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Forex Education / Forex Trading Guide Lesson 6

Market Environment

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Is the market ranging or is it trending? One of the major considerations before you plan you trade.

Know Your Trading Environment

When two people go to war, the foolish man always rushes blindly into battle without a plan, much like a starving man at his favorite buffet spot.

The wise man, on the other hand, will always get a situation report first to know the surrounding conditions that could affect how the battle plays out.

Know Your Forex Trading Environment

Like in warfare, we must also get a situation report on trading environment. This means we need to know what kind of market environment we are actually in. Some forex traders cry saying that their system sucks.

Trading System Sucks

Sometimes the system does in fact…suck.

Other times, the system is potentially profitable, but it is being utilized in the wrong trading environment. Seasoned forex traders try to figure out the appropriate strategy for the current market environment they are trading in.

Is it time to bust out those Fibs and look for retracements? Or are ranges holding?

Just as the coach comes up with different plays for particular situations or opponents, you should also be able to decide which strategy to use depending on trading environment.

By knowing what market environment we are trading in, we can choose a trend-based strategy in a trending market or a range-bound strategy in a ranging market.

Are you worried about not getting to use your beastly range-bound strategy? How about your Bring-Home-Da-Bacon trend-based system?

Have no fear! The forex market provides many trending and ranging opportunities across different time frames wherein these strategies can be implemented.

By knowing which strategies are appropriate, you will find it easier to figure out which indicators to pull out from your forex toolbox.

For instance, Fibs and trend lines are useful in trending markets while pivot points, support and resistance levels are helpful when the market is ranging.

Before spotting those opportunities, you have to be able to determine the trading environment. The state of the market can be classified into three scenarios:

  • Trending up
  • Trending down
  • Ranging

What is a Trending Market?

A trending market is one in which price is generally moving in one direction.

Sure, price may go against the trend every now and then, but looking at the longer time frames would show that those were just retracements.

Downtrend

Trends are usually noted by “higher highs” and “higher lows” in an uptrend and “lower highs” and “lower lows” in a downtrend. When trading a trend-based strategy, traders usually pick the major currencies as well as any other currency utilizing the dollar because these pairs tend to trend and be more liquid than other pairs.

Liquidity is important in trend-based strategies. The more liquid a currency pair, the more movement (a. k. a. volatility) we can expect.

The more movement a currency exhibits, the more opportunities there are for price to move strongly in one direction as opposed to bouncing around within small ranges. Other than eyeballing price action, you can also make use of technical tools you have learned in previous sections to determine whether a currency pair is trending or not.

ADX in a Trending Market

A way to determine if the market is trending is through the use of the Average Directional Index indicator or ADX for short.

Developed by J. Welles Wilder, this indicator uses values ranging from 0-100 to determine if price is moving strongly in one direction, i.e. trending, or simply ranging.

Values more than 25 usually indicate that price is trending or is already in a strong trend.

The higher the number is, the stronger the trend.

However, the ADX is a lagging indicator which means that it doesn’t necessarily predict the future.

It also is a non-directional indicator, which means it will report a positive figure whether price is trending up or down.

Take a look at this example. Price is clearly trending downwards even though ADX is greater than 25.

ADX greater than 25 usually indicates a trend

Moving Averages in a Trending Market

If you’re not a fan of the ADX, you can also make use of simple moving averages. Check this out!

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Place a 7 period, a 20 period, and a 65 period Simple Moving Average on your chart. Then, wait until the three SMA’s compress together and begin to fan out.

If the 7 period SMA fans out on top of the 20 period SMA, and the 20 SMA on top of the 65 SMA, then price is trending up.

Moving averages in an uptrend

On the other hand, if the 7 period SMA fans out below the 20 period SMA, and the 20 SMA is below the 65 SMA, then price is trending down.

Moving averages in a downtrend

Bollinger Bands in a Trending Market

One tool that is often used for range-bound strategies can also be helpful in trend discovery. We’re talking about Bollinger bands or just Bands.

One thing you should know about trends is that they are actually quite rare. Contrary to what you might think, prices really range 70-80 percent of the time. In other words, it is the norm for price to range.

So, if prices deviate from the “norm” then they must be in a trend right? What is one of the best technical tools we have mentioned in the previous grades that measure deviation?

If you said a ruler, we give you mad props for effort.

If you said Bollinger bands, we’ll give you cyber milk and cookies! Here, take some.

forex trending market

Bollinger bands actually contain the standard deviation formula. But don’t worry about being a nerd and figuring out what that is.

Here’s how we can use Bollinger bands to determine the trend! Prepare for the craziness.

Place Bollinger bands with a standard deviation of 1 and another set of bands with a standard deviation of 2. You will see three set of price zones: the sell zone, the buy zone, and the “No-man’s Land.”

Using bollinger bands to identify trend.

The sell zone is the area between the two bottom bands of the standard deviation 1 (SD 1) and standard deviation 2 (SD 2) bands. Bear in mind that price has to close within the bands in order to be considered in the sell zone.

The buy zone is the area between the two top bands of the SD 1 and SD 2 bands. Like the sell zone, price has to close within the two bands in order to be considered in the buy zone. The area in between the standard deviation 1 bands is an area in which the market struggles to find direction.

Price will close within this area if price is really in “No-Man’s Land”. Price direction is pretty much up for grabs.

The Bollinger bands make it easier to confirm a trend visually.

Downtrends can be confirmed when price is in the sell zone.

Uptrends can be confirmed when price is in the buy zone.

What is a Range-Bound Market?

A range-bound market is one in which price bounces in between a specific high price and low price.

The high price acts as a major resistance level in which price can’t seem to break through. Likewise, the low price acts as major support level in which price can’t seem to break as well.

Market movement could be classified as horizontal or sideways.

Range-Bound Forex Market

ADX in a Ranging Market

One way to determine if the market is ranging is to use the same ADX that we discussed earlier.

A market is said to be ranging when the ADX is below 25. Remember, as the value of the ADX diminishes, the weaker trend is.

ADX in Ranging Market

Bollinger Bands in a Ranging Market

In essence, Bollinger bands contract when there is less volatility in the market and expand when there is more volatility. Because of that, Bollinger bands provide a good tool for breakout strategies.

When the bands are thin and contracted, volatility is low and there should be little movement of price in one direction.

However, when bands start to expand, volatility is increasing and more movement of price in one direction is likely.

Bollinger Bands in a Ranging Market

Generally, range trading environments will contain somewhat narrow bands compared to wide bands and form horizontally.

In this case, we can see that the Bollinger bands are contracted, as price is just moving within a tight range.

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The basic idea of a range-bound strategy is that a currency pair has a high and low price that it normally trades between.

By buying near the low price, the forex trader is hoping to take profit around the high price.

By selling near the high price, the trader is hoping to take profit around the low price. Popular tools to use are channels such as the one shown above and Bollinger bands.

Using oscillators, like Stochastic or RSI, will help increase the odds of you finding a turning point in a range as they can identify potentially oversold and overbought conditions.

Here’s an example using GBP/USD.

Stochastic in a Ranging Market

Bonus tip: The best pairs for trading range-bound strategies are currency crosses. By crosses, we mean those pairs that do not include the USD as one of the currencies in the pair. One of the most well-known pair for trading ranges is the EUR/CHF.

The similar growth rates shared by the European Union and Switzerland pretty much keep the exchange rate of the EUR/CHF stable.

Another pair is AUD/NZD.

Conclusion

Whether you’re trading a pair that’s in a trending or ranging environment, you should take comfort in knowing that you can profit whatever the case may be.

Find out how you can pick tops and bottoms in both trending and ranging market environments.

By knowing what a trending environment and a range-bound environment are and what they look like, you’ll be able to employ a specific strategy for each.

As the old wise man in Central Park says, “Only a fool dips his cookies in habanero salsa!”

Trend Retracement or Reversal?

Imagine this scenario. Price starts to rise. Keeps rising. Then it starts falling.

And falling some more. And then it starts going back up.

Have you ever been in this situation before?

Retracement or Reversal?

It looks as though price action may be rallying and a buy trade is in order.

WRONG!

Failed Price Trend Reversal

You’ve been hit by the “Smooth Retracement!” Nobody likes to be hit the “Smooth Retracement” but, sadly, it does happen.

Why?

In the above example, the forex trader failed to recognize the difference between a retracement and a reversal.

Instead of being patient and riding the overall downtrend, the trader believed that a reversal was in motion and set a long entry. Whoops, there goes his money!

Check out how Happy Pip got fooled by the “Smooth Retracement” in one of her AUD/USD trades. In this lesson, you will learn the characteristics of retracements and reversals, how to recognize them, and how to protect yourself from false signals.

What are Trend Retracements?

A retracement is defined as a temporary price movement against the established trend.

Another way to look at it is an area of price movement that moves against the trend but returns to continue the trend.

Trend Retracements

Easy enough? Let’s move on…

What are Trend Reversals?

Reversals are defined as a change in the overall trend of price.

  • When an uptrend switches to a downtrend, a reversal occurs.
  • When a downtrend switches to an uptrend, a reversal also occurs.

Using the same example as above, here’s how a reversal looks like.

Reversal

What Should You Do?

When faced with a possible retracement or reversal, you have three options:

  1. If in a position you could hold onto your position. This could lead to losses if the retracement turns out to be a longer term reversal.
  2. You could close your position and re-enter if the price starts moving with the overall trend again. Of course, there could be a missed trade opportunity if price sharply moves in one direction. Money is also wasted on spreads if you decide to re-enter.
  3. You could close permanently. This could result in a loss (if price went against you) or a huge profit (if you closed at a top or bottom) depending on the structure of your trade and what happens after.

Because reversals can happen at any time, choosing the best option isn’t always easy.
This is why using trailing stop loss points can be a great risk management technique when trading with the trend.

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You can employ it to protect your profits and make sure that you will always walk away with some pips in the event that a long-term reversal happens.

How to Identify Reversals

Properly distinguishing between retracements and reversals can reduce the number of losing trades and even set you up with some winning trades.

Classifying a price movement as a retracement or a reversal is very important. It’s up there with paying taxes.  *cough* There are several key differences in distinguishing a temporary price change retracement from a long-term trend reversal. Here they are:

RetracementsReversals
Usually occurs after huge price movements.Can occur at anytime.
Short-term, short-lived reversal. Long-term price movement
Fundamentals (i.e., the macroeconomic environment) do NOT change.Fundamentals DO change, which is usually the catalyst for the long-term reversal.
In an uptrend, buying interest is present, making it likely for price to rally. In a downtrend, selling interest is present, making it likely for price to decline.In an uptrend, there is very little buying interest forcing the price to fall lower. In a downtrend, there is very little selling interest forcing the price to rise further.

Identifying Retracements

Method #1: Fibonacci Retracement

A popular way to identify retracements is to use Fibonacci levels. For the most part, price retracements hang around the 38.2%, 50.0% and 61.8% Fibonacci retracement levels before continuing the overall trend.

If price goes beyond these levels, it may signal that a reversal is happening. Notice how we didn’t say will.

As you may have figured out by now, technical analysis isn’t an exact science, which means nothing certain… especially in forex markets.

Retracements

In this case, price took a breather and rested at the 61.8% Fibonacci retracement level before resuming the uptrend.

After a while, it pulled back again and settled at the 50% retracement level before heading higher.

Method #2: Pivot Points

Another way to see if price is staging a reversal is to use pivot points. In an UPTREND, traders will look at the lower support points (S1, S2, S3) and wait for it to break.

In a DOWNTREND, forex traders will look at the higher resistance points (R1, R2, R3) and wait for it to break.

If broken, a reversal could be in the making! For more information or another refresher, check out the Pivot Points lesson!

Reversals and Pivot Points

Method #3: Trend Lines

The last method is to use trend lines. When a major trend line is broken, a reversal may be in effect.

By using this technical tool in conjunction with candlestick chart patterns discussed earlier, a forex trader may be able to get a high probability of a reversal.

Breakout Triggers a Reversal

While these methods can identify reversals, they aren’t the only way. At the end of the day, nothing can substitute for practice and experience.

With enough screen time, you can find a method that suits your forex trading personality in identifying retracements and reversals.

Protect Yourself From Reversals

Whenever Happy Pip goes swimming at the beach or the pool, she always wears her hot pink rubber ducky floaters.

Whenever she trades retracements, she uses stop loss points.

Pink rubber ducky floaters are life savers. Stop loss points are capital savers.

Trading Reversals in Forex

As we said before, reversals can happen at any time. Retracements can turn into reversals without warning.

This makes using trailing stops in trending markets very important.

With trailing stop loss points, you can effectively prevent yourself from exiting a position too early during a retracement and exit a reversal in a pinch.

Conclusion

You don’t have to be shot down by the “Smooth Retracement”. You don’t have to lose all those pips.

And you most certainly don’t need to wear pink arm floaties (although if pink’s your favorite color, it’s okay – we don’t judge).

Just know how to distinguish retracements from reversals.

This is part of growing up as a trader. Having the ability to do so will effectively reduce your losses and prevent winners from turning into losers.

With lots of practice and experience, you’ll find yourself being able to trade accordingly to retracements and exit with a profit more times than not.

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