Trading against the trend is an invitation to ruin, as the trend is always the trader’s friend until it ends. Accurate trend detection is a skill that eludes many traders, which is why many end up on the wrong side of the trend at any given time. In this article we will consider several ways that traders can use to detect a trend.
What Is The Trend?
You would be surprised that many traders in the retail end of the market have absolutely no idea of what the trend is. So it would not be a bad idea to first of all, give a general description of the concept of the trend.
The trend can be defined as the long-term tendency of the price action to move in a particular direction. So we can come to the following conclusions about the trend:
- Direction of the price change depends on the time frame on which price time series is considered. In other words, the time frame that the trader uses for analysis of trend direction will impact the outcome of the analysis.
- The direction of price change depends on the reference point used in the analysis of the trend. In other words, where the trader starts the analysis from to identify a trend.
The various trends
Looking at the figure, you can see several trends at play. First there was a sideways trend (white horizontal arrow), followed by a season of uptrending prices (orange arrow) and finally a downtrend (blue arrow).
If we look closely, we will also see that the length of time that each trend was at work in the market differs. The sideways trend was the longest (2nd to 5th of May or 3 days), followed by the downward trend which lasted a bit less (8th to 9th of May or 2 days), and the uptrend which only lasted 1 day.
So, before you identify a trend, it is imperative to determine what time frame you are interested in, and which one is indeed suitable for the analysis of the trade. For trading purposes, the time frame will first of all determine the time that the trader will hold on to a trade position in the market, from the time the trade is opened to the time it is closed.
In addition to that, the levels of protective stops and expected profit targets as well as the frequency of trade operations will depend on this information.
That is why it is important to understand how to use the new MT4 Build 600 (and above) trading platform tools to aid in trend detection. New traders will find this especially invaluable. The process can also be automated by writing code for indicators that automatically detect the trend, but this is beyond our scope here.
For definitive purposes, we will use the daily price chart (which is the D1 timeframe on the MT4 terminal) of the EURUSD in our analysis. The EURUSD is a very liquid currency pair, which means that there is never a shortage of buyers or sellers.
Typically, a trade position can be held on a daily time frame for at least a few days to several months. The aim of such a trading strategy is to rake in hundreds and even thousands of points from a single trade. However, this means that any protective stop losses will be located at a distance of several hundred points, with the profit targets at least twice that distance.
Even though all of these strategies for trend detection can be applied to any time frame. However, use of smaller time frames to detect trends is risky because they are more liable to be impacted by all the intraday market noise created by news releases, market speculative activity and other factors that generally increase market volatility.
In contrast, the longer is the trend, the less likely impact from all these extraneous factors. So with a longer time frame, it’s more likely to earn money than to lose it. So we will use the daily time frame for our trend detection.
How to Detect a Trend
Many forex strategies depend on trend detection. You may have even used some of these without knowing. Trends are detected via the following means:
- Moving Averages
- Zigzag peaks
- The ADX indicator
- Using the colour of the Heiken Ashi candlesticks
These methods will now considered based on their individual merits.
a) Trend Detection Using Moving Average
Perhaps, the easiest way to detect a trend and its direction is by the use of moving averages. Traders may opt to use one moving average (not recommended) or use a combination of several moving averages.
Let’s formulate a simple rule for one moving average:
- Trend goes up if at a given time frame the closing price of bar is above moving average.
- Trend goes down if at a given time frame the closing price of bar is below moving average.
In this case the closing price of the candlestick is used so that the incidence of “false” trend changes is reduced to minimum, when the price fluctuates up and down near the moving average (the so-called “bounce”).
Let’s illustrate this method:
a) Identifying a Trend Using Moving Average
Here we use the EURUSD D1 chart and a simple moving average with period 200, built on the closing prices (orange line on the chart).
A special indicator is to be used here: the MATrendDetector. The trend direction is given by the position of the MATrendDetector histogram, relative to the zero axis. Above 0 corresponds to the up trend while below 0 corresponds to a downtrend.
Using the position of the price relative to the MA will produce several false signals. That is why it is better to use a combination of moving averages or better still, use the MATrendIndicator as the basis for trend determination with moving averages.
b) Trend Detection Using Three Moving Averages
As we just mentioned, the use of multiple moving averages will filter out several of the moving average signals that would prove to be false in the market. This is usually achieved by using two or more moving averages with different periods.
The trend detection rules when using multiple moving averages are as follows:
- Trend goes up if at a given time frame every short term moving average is higher than all other moving averages with higher period.
- Trend goes down if at a given time frame every short term moving averages is lower than all other moving averages with higher period.
This is the basis of the moving average cross strategies in forex.
Let’s illustrate this method:
Here we use the EURUSD D1 chart and simple moving averages with periods 200 (red line), 50 (yellow line) and 21 (blue line), built on the closing prices.
Another trend indicator is used here: the FanTrendDetector (not shown). The trend direction is once again indicated by the position of the indicator histogram, relative to the zero axis. Above 0 corresponds to the up trend while below 0 corresponds to a down trend. If histogram value is equal to zero, this means that the trend is sideways. The MATrendDetector indicator is also added for comparison.
The combination of the trend indicators and at least three moving average indicators will radically reduce the number of
false trend change signals that are thrown up, making any trades set on the basis of the trend change with the moving average highly accurate. However, there is a compensatory delay in trend detections, but this is ok. It is better to have fewer signals that can produce hundreds of pips (remember we are using the daily chart), than to produce several signals which will end in losses.
c) Trend Detection Using Maximums and Minimums of ZigZag Indicator
According to Charles Dow:
- The trend goes up if every next local top of price chart is higher than previous local top and each subsequent local bottom of price chart is also higher than previous local bottom.
- Trend goes down if each subsequent local bottom of price chart is lower than previous local bottom, and each subsequent local top of price chart is also lower than previous local top.
We will find local tops and bottoms by the tops of the Zigzag indicator.
Trend Detection Using ZigZag Indicator
Again we use the daily chart for the EURUSD and the Zigzag indicator with the following parameters:
– ExtDepth = 5, ExtDeviation = 5, ExtBackstep = 3.
In the figure bottom you can see specially developed trend indicator – ZigZagTrendDetector.
The main drawback of this method of trend detection – in real-time it’s impossible to understand whether the extremum is already formed or not. On the history the extrema can be seen very well, and you can understand where they were formed. However, when price changes real-time, the formed extremum may suddenly disappear or appear again. To see this, just look at Zigzag’ lines plotting in visual testing mode of any expert.
This drawback makes this method worthless for practical use in trade. But it is very useful for technical analysis of historical data to find patterns and to assess the quality of various trading systems.
Trend Detection Using ADX Indicator
The following discusses the method of trend detection using the Average Directional Movement Index (ADX) indicator. This indicator is used not only to detect trend direction, but also to assess its strength. This is a very valuable feature of ADX indicator. The strength of trend is determined by the main ADX line – if the value is greater than 20 (the generally accepted level, but not necessarily the best at the moment), then the trend is strong enough.
The direction of trend is determined by the +DI and -DI lines to each other. This indicator uses the smoothing of all three lines with exponential averaging, and therefore has a delay of response to trend change.
Let’s formulate the rule of trend detection:
- The trend is up, if the +DI line is higher than the -DI line.
- The trend is down, if the +DI line is lower than the -DI line.
In this case, the ADX trend line is not used to detect a trend but rather is used to cut down on the number of false signals that this indicator tends to produce. If trend is weak (ADX is less than 20), it is best to wait until the trend gains some strength, and only then is it safe to trade with the trend.
Let’s illustrate this method:
Identifying a Trend Using ADX Indicator
Here we use the EURUSD D1 chart and the ADX indicator with following parameters: PeriodADX = 21 (thick blue line – value of ADX trend strength, thin green line – value of +DI, thin red line – value of -DI).
In the figure bottom you can see specially developed trend indicator – ADXTrendDetector. For comparison, in the upper chart (crimson) of the ADXTrendDetector indicator the trend strength filter has been disabled (ADXTrendLevel = 0), and in the lower chart (blue) – it has been enabled (ADXTrendLevel = 20).
Notice, that part of the so-called “bounce” in detecting trend direction has been dropped out, when we turned on the trend strength filter. It is desirable to use this filter in real work. Further improvement of indicator quality can be achieved by the skillful selection of external parameters in accordance with current situation in the market (flat/range/trend) and depending on the nature of currency pair movement.
In general, this indicator provides a good opportunity to build trend tracing trading systems as the inputs filter.
Trend Detection Using NRTR Indicator
The following method of detecting a trend – using the NRTR (Nick Rypock Trailing Reverse) indicator. This indicator is always located at constant distance from the reached price extrema – lower prices on uptrends and higher prices on downtrends. The main idea of this indicator – small corrective movements against the main trend should be ignored, and movement against the main trend, exceeding a certain level, signals about trend direction change.
From this statement comes the rule of detecting trend direction:
- The trend is up – if indicator line corresponds the uptrend on bar closing.
- The trend is down – if indicator line corresponds the downtrend on bar closing.
Identifying a Trend Using NRTR Indicator
This large blue dots correspond to the upward trend, while the large red dots – to the downward trend. At the bottom of the chart displayed our trend indicator NRTRTrendDetector, described below.
Trend Detection Using Three Heiken Ashi Candlesticks
Another popular way to detect a trend is by using the Heiken Ashi candlesticks. Heiken Ashi charts are the modified version of Japanese candlesticks charts. Their values are partly averaged with the previous candle.
This method is usually not free from false signals, especially when price action fluctuates in a sideways range. Furthermore, this indicator can redraw not only the last bar, but also the penultimate. bar. In other words, the signal on the candlestick on which the trade entry is based may be reversed on the next bar. This is due to the fact that when the color of candlesticks is determined, two bars are analyzed, so it is recommended to use this method in conjunction with other supporting signals.
It is hoped that the addition of these indicators shown above will help the trader to be able to identify trends better and know exactly when to trade with them. Attached is a zip file containing the indicators that have been described above. Please practice these fully on demo before applying them to a real money account.
The author’s views are entirely his or her own.