How to Determine Forex Trend Direction

If your trading personality is a good match for trend trading, then this post will show you how to get started. There are several different methods for determining a trend. The most important thing to remember is that you should find the one that works best for YOU.

The trend direction in Forex trading can be determined by using a trend following indicator or by analyzing price action. Frequently used trend following indicators are moving averages, the Relative Strength Index (RSI) and Moving Average Convergence Divergence (MACD). Trends can also be identified through price action analysis by drawing trendlines or observing progressively higher lows, in an uptrend, or lower highs, in a downtrend. 

In this post, I'll get into more details on how to use these tools to determine a trend the currency markets. I'll also show you a couple of popular trend trading systems.

Test each of these methods out in demo or backtesting and get a feel for what you are most comfortable with, and gives you the best results.

The 2 Schools of Thought in Trend Trading

There are 2 ways of looking at trend trading.

Each one has its advantages and disadvantages.

Some strategies try to get into the move as soon as possible. When you trade this way, your winning percentage is usually low.

However, the upside is that you also have very large winning trades when you are right.

Another way to approach trend trading is to try to get most of the middle of a trend. This method requires a little patience because you have to wait for a trend to develop. In addition, you have smaller winners because you're only getting the middle of the trend.

The potential benefits of this method are that you generally have a higher win rate than the previous method and you might have a little more confidence entering a trade because the trend is more defined.

Now with those concepts in mind, let's get into the methods that you can use for trend trading…

Price Action Analysis

The method that I prefer to identify a trend is pure price action. This involves looking at the Energy Flow of price, and is the purest form of technical analysis.

So the first thing to look at is:

• Higher lows in an uptrend
• Lower highs in a downtrend

But it's a little more complex than that.

First, let's take a look at a chart. The circled areas are places where price formed higher lows and you could have potentially entered trend trades.

Next, we need to understand what the market typically does before a trend. Many times, there's a consolidation period before the trend, as price “gears up” to make a big move.

You might have a chart that is showing higher lows or lower highs, but it might not be the start of a trend because price didn't consolidate before it started trending.

Trendline Analysis

You can also use a simple trendline to define a trend.

Here's the same trend, identified by a trendline.

In this example, we can simply draw a line to connect the points that we circled above.

Some traders will stay in a trade until price breaks the trendline.

Of course, some currency pairs are more volatile than others. So you should test your trendline strategy extensively before trading real money.

This method might not work in very volatile markets.

Again, there's no right or wrong answer here. Use whatever makes the most sense to you.

Trend Indicators

You can also use indicators to determine a trend. Some traders find this more comforting because they have definitive number or line that they can use to define a trend.

Here are some examples…

Moving Averages

One simple way to identify a trend is to use one or more moving averages. It can act as a dynamic support and resistance level in a trend.

Single Moving Average

For example, the 20 exponential moving average (EMA) is a popular moving average to use to identify trends.

The great thing about this method is that it's very simple and since it's dynamic, it can adjust to market volatility.

Moving Average Crossover

Another way to use moving averages to determine a trend is by using a moving average crossover strategy. You can use the simple 50 and 200 moving averages, which are commonly used settings.

I did a test on this system with multiple backtesting software products, and the tests turned out positive.

See the results in this video.

Relative Strength Index (RSI)

Another indicator that can be used to identify and ride trends is the RSI. You can track the 50 level on the RSI and use that as a way to identify pullbacks that can be used to enter an existing trend.

I did a test with this strategy and it turned out profitable. More testing would have to be done, but you can see the results here.

Moving Average Convergence Divergence (MACD)

The final popular indicator that can be used to trade trends is the MACD. You are looking for a crossover in the MACD signal line to take a trade.

Here's one example of a long trade. You could have entered at the left arrow and exited at the arrow on the right.

As you can see, this trade would have been profitable, but the exit was not ideal. So you would have to do some testing to figure out a good exit strategy.

Maybe exiting at the next crossover is a good idea.

…or maybe that should just be a signal to start trailing your stop loss.

Only testing will show you the best way to exit. 

Like other trend indicators, you cannot take every signal because that will give you too many signals and eventually blow out your account.

Therefore, you would need to have some sort of filter that will allow you to only trade the higher probability crossovers.

Trend Trading Systems

Now let's take a look at more complex trend trading strategies. They contain some of the elements listed above, but also add in other rules for money management and scaling in/out.

Bill Williams Trading System

This trading strategy is not widely known, but it's one of the most aggressive trading strategies that I've ever seen.

It uses a set of proprietary indicators. Luckily they are available for free on most trading platforms.

If you like huge winners and don't mind a low win rate, then this strategy is for you.

The Bill Williams method looks for consolidation periods and enters the market when price breaks out. Then it aggressively adds positions as the market continues to move in your favor.

I've tested this strategy it can lead to some gigantic winners. The only downside is that it takes a lot of time to manage, so you can really only trade a few markets at a time.

Here's an example of what the indicators look like. They are available for free on TradingView.

Get the complete trading system in Bill's book here.

The Turtle Trading System

This trading system is well known.

It was featured in the Market Wizards book and many of the traders that learned this system went on to run very successful hedge funds.

After the non-disclosure period was over, “Turtles” like Curtis Faith shared the trading strategy that they were taught.

The system is based on the Donchian Channel breakout strategy.

But it adds in some position sizing rules and other risk management rules that help the trader maximize trending environments and minimize losses in whipsaw environments.

I've found that for some people, this method of trading makes complete sense. This guy is one example.

For others, it's too complex.

…and that's fine too. You should use whatever trading method works for you.

If you don't want to buy the book, you can also get the free PDF here.

Here's an example of Donchian Channels applied to a chart on TradingView.

Conclusion

So those are the most frequently used ways to identify and trade a trend. Of course, the tricky thing about trends is that you never know when they are going to end.

Therefore, you either have to try to get in early to capture most of the move, or look for an established trend and take a piece out of it.

But when you have the right tools on your side, and you practice using them, you can spot trends and profit from them.

Regardless of which method you use, be sure to test your trading strategy thoroughly before you risk real money. 

If you're new to trading, start by taking our free beginner's course. Once you understand the basics, then it's time to create a trading plan and start backtesting.

Stay tuned for future backtesting blog posts where I test these trading ideas and show you the results. 

 

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