Talking Points:

Identifying a Trend

Crowd Behavior

Watching the Crowd Turn

Identifying a Trend

There are multiple ways to identify a trend. The simplest, and many times most effective manner is to utilize a moving average, which is often the closing price of ‘n’ periods summed up and divided by ‘n’. The most common moving average is the 200 day Moving average encompassing roughly a year of price data.

Click on Chart For Detailed Levels and Sentiment Information on GBPUSD

There are other ways to effectively identify a trend. One historically popular method is the Ichimoku Cloud,where the cloud can act as support in an uptrend or resistance in a downtrend. Another simple tool is to look at historical pivots direction. If pivot points are moving higher week over week or day over day, then the average of the high +low + close of that trend is moving higher and should not be fought until the market as a whole begins to reverse at which point you can then begin following but it’s likely best not to lead.

Crowd Behavior

Sentiment is a fancy word for crowd behavior. It is easy to see that crowd belief often creates its own momentum. If you’ve heard of the term “safety in numbers”, then you understand the concept that the more that believe the concept, the easier it is for new people to believe the same concept. On an individual basis though, people tend to think they are smarter than the crowd as a whole and know things that the crowd doesn’t.

(Screen capture from DailyFXPlus.com)

While this can be true in certain instances from a trading perspective we are going to shine a different light on the subject crowd behavior. Surprisingly, as shown by the speculative sentiment Index, the trading crowd tends to prefer fighting the trend. If the trend is made up of larger and more aggressive number of buyersthan sellers, then it is odd at first glance to see how SSI works but that is exactly what we’re going to discuss.

It may be helpful to think of two crowds that are playing at the market at any one time. First, you have the institutions and the large money that are well-informed and with deep enough pockets to move the market and understand the market very well. Second, you have the retail crowd that is hoping for the big score yet have shallow pockets and is often trying to test a turn or lead the market in hopes of doubling or tripling their money. Sentiment reading can be found in DailyFX Plus. From a sentiment perspective, we will focus on joining the institutions and fading or trading against the retail crowd that are often wrong on big trends.

To see what the big players are doing like hedge funds and banks, one can look to the commitment of traders report from the CFTC. You can read here if you’re not familiar with how to use that report. To see what the second group is doing, we can look at the speculative sentiment Index published twice a day on daily FX plus and available live via daily FX on-demand.

Watching the Crowd Turn

We discussed how the crowd is split into two groups. First, the pros with deep pockets and second, the retail crowd with shallow pockets hoping to score big. The ideal set up for a trend follower is to find a clearly identified trend with technical indicators that the retail crowd is fighting and continuing to press that trend confidently until the retail crowd starts to follow it upon which we can use trailing stops or look for a reversal.

Sentiment Bars Show Retail Traders Predictably Bad at Trading Cable Direction

(Screen capture from DailyFXPlus.com)

Multiple trends in the FX market have shown a polar opposite effect of trend direction and crowd sentiment. In other words when the trend is lower, the retail crowd is buying and when the trend is higher, the retail crowd is selling. As you now know, the reason the trend is lower or higher is because of the big and smart money that were hoping to follow while avoiding the retail reversal mindset trend.

Summary

A clearly identified trend on the chart that the crowd is fighting has historically been an ideal scenario for trend continuation. As long as the retail crowd is fighting the trend and the technical signals hold for trend continuation, trend continuation should be favored. Only when trend indicators like a moving average start to change direction or price aggressively moves against the trend indicator and the retail crowd flips by fighting the new trend should a position adjustment be sought.

Happy trading!

---Written by Tyler Yell, Trading Instructor

To contact Tyler, email tyell@dailyfx.com

Tyler is available on Twitter @ForexYell