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Forex Basic Strategies

Trend Trading When There Are No Trends

During a larger part of 2019 traders have witnessed probably the least volatile forex market in history. These periods are often followed by steady bullish equities markets when most of the capital goes on this side of trading. Forex traders that use trend following methods have two options in these situations. Trade as they are still in trending markets and give back what they have earned during the previous year or use this environment to their advantage. The situation from 2019 is perfect grounds to learn, test, and separate consistent traders from the rest. 

To some degree, trading forex does not put you in a position where you feel out of control, like in the stock market with reports or crypto with so many unannounced events, etc. In forex, even when trades do not go your way, you still have some control. There are a few ways to recognize dead markets, some are quite obvious but beginner traders may need more clarification. Taking advantage of dead markets does not come from trading, it is by adjusting our trading systems to avoid them. Experiencing dead markets in real-time is a great opportunity to secure our future results. So traders will need a plan, and we will put in place one as an example of what you should do when you enter flat waters. 

First, a tool is needed to measure how volatile the forex market is. Volatility can also be substituted with volume, what we want to measure is the activity on the market. One such example tool used by prop traders is the Euro FX VIX ($EVZ), Index created by CBOE. Pay attention to our Volume articles about incorporating filter indicators into your system. This tool is just another filtering method that can be applied to your plan outside the usual MT4/5 indicator combo. Now, the $EVZ Index is published by a few charting sources, one can be Yahoo Finance, barchart.com, TradingView or you can even go to the CBOE site. If you notice the “Euro” in the Index name, do not think it applies to the EUR currency only, it is a good indicator for the overall forex market volatility. 

$EVZ presented as a histogram on Yahoo!Finance:

In the picture above we can notice a sharp jump in the activity once the world was hit with the COVID-19 pandemic. Just a few weeks before, the $EVZ was bottoming below the 5 mark for quite some time. The whole of 2019 was one of the quietest long periods in forex history. The Index can also be represented as a bar chart but you should not pay attention to the highs and lows, just focus on the close value. The 2019 anomaly created a stir as trend traders found their systems losing more than usual and just after the dead period traders experienced the pandemic shock. To adapt, a completely different instruction has to be used for your trading plan. Another interesting correlation to dead markets is the movement of the equities market. What some traders have found is that when S&P 500, for example, is trending but slowly, in constant small increments each day, forex markets start to die out. 

In the picture above we can see whenever a gradual S&P 500 (red line) increase is present, the $EVZ (blue line) Index is slowly waning out. Immediately after a disruption in the equities market, the forex is full of currency flows. Downward equity moves are especially sensitive as people move the money out of equities and move into forex or other markets where investing is more lucrative. The negative correlation is evident, since 2017 the S&P 500 is slowly moving up and forex is not what it has been before 2014 where trend traders’ standard gain was around 200 to 300 pips a day. 

If we take a look at the ATR indicator, calm periods can also be spotted which can drive trend followers impatient. They will not get signals, the signals are not resulting in long trends or more likely they are fake moves. Trend following strategies have only one weak moment and that is until the Take Profit target is hit. After that, prop traders secure their wins by scaling out and moving Stop Loss orders to breakeven. Signals that end with a reversal before the TP is most likely a loss and are more common in dead markets. 

Trader’s psychology is at the test here. When you are in a dead market and you are losing, this is a good thing! It is time to take advantage of this. Understand these conditions happen and will happen again. The next time it happens your trading plan will be ready. Chaos theory applies, the order goes into chaos, and chaos back to order. In case you are a beginner and just testing your system for the first time in 2019, know your system will be adjusted to this dead market and may even be not as successful as you would want. On the other hand, since you are a beginner, you should be trading on a demo without any real capital to lose. To some traders, if you are trading in dead markets and still on breakeven, your system is on a good track to endure dead markets and reap consistent gains when it is not. When you are testing your volume indicators or tools, dead markets are extremely good for forwarding tests. Once you have picked your favorite volume indicator it should filter most of the flat mini periods in a dead market by keeping you from taking any trades and even give you small winners sometimes from rare trends worth taking. This element is crucial but some may find it is the hardest to find. 

If you are still struggling to find a good volume indicator then just go and use the $EVZ we have presented. Create a set of risk management rules for your trading and apply them to your trading system. As an example some prop traders use, whenever $EVZ value is below 8, reduce your positions to 50% of what you normally take. If it goes below 7, use only 25%, stop trading below 6. This measure alone will benefit your end line and filter 90% of bad signals when combined with your volatility indicator. When you realize you are losing consistently at some game or market, avoidance is one great and simple measure that will help. Avoidance or filtering your signals in an environment where you lose is the same principle, just formulated into a strict trading plan. Even though it is fun to be in action, your ability to avoid it is what will separate you from others. 

Another interesting conclusion prop traders made during the dead markets is that the USD pairs are just not good even for small trend signals. So their suggestion is just to avoid all signals from these markets once you measure a dead market. Sticking to cross pairs is also going to be tricky but you can make one adjustment to increase your odds. Scaling out principles explained in one of our articles where you leave out a part of a position to continue riding the trend may not be a good idea in dead markets.

Since trends are not going to last for very long, it is just better to take a whole position at your first take profit target. So whenever $EVZ is below 8, for example, make this adjustment to your system. Those 200+ pip trends are not going to happen, so all of your high percentage setups may just lack that extra mile that makes all the difference on your account. Just avoid aiming for big and cut everything at your first price target. If you are following our ATR based money management, your risk to reward ratio will be 1:1 in these conditions. This is not good money management for normal conditions and will not provide you with a positive account, it is just temporary. The risk of a reversal is increasing as you keep your position longer, so based on testing it is just better to end sooner.

Once the market is active again know that your volume indicator and system are still calculating historic movements and the signal is not there yet. More often than not, the first trend after the calm phase will be missed since your indicators are lagging. As mentioned in the Volume articles, these indicators need data and would be useless if too sensitive. Be ready to accept missing out on first movements after the dead market. Do not attempt to make indicators more sensitive just to grab the first trend, it will make your system susceptible to fake breakouts frequent in calm markets and you will face new losing streaks. Experts even say the first strong moves are likely to be corrected after a day or two, and that means 1 or 2 candles if you are trading on a daily chart. Relax and know your account endured the storm (calm market) of fake moves where other traders not accounting for the volume (which is quite often) lost their morale and most of their accounts. Robust trading plans with these elements are only a result of your hard work majority of traders just lack. 

Lastly, there is one more adjustment you can make when you are close to being out of the game. It is an extreme indication something went wrong with your plan, money management, or psychology part, but if you are on the line for some reason try changing your target timeframe. Daily charts may lack conviction but smaller time frames are certainly better. Here, your daily chart trading system (for example) will be performing in an environment it is not designed to so expect less impressive results. However, the system you have designed should be universal, if you are following the structure we have provided before. Smaller time frames have a lot of other factors you need to pay attention to. This also means you need more time, more nerves, and less sleep. News event moves here are bigger and more unpredictable, then we have trading sessions and more factors. The smaller time frames we go to, the more nuances can get our trends to reverse.

However, here is also where you will find your volume if you desperately need to trade. Such needs may come if you are expected to trade by your client or a prop firm and you are in a dead market. Sometimes it may happen because you need income. If you need income by trading forex with money you cannot afford to lose, know you will fail in the long term. Other reasons to change your timeframe such as impatience will also lead to failure. Simply know forex does not forgive, it can only serve those who put in the work in the system and train their mindset.

Categories
Forex Basic Strategies

A Foolproof Strategy for Following Price Trends

Easily one of the most effective forex trading strategies is to take advantage of prevailing trends in price movements – but how do you identify trends and why are they important?

Keeping It Simple

There are so many forces combining and intersecting to affect the price of a currency pair that it’s impossible to pick out one, split it off from the rest of the flock, and reliably analyze it in any meaningful way. There are just too many factors working together. Global news events, national government policies, central banks, big private market players, and a multitude of other components and ingredients all act upon one another and are filtered through the minds of millions of traders and how they perceive what’s happening in the world. It’s better, overall, to think of the market as a giant blender that takes all of that information – all the known knowns, known unknowns, and unknown unknowns – and swirls them all together. The resulting blend is the price of a currency or security.

In a way, it doesn’t really matter what you know. The market simply doesn’t care. Even if you feel you have some golden piece of information about some upcoming news events or anything like that, the market doesn’t care. It doesn’t matter what you know as much as it matters what everyone trading that currency knows. Even then, there are too many other contributing factors – like what the big players know and what they think the little guys they prey on know. If you think too long about it, the way the markets work becomes so complex that it gets harder and harder to wrap your head around it.

So what do you do in a situation like that? How are you supposed to take the information you have available to you at the moment to make predictions about the price movements in the future? Even in the immediate future? It’s a question as old as the hills and it’s the crux of what every trader out there is trying to do in one way or another.

One answer is to simplify things for yourself. Yes, the market is driven by this myriad of interlocking, interacting forces that would take all of the world’s supercomputers, linked together and working in concert to work out… And even then they couldn’t do it. But, when all is said and done, the price of a currency is still, ultimately, just an expression of the balance between buyers and sellers. Some traders will say that, at the end of the day, a trader’s job isn’t to know what affects the market. In short, the argument goes that you don’t even have to care what the underlying fundamentals are because you’ll never outsmart the market.

If you’ve simplified it down to the point that you don’t know, can’t know, or shouldn’t even care what moves the market, all that’s left is to you is to play the market that’s there in front of you. No wishing or hoping what it might be, no trying to outwit the market, just taking what’s actually there and using it to your advantage.

Going with the Flow

Everyone out there who’s doing any kind of trading – whether they’re a pro trader or just dabbling to try to supplement their income – wants nothing more than to be a consistent trader. Achieving consistency is probably one of the most important goals you should have in terms of how you execute your trades. And there’s only one way to start heading towards that goal. In order to achieve consistency in your outcomes, you have to be consistent in how you conduct yourself.

Trend trading is arguably the best, most efficient, and most effective way to approach the levels of consistency you should be aspiring to. And if that sounds like a bold claim, you should know that there are proper scientists, academics, and statisticians out there at highly prestigious learning establishments who have put in time and money, and intelligence into assessing these things. There are actual peer-reviewed studies that support the claim that trading by following trends is the most effective way to trade.

Being on the right side of an already established trend is a simple and effective way to give your trading system an advantage it couldn’t otherwise have. And the simplicity – which folds into the keep it simple philosophy outlined above – is the most beautiful part of this approach. In a sense, there’s nothing much to it. Almost anyone can take a look at a chart where there is a trend emerging in the price movement and be able to say, “yup, that’s definitely heading upwards” or, “oh yeah, that’s going down”. Although it would be great if it really was literally that simple, there is a point in reducing it to just that level of analysis because, when comes down to it, identifying a trend is the critical part of this approach to trading. Now, of course, it isn’t actually as simple as pointing at a line on a chart that’s going up and saying, “duh, that’s an upward trend” but the underlying point remains – trend trading is as simple as identifying a trend and using it to make winning trades

Sadly, when you actually open a chart and start putting money on the line in real-world trades, you are faced with a number of very scary problems. Sure the price of currency X vs. currency Y has been going up for the past five trading sessions but what if that’s it for the trend and it reverses tomorrow? What if I put my money in and it switches? What about pullbacks? Alternatively, how do you know that the price heading upwards isn’t just part of a longer ranging movement instead of the start of a trend? The fact is, you can never know what part of the trend you are at right now. But that’s where deploying the tools, indicators, and know-how you have built up as a technical trader comes into play. Technical analysis is what will set you apart from just any idiot pointing at a chart and saying, “looks like it’s going up”.

Identifying Trends

The most obvious way to identify a trend is to believe your own eyes. Looking at a chart and knowing the right signs is your first step towards properly appraising whether a price movement is an actual, tradeable trend. This means that you need to know some of the key identification characteristics. If this sounds basic, that’s because it is. But that doesn’t mean that you can ignore the basics and it’s always worth revisiting them for the sake of refreshing your knowledge and for those traders who are just starting out and still putting together their trading systems.

Obviously, a trend is when the price moves in one direction or the other – either upwards or downwards. But since nothing in the market is that consistent for very long, there will always be oscillations and it is important to understand that they may or may not be departures from the trend. Some pullbacks will actually be a signal that the trend has lost steam and that it is coming to an end. Other pullbacks will be simply that, a short-term movement of the price in the opposite direction before the trend continues on its way. These pullbacks will result in mini peaks and troughs in the price movement – often called swing highs and swing lows. In a trending market, you are looking for those swing highs and swing lows to follow a distinct pattern.

In the example of an uptrend, the swing highs should be coming in higher and higher each time and the swing lows should also be higher than preceding swing lows. That way, you get a structure where each swing high is coming in at a higher level than its predecessor, as is each swing low. The peaks outperform previous peaks and the troughs also outperform those that came before. This gives you your classic uptrend pattern. A downtrend is the same but in reverse, with the swing highs coming in lower and lower and the swing lows following suit.

If you are not seeing this pattern, you are not looking at a trending market. Alternatively, if you did have this pattern in place for a while but it starts to break down, this is a sign that the trend is likely to be running out of steam and could settle into a ranging market or could fall into a reversal.

This is all very well and good if you go into your charts and look at historical price movements. You will have no problem coming across past trends and saying to yourself, “yup, that was a nice little trend right there”. But if you want to apply this to your trading, you will come up against the classic problem of not being able to see the future. Sure you might be looking at something that looks to all intents and purposes like a trend unfolding before your eyes but, because you don’t have a magic crystal ball on your desk, you have no idea if the next pullback will be the one that sends the price rocketing in the opposite direction.

So, while eyeballing the charts is an important starting point, it doesn’t get you very far on its own. You will need to deploy a combination of other techniques to get confirmation that the trend you are looking at has legs on it and will continue long enough for you to enter a worthwhile trade.

One approach is to couple your Mark 1 Eyeball with a moving average. If you are looking at an uptrend, you might want to take a look at a moving average covering a significant period (20 days, say). Here you will ideally want to see the price consistently staying above the moving average the whole time. If the price doesn’t remain reliably above the moving average the signal that this is a strong trend is flaky at best and you are probably looking at a weak trend or even a choppy market. Also, if you are looking at an uptrend, all the swing highs and lows are falling into place and the price is staying above your moving average, an additional confirmation will come in the form of the moving average itself rising during the trend. Remember, this shows that the average price has been steadily increasing recently and is a good additional sign that this is a reliable trend.

A good tip is to also combine two moving averages that will give you a picture of two time periods – for example, a 20 day and a 50 day moving average. If both of your moving averages are rising, this is even more solid confirmation of the uptrend. The degree by which the moving averages are rising is also an indication of the strength of the trend – if they are starting to flatten out, the trend might be taking a break or even coming to an end. 

Using moving averages is one way of getting additional confirmation that the pattern you are looking at is indeed a trend but it isn’t a reliable way of getting you into a trade because you will be sitting around waiting too long before they show you what you need to know. By that time the price could have moved significantly and you will already be late coming into the game. For that, you will need to pair up your visual appraisal of a trend and your moving averages with an additional indicator that will actually be able to lead you into a useful trade.

Finding a Trend Indicator

One really great thing about being a forex trader these days is the absolute plethora of various technical indicators available to you that are out there just waiting to be discovered. There are literally thousands of indicators out there and this is a huge potential advantage to you, the individual trader, looking to get an edge and develop a reliable trading system. On the other hand, the sheer number of indicators does also lead you into the paradox of choice. How do you know which ones are good and which ones suck? Well, one way is to just go out and thoroughly test every indicator you come across but who has the time for that? If you do, great. But most people will want some guidance on which indicators perform well and which ones don’t. You will still have to do some testing of indicators to double-check that they really do work, scan them for repainting or other bugs, and to make sure that they work the way your trading system needs them to. But even so, you will need a clear set of criteria that will guide your search for your trend indicator so that you know what you are looking for and also so that you can recognize what you need when you find it.

First of all, you will need a trend indicator that doesn’t lead you into a trade too early on in the game. Lots of indicators out there will throw out trade signals at the drop of a hat that you then have to work hard to filter out because, inevitably, most of those trades will not be winners. A trend indicator that’s too wild is not your friend because it’s likely to tell you there’s a trend emerging even when that’s not the case. The market isn’t always trending and so a wild indicator will get stopped out more often than not.

Conversely, you don’t want an indicator that gets you into a trade way too late. First of all, because you will end up waiting for weeks or even months before it signals a trade and in that time you could have missed a whole host of potentially profitable trades while your indicator was silent. Even more importantly than that is that a slow indicator might take you into a trade when most of the trend has already run its course. You’ll just be coming in at the end when the pickings will be at their slimmest or when you’ll take home nothing at all. Just because an indicator is choosy when it comes to signaling a trade, doesn’t necessarily mean that the trade it does take you into is going to be a good one.

Getting the right balance between these two extremes is where the art meets the graft. There is simply no way of taking a short-cut through the work you are going to have to do to pick out an indicator that works for you. Using the above guidelines only gets you so far. And that’s no small thing. Being able to eliminate indicators early on in your testing process will save you a ton of time but you will still have to put the work in to find those little nuggets of gold.

That said, you will also have to show an awareness of the pitfalls of trend indicators. One of these is that they lead you into trouble if the market is choppy. Take, for example, the Parabolic SAR – an indicator lots of traders use as a trend indicator. Now, this thing is absolutely great if the market really is trending but it will reliably lead you into losing trades if the market is choppy or if it’s going sideways in a tight range. The way to avoid that is to combine it with other trend identification rules (like those above) to make sure you are using it in the right way. This doesn’t just go for the SAR, lots of indicators will only work the way they are intended if you combine them with other technical analysis tools like price action, chart pattern identification, and even other indicators like the moving average as described above. The way you hone this down to a working system is to put the whole thing through a rigorous testing procedure that will include backtesting and running it through a demo account to test it in a real-world environment. 

What to Avoid

If you want to focus on following trends, you will want to want to avoid a currency pair that is displaying a sideways trend. This means that, in addition to becoming a master at identifying uptrends and downtrends, you will also need to get good at determining that the market is heading sideways and that it is time to go and look at other currency pairs for the moment. That is not to say that a sideways market is untradeable – if it is ranging regularly there might be trades to be made in there – but if you are looking just at following trends, this is not your time to shine.

A sideways market will display the exact opposite of the tell-tale signs we covered earlier – the swing highs and lows will not be progressing in a given direction and consistently forming higher and higher (or lower and lower for a downtrend) peaks and troughs and the price will be crashing through your moving averages in both directions. 

Roundup

The things to take away here are that trend trading is the most effective way to gain an edge in your trading. You don’t need to take anyone’s word for that, you can go and find some of the academic and scientific studies that confirm this through rigorous study of trading effectiveness. They are out there and if you are the kind of person that gets some comfort from their ideas and beliefs being underpinned by a measurable scientific approach to something, then you will definitely benefit from finding these studies and reading through them.

Trend identification is ultimately a simple concept and you don’t have to make it more complicated than it is by overthinking it. But identifying a trend in real-time, in real-world conditions, and in a way that leads you into a trade that will result in you hitting your targets, well, that’s an art. To hone that art you will have to put in the work testing combinations of analytical approaches and indicators until you have a system that works reliably and that suits your own trading style.

Finally, trend trading is trading at its purest. You are trading the market as you see it before you, free of any confusing noise. The market doesn’t care what you think or feel about future price movements and neither should you. To be a successful trend trader you will have to focus on developing a trading system that you can rely on time and time again to tell you what the market is doing. Once you have that, you can focus on what your system is telling you, allowing you to trade with confidence.

Categories
Forex Basic Strategies

The Secret Formula for Successful Trend Trading

Why do trends work? The momentum-or inertia of prices to move in the same previous direction beyond what we might expect from a random path-is the oldest, most intense, persistent, and ubiquitous investment factor of all the discoveries and analyses to date.

Why do trends work? It is the oldest, most intense, persistent, and ubiquitous investment factor of all discovered. However, empirical evidence alone does not guarantee that this or that anomaly will continue to manifest in the future. As we saw earlier here, in emerging phenomena produced by human actions such as economics and markets, empirical evidence is never enough and we need to know and understand why things happen. We then ask ourselves a few key questions:

  • Why does this phenomenon occur in all markets and at all times?
  • Why does this phenomenon occur in all markets and at all times?
  • And most importantly when it is actually used to invest our money: will inertial prices continue to show in the future?

Understanding how and why price inertia is generated is essential because if the reasons behind it are inevitable, then inertia will also inevitably persist in the future and we can use it as a tool to invest. The good news is that there are at least three reasons for this inertia to occur, to last, and ultimately to be an inevitable phenomenon such as the existence of economic cycles:

Why Do Trends Work? Structural Reasons for the Collective Investment Industry

Most institutional investors responsible for funds or investment portfolios have to comply by law with pre-established market risk limits in their prospectuses. This forces them to reduce their exposure to those assets whose risk (usually measured by their volatility and/or VaR) is growing. I mean, to sell when volatility goes up. By complying with the legislation, their sales help the formation and continuity of bearish trends. On the contrary, a decrease in risk (a drop in volatility) leads them to buy more, in turn fueling the upward trends in assets that are rising in price.

But it is not only the regulatory control of risk that feeds trends. The professional managers, on a personal level, are prisoners of the benchmark that their funds try to overcome (without hardy success, as the works of Pablo Fernández and the SPIVA reports demonstrate), so they cannot “stay out” of the bullish movements. If you don’t buy the assets that are coming up and sell them when they go down (even if you don’t know why or disagree with the reasons for the move), you run the risk of walking away from your benchmark and getting fired. The fear of losing their jobs translates into feeding, to a greater or lesser degree according to their independence to the benchmark, bullish and bearish tendencies when they appear. As I have repeated on other occasions, the professional managers of large firms do not manage the money of their clients, but their professional survival.

The professional managers of large companies do not manage the money of their clients, but their professional survival. In addition, when a fund is surpassing its benchmark, it draws the attention of media and investors and attracts new subscriptions, which have to be invested in those assets in which the fund is already invested, further fueling previous upward trends. The same is true of those funds that are falling in the ranking behind the benchmark: they suffer refunds that force them to sell and thus feed the bearish tendencies.

In short, there are strong incentives for institutional actors to do what others do. That is, it is the very idiosyncrasy of the management industry (investment and pension funds, large insurers, etc.), coupled with the incentives of their own professionals, This obliges the major players who provide the bulk of the volume to the markets to align with the trends and to feed them inevitably. There are strong incentives for institutional actors to do what others do.

As we see, both legislation and the incentive structure in the industry should change radically so that this reason would lose influence on price formation and its inertia.

Why Do Trends Work? Macroeconomic Reasons

Regardless of the structural reasons for the industry we have just seen, the existence of economic cycles causes some assets to behave better or worse than others for long periods of time.

Each state of the cycle or combination of states-expansion, recession, inflation, and deflation-generates different underlying dynamics in the economy, causing some types of assets to revalue more than others in different periods. Depending on the time of the cycle in which the economy is polarized, there are therefore trends of several years usually called bullish or bearish markets (secular bull/bear markets). For example, during periods of economic expansion, which can last from one to twelve years (we have 10 years with the current one), the stock market as an asset is revalued more than the rest of the assets (as a manifestation derived from the economic boom itself), unlike during economic recessions. These secular trends are also unavoidable and exploited by some inertia strategies that focus on the long term of economic cycles.

In order for this phenomenon to cease to occur, economic cycles should die out, which is impossible due to the inevitable emergence and spread of imbalances throughout the economy, or at least the connection between the behaviour of certain assets and the phase of the cycle should disappear. However, it is precisely through objective observation of the prices of certain assets that we can measure with some precision the stage of the cycle in which the economy finds itself.

Why Do Trends Work? Behavioral Reasons (Biological and Evolutionary)

Why do trends work? The pervasiveness of fear and greed in financial markets is evident to anyone with a modicum of investment experience, as ultimately markets are made by people.

Everything that is developing in the world, at any time, resemble precedent. This depends on the fact that being works of men, always having the same passions, by necessity they must produce the same effects. -Machiavelli, Speeches (Book III, Chapter 43)

The human being is gregarious and fickle by nature. What costs you the most, especially when it comes to investing, is to be consistent and faithful to your principles and strategies. At the moment when the price of a certain asset begins to rise significantly, it becomes the topic of fashion, narratives are built to justify it and attract the attention of investors. Regardless of whether the reasons for such revaluation are more or less justified, new investors join the movement by buying in the hope that it will continue. This contributes to nourishing the upward trend in a virtuous circle of growing and widespread greed transformed into buying pressure.

This self-fulfilling prophecy also works in reverse. When a price falls steadily, doubts, negative narratives and fear of losses spread quickly among investors like a virus, producing a vicious circle of sales fed back by a growing fear that may eventually turn into selling panic. These phenomena alone, regardless of whether asset increases or decreases are rationally, structurally, or economically justified, are capable of providing sufficient inertia to prices and building trends on different time scales.

This is so today and it was already four centuries ago in Amsterdam that narrated the Cordovan José de la Vega in his book “Confusion of confusions”. In its pages, describing the regulars of the Dutch stock market of that time, we observe exactly the same type of behavior that we see today in real-time through our mobiles. Nothing has changed in four centuries, and it is unlikely that our nature will change in the next 400 years. We observe exactly the same type of behavior that we see today in real-time through our mobiles.

In fact, trends are a ubiquitous phenomenon, which is systematically found in all historical price series that have been found, going back up to 800 years in the past. Regardless of the time and more importantly, culture-trends can be observed in both the formation of the prices of rice in medieval Japan and in our contemporary stock exchanges. The same pattern of the tulip bubble in the early 17th century Holland is repeated in the bubble of the South Seas of England in the following century or the real estate bubble in Spain in the early 2000s. As if it were a melody underlying the music of the markets, inertia in prices appears in each and every culture that has developed free markets.

Trends are a ubiquitous phenomenon, systematically found in all historical price series.

The Stubbornness of Human Nature

The question we, as traders, must ask ourselves is: Will inertia strategies continue to work in the future? We can answer this question with another: what is the factor common to all markets, assets, and historical epochs? The answer is ourselves; the human being. What is the factor common to all markets, assets, and historical epochs? The answer is ourselves; the human being.

Markets are the product of human action and are therefore inevitably conditioned by their nature. As long as humans continue to negotiate freely in the markets, we will do so thanks to an organ that we cannot detach or dispense with: our brain and its nature. An extraordinary and unique tool in the Universe, but full of biases, fallacies, and emotions that interfere with its rational functioning.

Convex strategies using inertia will continue to work in the future because the human being born today has the same brain as the human being who traveled the steppes 50,000 years ago. Biological evolution has not had time to adapt to rapid cultural and biological evolution. We continue to come into the world today equipped with a brain prepared for a world that has ceased to exist. Our biological heritage will carry potential energy future trends that will inevitably continue to form in the future.

Why do trends work? Without being aware of it, it is ultimately our biological heritage that loads potential energy future trends that will inevitably continue to form in the future, thanks to the particularities of that «kilo and a half of gray matter» that we all transport into the skull. In any case, it is really surprising how certain incentives and biases to the human being can emerge and be identified through phenomena as complex and chaotic as financial markets.

The most important reason why inertia will continue to permeate the markets-and it will therefore be profitable and prudent to continue to take advantage of it when it comes to investing is that it is impossible to want to change the human condition overnight and its biological heritage of millions of years, as the medieval Japanese quote says at the beginning of this article. To become the perfectly rational machines that economic orthodoxy dreams of and produce that perfect random path in price formation in markets, we should lose our human nature; stop being human. Something that doesn’t seem feasible can happen soon.

Notes:

[1] Why do trends work? Investment factors are anomalies or deviations in the price behaviour of financial assets that, in theory, should not exist if they follow a perfectly random path. Although more than 600 factors have already been identified, the five most significant are a) Value, b) low-volatility stocks, c) high-growth or growth stocks, d) small-size stocks relative to the rest of the market, and finally, e) “inertia” of prices to continue their previous trend beyond the theoretical random trajectory proposed by academic orthodoxy. 

[2] Why do trends work? The investment industry uses price inertia (the “momentum”, also known as “Trend following” or “CTA strategies”) to seek or increase investment returns. In the case of momentum, it usually refers to investments that are limited to capturing only bullish trends (long-only), being able to be applied as absolute momentum (when only the inertia of the asset being measured is taken into account) or relative momentum (when comparing the relative momentum of an asset with others to decide which/is overponderar). The trend-following/CTAs or trend tracking is similar, but is open to capturing both bullish and bearish trends, in multiple markets, and in different time windows.

Why do trends work? We must remember that the different modalities of what I generally call “Funds or inertia strategies”-although implemented in sometimes very different and sophisticated ways-respond to the same underlying phenomenon that is dealt with here. Little known to the novice investor, there are currently more than $400 billion ($400 billion Anglo-Saxon) managed on the basis of this same common phenomenon. As with all investment factors, we must always remember that not by focusing on a factor «theoretically usable», a better return is guaranteed.

[3] Why do trends work? Let us remember something obvious but with profound consequences in the formation of market prices: people do not like to lose money at any time or under any circumstances. This is so even if temporarily losing is part of a larger and more profitable plan over a longer period of time. Let us recall, for example, the case of Peter Lynch’s Magellan fund, which, although it achieved an annualised return of 27% in the 13 years it was in operation, none of its investors achieved such a return and a large majority lost money by investing in that fund! (by always subscribing and repaying at the worst times and not allowing the strategy to converge to its long-term profitability).

Why do trends work? Although we understand it rationally, any temporary loss or potential produces a great suffering; a real pain that our emotional brain never fully comprehends. Inertia strategies, even if they work, require taking on inevitable and numerous losses along the way-sometimes for several years. It is inevitable and consubstantial to any convex strategy. But when it comes to starting to lose money, most people prefer to abstain and choose a type of strategy that best suits the biased emotional response of their steppe brain, rather than accepting the unpredictable and volatile nature of markets.

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Forex Market

Overview of Trends and Lagging Tools

Veteran traders often develop a kind of intolerance to certain life and relationship issues. This intolerance developed from a professional mindset for decision making, making it clear for them to decide should they get involved, spend time, or not with a certain person or issue. To some, this behavior may seem like intolerance but in fact, it is decision-making skills used in real life. Veteran traders have realized progression is quick when we stick to our decisions and learn from bad ones, making it easy to repeat the right call in already experienced situations.

When it comes to deciding which trading tools to try and test, it is also clear to them. If we categorize indicators and tools to Lagging and Leading, they know which to pick based on their system, mindset, and experience. Lagging indicators are not regarded as good to trading by the masses since they have the “lagging” word to it. So beginners may wonder, why are people still creating them, and why traders use settings that seem unresponsive to the market price action? Even if you are testing your trading system for a few months you will realize lagging indicators are the kind you have better results with for trend confirmations. 

Lag is mostly a negative effect we experience when we speak about trade execution, internet connection, but also about motors, plane control, transport, and so on. Therefore, we are wired to think lagging indicators are also not as good as leading indicators. Well, trend-following strategies are mostly based on lagging indicators. If you are trading reversals, you would need leading indicators such as RSI, Stochastics, and similar indicators that give signals before a trend emerges or stops. Since trend-following strategies are proven to be the best form of forex trading, most professional traders use at least one lagging indicator in their systems.

The role these lagging indicators have is mostly trend confirmation, but interestingly, volume indicators are almost always lagging type too. Now, let’s be clear what is the definition of a lagging indicator. One of the better explanations is given on babypips.com, leading indicators fall into the reversal category while lagging leads you to trends that are already happening. Leading indicators give you the signal to trade before the trend emerges, therefore they “predict”. As with most predictions, they do not foresee the future and fail in a trending environment. 

Consequently, experienced trend-following traders do not use them to find trends. But it does not mean they do not use them for other purposes. One of the most popular leading or reversal indicators is RSI. Some reversal indicators based on the RSI are very good trend exit point indicators, as described in one of our articles about when to exit. Most of the leading indicators are based on the oversold and overbought concepts or levels where they tend to be range-bound. Trends do not respect any ranges and the best lasts for weeks.

Now, for psychological reasons people like to get into action and try to predict or bet on many events, including trends. This makes reversal indicators more popular than lagging indicators, not just by the download count but also on the internet. Unfortunately, the internet is full of marketing which gives what people want to see, and when something is described as “lagging” it does not sound good. Experienced traders just have clear decision making when picking what tools they need and then test it out to rank the best. They do not pay attention to what the mass wants or think it is good, their benchmark of what is good is their back and forward testing result. 

Ratings on indicators do not always come from established professional traders if they are based on the votes of users. If they are based on marketing, it gives us even less reason to pay attention to. You will typically find some comments or ratings on the MetaQuotes site and also on other indicator sources for the MT4/5 platform. These do not mean much to the one on a quest to find a good trend confirmation or exit indicator. Every trading system is unique and adequate to each trader, if a tool does not do a good job to one it does not mean it is bad for yours. Again, if you have decided it can fit your system, test it out, just know a reversal or leading indicator is not the type you want as a trend confirmation indicator

In our article about trend confirmation indicators, we go deep into how to test and where to find for the MT4 platform. We also mention types and how to spot good ones. Essentially, all of these are lagging and will give you a signal to trade only when there is enough data (historic movements) that fit into their calculations. Now, most people are impatient and can even tweak the setting of such indicators to show too many signals, many of which are false. This tendency is similar when we are attracted to leading, predictive, reversal indicators for the wrong purpose. 

The use of leading indicators is bound to reversal strategies, and reversal strategies work in calm, trendless markets. On some occasions, a reversal strategy could be used for pullbacks in a direction of a major trend although these setups are somewhat less successful according to stats by prop firms than classic trend following. Some of the best leading indicators are based on RSI and other popular tools but are much newer and produce much better results. 

Better category names for indicators would probably be reversal and confirmation indicators to avoid bias with the “lagging” word. Similarly to some life events, it is best to decide an action after all is settled, you do not want to make any rash, emotional decisions. Impatience is easily punished in forex, some try to understand why and learn while most just continue to lose or give up. This market will filter the ones who are just expecting an easy way to financial freedom and rewards those who were persistent enough to learn the right way. 

Setting your indicator to be reactive instead of confirmative will limit the beneficial effect of having a “lag”, as when you zoom in too much to see a bigger picture. On the other side, a setting that forces the confirmation period too long will give you signals too far between to be useable, as when you zoom out too much to see relevant action. A good example is the popular 200 EMA used by some investor type traders. If you want to be a day trader, stick to timeframes and settings relevant to your needs. A trend trader that has a position open for a few days on average should not be concerned with what happened 200 days before. 

Another point with popular tools (reversal indicators) is that they are based on oversold and overbought levels which are by the opinion of most traders, not relevant to forex. Also, when you are using popular tools is means you follow what the masses are doing. The mass effect triggers the attention of the big players on forex – funds, and big banks. Consequently, the price will move in the opposite direction of what most traders follow. This phenomenon is evident when we look at the sentiment tools on the most liquid forex pairs and indexes. Crypto and other alternative markets lack this correlation, as the big players do not have or cannot have an effect on them. 

In conclusion, understand that names and ratings do not matter, your testing and system performance with these tools do. You will make an easy selection of what can fit your system well once you get some experience with testing and searching for tools. Know to set up your lagging indicators optimally, test, and find the best setting this way. Lagging indicators will not work well in calm markets without volume, they should be just one element in your system. Reversal or leading indicators are not useless, their role is probably found when looking for an optimal point to exit a trend-following trade. Just do not think there is magic in their predictive nature, even when others say it is amazing.