Newcomers to trading the foreign exchange currency markets do well to accept the observation of experienced seasoned traders that the idea of a perfect Forex trading tool is an illusion.
While no perfect Forex trading tool exists, using a combination of tools to identify a converging of favorable market factors can yield a majority of high probability trades over a period of time.
Trendlines certainly deserve close consideration and many successful traders add them to their collection of Forex trading tools.
It should be stated at the outset that trendlines by themselves do not provide a strong enough signal to warrant making a trade. They are a useful addition and provide confirmation of signals from other tools. (See resource box for a visual example of using a trendline as a trade entry point)
The Three Trendline Strategy
Consider these three main types of trendlines you need to know and use if you are going to make any sense of trendlines.
Trendlines are lines drawn across significant lows in an uptrend, and significant highs in a downtrend. The more candles to the left and right of the lowest candle in an uptrend or the highest candle in a downtrend make the low or high point more significant.
1. Short Term Trendlines
Draw these lines across the most recent two lows (for an uptrend) or highs (for a downtrend). These are best observed on a smaller time frame such as a 15 minute or 30 minute chart.
2. Medium Term Trendlines
These are best observed on a higher time frame such as a 60 minute chart. Again connect the nearest significant low to current price action to the previous significant low in an uptrend or the nearest significant high to current price action to the previous significant high in a downtrend.
3. Long Term Trendlines
Use higher time frames such as the 4 hour chart or the daily chart to draw long term trendlines using the same method described for Medium Term Trendlines.
The long term trendline can be a powerful Forex trading tool. Keep in mind that the daily chart is used prominently by traders of big institutions. Such traders probably do not engage in small moves on an intra day level. They are more concerned about taking a position on a currency pair.
The daily chart is consulted by them when making decisions. So by drawing a trendline on a daily chart you can present to yourself graphically just where price is and where it is likely to either possibly bounce and retrace or continue with the current momentum.
Using Trendlines As An Effective Forex Trading Tool
Trendlines on the short time frame merely give you a defined picture of current price action. These trendlines are broken often during the course of a day. It is probably not a good idea to enter trades based on trendline breaks from a small time frame chart. Their main use is to give you a clear, instantly recognizable graphical representation of current price behavior.
However, here is where trendlines can prove to be a useful Forex trading tool:
If you notice price coming back to test a trendline on the higher time frames, (anything over 30 minutes), look at other factors. For example:
- Draw in horizontal lines to mark key support and resistance using previous highs and lows.
- Draw Fibonacci retracement and extension levels.
- Calculate the daily pivot points and put them on your chart.
- Have the 200 EMA (Exponential Moving Average) shown on your charts.
Now, if price were to bounce or touch the trendline on the medium to higher time frames, that is, on the 60 minute, 4 hour, or even daily charts, does that price point also coincide with or match up with one of the other indicators mentioned above?
If for example the trendline intersects with a pivot point which is also a Fibonacci 50% or 62% retracement, or 127% or 162% extension, then you have a convergence of factors. If you entered a trade at that point there is a high probability you will catch at least 10 to 20 pips on the first move on the bounce.
Looking for such opportunities takes patience. They don’t come up so often but when they do you can be ALMOST guaranteed a successful trade if you keep your first profit target to a reasonable level.
If trading multiple lots, then be sure to take your first profit at the 10 to 20 pip level and let one or two other lots run if price continues in the direction you anticipate. At the same time of course you would move up your stop to break even point after taking first profit so your trade can now run without risk.
Employ trendlines as a Forex trading tool with caution and discretion. Covering your charts with every trendline possible will only result in confusion and blurry analysis.
One or two trendlines at key or significant swing points, (price highs and lows) can give you a defined, clear picture of price action, which, when coupled with your other Forex trading tools, can result in profitable trades.