What is a Trend?
In financial terms, a trend is identified as the general direction of the price movement of an asset or market. The price movement can take the form of a series of highs or lows and the time frame of its existence can either be short term or long term. As a general rule, a trend is regarded as a binary options trader’s friend as it represents one of the better ways to trade the market.
One of the ways in which traders identify if a market or an asset is trending is with the use of trend lines. Trend lines are basically straight lines drawn between two points on a price chart. The two points always consist of a high and a low point stretched over a time period. For example if the price of the EUR/USD currency pair on the 4th of November 2016 is trading at $1.1384 and by the 5th January 2017, it has fallen to $1.0607, then the trend line will start from the $1.1384 high point (Point A) and stretch all the way down to the $1.0607 low point (Point B).
Because trends move in only a particular direction, it is possible to predict the next possible data point on the price chart using tools such as the Elliott Wave theory.
The Elliott Wave Theory
Developed in the 1920s by Ralph Nelson Elliott, the Elliott Wave theory is based on the idea that the market moves with a repetitive cycle. These waves were a result of the shift in the predominant psychology of the investors between optimism and pessimism. Basically, all market moves in 5 impulse waves in the direction of the trend followed by 3 corrective waves (shown in red in a diagram below) moving against the trend.
Using the Elliott Wave to identity trends
Because of the repetitive nature of these wave cycles, the Elliott wave theory can be utilized to help you identify trends in 5 different ways.
- Isolating the Dominant Trend
The key to identifying if the overall trend is up trending or down trending is to look at the direction of the first 5 impulse waves. If the impulse waves are moving on the upside then the trend is trending in the upward direction. Conversely if the 5 impulse waves are in a decline, then the trend is down trending. The reason why you want to identify the overall direction of the trend is because you want to trade in the direction of the trend rather than against it. In other words, follow the path of least resistance.
- Market Reversal
Because a trend moves in 5 distinct impulse waves and is then followed by 3 corrective waves and in a hierarchical manner, this will give you a heads up as to where to expect the resumption of the larger trend and place your trade at the right position.
- Trend Maturity
With the Elliott wave theory, it is also possible to tell when the trend is about to mature. When a trend matures, it is to be expected that the market will start to reverse. Hence, by observing the 5+3 wave movements of the trend, we will be able to know when we should start liquidating our market positions.
By looking at the diagram above, we see that the trend has completed 5 cycles of the 5+3 wave pattern. Hence, we can expect the market to reverse itself in order to complete the 5+3 wave pattern at point C of the 5th cycle.
- Price Targets
When used with the Fibonacci Retracement ratios, the wave theory lets you identify price targets for placing your trades.
The relationship between the different waves and the Fibonacci ratios are as follows:
- Wave 2 is .618 of wave 1
- Wave 3 is 1.618 of wave 1
- Wave 4 is .382 of wave 3
- Wave 5 is equal to wave 1
Knowing the probability of where each wave will be at allow us to set price targets for our trades.
- Invalidation Points
The Elliott wave theory has 3 ironclad rules which cannot be disregarded when analyzing the price movements.
- Wave 2 retracement cannot exceed 100% of wave 1
- Wave 3 cannot be the shortest wave
- Wave 4 never venture into wave 1 price territory
If the analysis of the price movements fails to follow these rules, then the analysis is based on the wrong premise. With these rules in place, it is possible to discern the ideal level to place the stop loss levels. For example, since wave 2 can never retrace more than wave 1, then it is possible to place a stop loss level at the starting point of wave 1. Since wave 4 can never venture into the price territory of wave 1 and when the price level has completed wave 3, we can place another stop loss level at the peak of wave 1 hence letting us protect the profits that we have earned so far.
As we can see, the Elliott wave theory is extremely useful in helping traders spot the ideal levels to place their trades as well as the levels where they should cut their losses. Used correctly, it is possible to predict correctly how prices will move 80% of the time while at the same time letting you know with its ironclad rules if your price analysis is wrong.
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References and Further Reading:
- Research on futures trend trading strategy based on short term chart pattern (Saulius Masteika, Aleksandras Vyta)
- Emergence of trend trading and its effects in minority game (Xing-Hua Liu, Xiao-Bei Liang, Nai-Jing Wang)
- Trend Trading: A seven step approach to success (Daryl Guppy)
- Trend-following trading strategies in commodity futures: A re-examination (Andrew C. Szakmary, Qian Shen, Subhash C. Sharma)
- Trend Following Trading under a Regime Switching Model (M. Dai, Q. Zhang, and Q. J. Zhu)