becomes one step at a time. I look for a major supply or demand areas get traded into and break things down on a smaller scale to more precisely define it. Also, any fundamental changes in rate / monetary policy, broad economic health, etc., usually do it for FX. Any long term movement is going to have a strong fundamental backdrop in some way, shape or form. When that changes, you’re either entering consolidation or reversing a trend.

  • ztopsmiles
    Reply

    Steve I love your stuff. I have a question. I heard a guy talk about unfinished business. He was a prop trader. Just caught the end of his point. But if I understood him correctly, certain price action suggests that big players will go back to certain areas because there is what he calls unfinished business. Do you understand what he’s referring too?
    And if so, I can I pick those areas out. I got the impression it was different than supply and demand areas. Not sure?

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  • […] 5 Trend Following Rules Volatility in the markets has picked up again and this is why this article is a must-read now. The 5 rules are not tailored around a specific trading method, but offer an in-depth view on how trends move and what to be aware of. […]

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