If I had a penny for every time I’ve heard the phrase “the trend is your friend” It’s possible I would be able to retire from trading forex.
It has to be one of, if not thee most often repeated pieces of trading advice heard online and in books.
The question I want to answer today is: “Is the trend really your friend” ?
The concept of trend is one which is implanted in the minds of traders from the very beginning of their trading career. Even in the first trading course I brought (which was terrible btw) the guy talks at length stressing the importance of trend and how its essential for you to be able to make money from the markets.
While the trend is needed to make money, whether you’ll make money or not from a trend depends on where you manage to get into the trend itself. Getting into the market at the beginning of a trend is a sure-fire way to make alot of money, the problem people encounter is: “How do you define when a trend has begun” ?
Why The Books Get It Wrong
The majority of trading books and courses teach you the longer the trend, the more likely it is to continue trending in the same direction.
The reason they believe this to be true is due to the herding and grouping bias present in humans.
When people see lots of other people doing something they feel like they need to do the same, in trading this concept translates to the trend.
The longer the trend, the more and more people who are all doing the same thing i.e buying or selling, people who are not in the trend will look at this and think they should also begin buying or selling as that is what everyone is doing, therefore it must be the right thing to do.
So trading in the direction of the trend offers people safety, they feel safe because their doing trading in the same direction as everyone else.
Unfortunately the books fail to take into account the way the forex market actually works.
Trends, as with everything else in the market have a cause and effect relationship. They do not manifest out of nowhere, certain things must happen in order for a trend to be created and for a trend to keep moving in the same direction.
Lets take a look at how trends really work…..
How Trends Really Work
To figure out if the trend is really our friend we must understand how trends themselves work.
Everything in the market happens for a reason, the market doesn’t go up and down on its own, there are real identifiable causes of why certain things happen in the market, trends are one such occurrence.
Trends are caused by a need to make money.
The Forex market is a zero sum game where one persons losses equate to another persons gain, in order for someone to make money on a trade another trader/traders must lose. The bigger the amount of money you want to make, the higher the number of people who you need to lose money.
Trend reversals occur because of the profit potential of the market continuing in the same direction has decreased, the longer the trend, the more and more people who are either long or short (depending on the trend) if everybody is entered in one direction then the simple way to make alot of money is send the market in the other direction, doing this will ensure all the people who were late into the trend( i.e retail traders) lose money, the money they lose goes into the pockets of the people who caused the reversal mainly the banks/hedge funds.
When the retail traders lose money by closing their trades it will cause the market to move in the direction of which the reversal is taking place, how far the market moves is entirely dependent on how many traders had trades open in the direction of the trend before the reversal took place.
The market movement generated by the traders closing losing trades will eventually reach a point where all the traders who lost when the market reversed identify the movement as a new trend.
This is usually the time when the market will stop trending and either consolidate or retrace.
It’s these retracements and consolidations which give the market the ability to keep trending in the same direction.
Here is the up-trend of USD/JPY
You can see I’ve marked all of the consolidations that took place in this up-trend, without these consolidation the trend would have not be able to continue, know why ?
Because the consolidations are the place where a significant amount of traders will lose money.
When the market stops moving in one direction and begins moving in the opposite direction a large portion of traders will believe a reversal is taking place, therefore they will begin placing trades in the direction of which they believe a reversal is taking place, in the example above it will be sell trades.
This is what happens in the consolidations above, the market comes to a stop, goes down a little and traders begin selling.
When the consolidation has fully formed, in other words, is making swings up and down creating the sideways movement, traders become confused as to which way the market is going to go, some believe its going to break lower others think its going to break higher, all of this confusion allows the large institutions to place trades into the market without causing any significant movement.
Each move higher you see after the consolidation is caused by the traders who were short inside the consolidation closing their trades at a loss, it’s this liquidation of losing positions which causes the majority of the movement in the market
Another thing to take into account is where the consolidation is within the trend.
A trend is like a scale of different emotions, at the beginning of a trend people fail to recognize a new trend is stating to form due to them believe the initial move up is a pullback to the preceding trend, so at this point most of the traders are still going short as they believe the market is going to continue moving lower.
As the trend keeps on moving in one direction more and more traders begin to believe the market is going to continue higher.
This means consolidation’s which form further and further into the lifespan of a trend contain substantially less traders going short than the consolidations seen at the beginning of trends. therefore the movement generated by the traders closing losing trades decreases as the traders belief that the market is going to continue trending has grown higher than the belief that it is going to reverse.
It will be here that the banks/hedge funds start taking all the profits off their positions.
They couldn’t do this at the beginning or middle of the trend as not enough people had gone long. You must understand, by the time the market reaches the last consolidation seen at the top of the image the banks and hedge funds are in billions of pounds worth’s of profits, to close a positions in that much profit requires hundreds of thousands of trader all going long.
This is why the banks need retail traders placing trades late into the lifespan of a trends, their profits depend making people do the wrong thing, if the majority of traders were still going short late into an up-trend the banks would not be able to close their trades and make a profit, therefore its essential for the concepts which surround trend trading i.e “longer the trend the more likely it is to continue in the same direction” be wrong because if it wasn’t, the banks would be able to make any profits, or they would make a significantly lower amount of profit than what they currently make.
Trends Are The Same Across All Time-frames
Although the example explained above is from the large up-trend on USD/JPY, I could have just as easily taken a trend on a different time-frame and shown you that it follows the same pattern.
Here’s a 5 minute chart of EUR/USD
The two vertical lines mark a single down-move which lasted around 16 hours.
Even though this isn’t a large trend like in the USD/JPY example the process which fuels the trend is the same. When the market stops falling and begins consolidating or retracing, people believe a reversal is about to occur.
They place buy trades with the expectation that the market is going to move higher.
When the market begins to fall, the trades placed by these traders suddenly go from being at a profit to begin at a loss, the traders then close their trades on mass creating the down-move you see after each consolidation and pull-back.
Even on time-frames as low as this its clear to see trends follow the same “pattern” as they do on higher time-frames.
The reason why we can switch time-frame and see the same pattern is because the market works the same across all time-frames, the only difference is the traders who are operating on other timescales.
Big trends like the one USD/JPY or EUR/USD are caused by the banks all working together to create a reversal, what we know as small trends on the lower time-frames are caused by intra-day bank traders doing the same thing only on a much smaller scale.
So Is The Trend Really Your Friend ?
It all depends on where you get into the trend.
If you can get into a trend right at the beginning (which is going be difficult as no technical signals would have appeared yet ) then the trend will be the greatest friend you’ve ever had, you’ll make so much money it that is likely you would stop trading altogether.
If you get into a trend when it near the end of its lifespan you’ll still be able to make a bit of money, but you must keep your expectations low, don’t fool yourself into thinking “the market’s been going up for ages surely its going to keep moving up?” As you now know the process and intentions behind trending movements.
The trend is critical if you are to make money from trading forex, “the trend is your friend” is only true if you properly understand where you’re at in the life of a trend.
If you would like more information on why the concept of trend has been made up in order for you to lose money then my book “Zero Sum Fun – How To Profit From Losing Traders” will give you a far more detailed explanation of the concepts discussed in this article. In the book, I also explain the three phases behind each trending movement, these are not the typical accumulation – distribution phase talked about in common technical analysis books but the three process which take place that causes each individual up and down movement in the market.
Thanks for reading please leave any questions in the comment section below.