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When Trend Following Indicators Reverse in FX

Discussion in 'Forex Discussions' started by painofhell, Sep 6, 2015.

  1. painofhell

    painofhell Content Contributor

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    When Trend Following Indicators Reverse in FX

    Trend Following Indicators

    What Indicates a Reversal?

    What Happens in a Reversal?

    Trend following is a great way to get the most of the big moves that happen in the FX market for all types of reasons. For the last 12 months, one of the largest trends in the FX market has been that of USD strength and Commodity FX weakness. Commodity FX is typically seen as the currencies whose economy is highly exposed to the directional trend of the commodity sector such as Australia, Canada, the Norwegian Krona, as well as many emerging market currencies.

    Given the drop in Oil over the last 12 months, many FX traders have looked to these trends in order to capture multi-hundred pip moves. However, the move has stalled and some are wondering if the move could soon reverse. The fundamental reasons for this are many but technical based traders have seen many strong trends stall, which leads to one of two scenarios, a trend stall that can last many months or trend reversal.

    Trend Following Indicators

    There are a multitude of indicators that can easily help you identify a trend and see at what point a trend may continue or reverse. The most popular indicators that traders have used in order to identify the trend are moving averages, trendlines or more advanced indicators like the Ichimoku cloud. Either way, a trend indicator is designed to give you a directional bias so that you can focus on trading in one direction only. As a helpful note, if trend indicators are not providing a clear directional bias, its likely best to not hold a directional bias until the price holds to one side of the indicators.

    This environment often means the markets are range bound and may be stuck in an environment of sideways consolidation. This consolidations can take weeks, months or years.

    What Indicates a Reversal?

    A reversal can be identified in a variety of ways. Typically, the most popular way to see a trend reversal is when price begins to fail pressing down or up in the direction of the prior trend with the same force that it was in the prior trend. Another simple way to denote a reversal is when a higher low in an uptrend, which was validating the trend is broken in price. Higher lows are a simple and effective way that traders look to price action to see if a trend is in play or not. Once the repetition of higher lows and higher highs stops, then the trend is seen pausing.

    Another methodology that is indicator based is looking to see if price breaks through the trend favoring indicator. Recently, EURUSD broke above the 200 day moving average for the first time in over a year. Even though this happened in late August, the trend really turned, or at least printed its lowest price in the year back in March. If you think about it that means it took 5 months for the lowest price of the year to break above the 200 day moving average. Therefore, it’s easy to see with that example that moving averages, especially the larger and slower moving averages take longer to reveal a trend reversal than a faster moving average like a 13, 21, 34, or 55. However, there is no Holy Grail moving average as a faster moving average may only indicator a shorter term trend pause without indicating a reversal.

    What Happens in a Reversal?

    A reversal happens in price but it’s also helpful to note when sentiment is changing. By sentiment, it usually means looking at whether or not the optimism is decreasing or increasing relative to the prior trend. While futures are uncertain in life and markets, if the sentiment turns aggressively due to a fundamental change in the underlying market, think monetary policy change, then a reversal may be underway. On the other hand, if the sentiment cools down but doesn’t reverse, then a pause but not necessarily a reversal could be in order. Pauses are difficult but often not very damaging to a trader. Difficult because it’s tough to ascertain when the trend will resume. However, they’re not very damaging because as long as you’re trading with the trend, the probability of trend continuation is still in your favor.

    Summary

    Either way you look at a trend reversal, its likely best in order to stay trading in the direction of the trend a look at reversals as opportunities to rejoin the trend at a better price. True reversals are rare and in the strongest trends, may only happen once over a year.
     
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