Traders employ a large number of technical indicators to help them identify and predict trend changes, but in reality tracking these changes is no simple task. So, the first question is:
“Is there a quick and easy way to predict changes in trend?”
The answer is yes. However, it’s important to understand the different types of markets and their particular psychology.
Markets are either trending or range bound. Trends in the market are based on market sentiment and supply and demand. A range bound market exists when there’s a sort of equilibrium between buyers and sellers.
A market may be trending – either rallying or falling. Alternatively, in a range bound market the market may be flat, trading within a channel or bouncing back and forth between two key support and resistance levels.
Range-bound markets are common and are frequently encountered by traders. Financial instruments are often range bound with only a short time of trending after it.
Charting Trend Changes – The Detail
The key to charting trend changes centres around understanding the following points:
1. Understanding chart patterns
2. Identifying divergences in the market.
A range bound market condition is a generalisation and is often incorrectly perceived by traders. A range bound market is not limited to a flat horizontal range, where price bounces off the support and resistance level unable to progress higher or lower. Triangle, flag, channel, wedge, and pennants are also categorised as representing a range bound market condition. These chart patterns can exist in and represent various aspects of trends; they are the pre-cursor to the beginning of a trend as well as potential changes in the trend, be it continuation of an existing trend or the end of a trend.
The Gravity Of The Situation
Think of a ball and how gravity acts upon it. If you throw the ball upwards, gravity will pull it down. When the ball touches the ground, it will bounce back, but with every bounce the momentum of stored and released energy in the ball will decrease and so will the height of the bounce. Eventually, the force of gravity will surpass any remaining momentum and the ball will stop. When it has stopped, someone may pick it up and the cycle continues – provided that the external force (such as someone picking it up) combats the force of gravity.
So, let’s say the ball is the price of a particular instrument, and gravity represents market participants. A market rallies because the sentiment in the market is bullish – traders jump in on the ride up knowing that it will not be forever. Savvy traders will have a set target in mind, exiting their positions on the way up; this in turn decreases the momentum of the market and before a turn in the market takes place, there is a noticeable decrease in momentum, range and volatility in the market.
This loss of momentum normally forms either one of the above mentioned chart patterns or in the analogy above this is when the bounce happens. This is what we call consolidation in the market, either through profit taking or uncertainty such as being close to a key level in the market, and the imminent release of high-impact economic news. Once the uncertainty has cleared out, normally in the form of a breakout, trend will resume.
Have a look at the chart below and the amount of patterns that exist within one day:
The above shows a down trend on GBP/USD 15 minutes. The trend ends when price closes above the resistance trendline and the pair proceeds to consolidate in a flat horizontal channel, before breaking down, continuing its initial direction and repeating the pattern but on a smaller scale.
The picture below illustrates what happens post the consolidation periods:
Along the way, several patterns repeat themselves, which is difficult to represent graphically. The point is that changes in the market are not as unpredictable or chaotic as traders often make them out to be. The market cycle can at times be very predictable if all the extra indicators are removed.
Keeping a clean view of the market will provide an unbiased view of market conditions. A significant reason why many people make incorrect judgements on trend charting is that they try to predict the market, with a bias that favours their own view rather than going with the flow of price.
Understanding divergence in the market can also help with identifying trend changes, and I will cover this next week.
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