Trading with the trend is a simple concept but putting it into practice isn't easy. This article will discuss how traders who prefer to trade in the direction of the trend can spot common patterns for entry. The alternative to having an approach based on recognizable patterns for entry is random entries, which only work in the early parts of strongest trends but can also be a dangerous approach as you're effectively flying blind.
In a phrase, the euphoria stops. While the trend may not be over in whole, something happens in the collective psyche in the short term that causes a few thoughts worth noticing. First, some traders believe this is the top. This causes them to get short and start to push prices down. Of all the trading approaches, this appears to have the smallest amount of success. That is not to say it can't be done successfully, it's just an approach that has maybe a 10% or less success rate, which requires a very disciplined and favorable risk:reward ratio where you have next to now patience for letting the move go against you because you're approach is that you're catching a top.
The second approach is one of profit taking. This is more common and allows institutions and individuals to book a profit at a favorable price and many even plan to re-enter back into the move when it resume or if it resumes. Either way, the first and second approach bring about a pause in the trend that is identifiable.
Identifying Trend Corrections
For our purpose, a correction is any counter-trend move that does not disrupt the overall trend. The typical definition in either direction is that an extreme price is not produced against the trend. Therefore, an uptrend will produce a series of higher highs and higher lows, but if consecutive higher lows are broken then the trend is seen as done or reversed and "buying dips" is not longer encouraged. In a downtrend, a series of lower lows and lower highs are developing and until those lower highs begin to break, re-entering in the direction of the trend is encouraged.
Types of Corrections
Lucky for us, there are two types of common patterns of a trend correction. As you can imagine, in the manic markets, the patterns are far from textbook, but they can often fit in one of the following descriptions as long as they don't break a higher low in an uptrend or lower high in a downtrend. One of the preferred tools to identify a corrective stoping point and thereby a buying point is Fibonacci retracement. While the whole scope of Fibonacci ratios as applied to the markets is outside of this scale, the slimmed down argument is that nature moves in robust fractals and the market is a manifestation of nature and moves in similar patterns that are identifiable. The common Fibonacci retracement points
The first type is a sharp correction that is often in a three-wave pattern as described by Elliott Wave Theory. A sharp correction will have the deepest cut or retracement against the prior move and when using Fibonacci retracements, you may see a move against the prior trend of 61.8%-99.9% of the prior trend. As you can imagine, once the half-way point is broken, it can get discouraging to buy if you don't have a plan but that's why plans are important because this can be a favorable place to enter.
The second type of correction is a sideways move. There are two common patterns within a sideways correct; a flat correction or a triangle. Both of these correction types will only correct a small amount of the prior trend and often happen when the trend has become popular, whereas the sharp correction are more likely to develop when there is doubt to the survival of the trend early on. USDJPY has had many sideways corrections that have been great buying opportunities in the past as long as money management is used because the end of the correction resulted in a strong thrust higher like you can see in the attached chart.