In today’s episode, you’ll discover when you shouldn’t ride a trend and why.
So tune in right now…
Hey, hey, what’s up my friend? In today’s episode, I want to talk about when you should not ride a trend.
Let me put in a little bit of context here, as one of my trading strategies is a trend following approach where I ride massive trends across different markets.
So when I talk about when not to ride a trend, this is mainly for discretionary price action traders who have doubts whether you should be riding this move or you should just capture one swing in the market. That’s the context that I’m coming from.
If you’re a systematic trend follower then, by all means, go and ride your trend and forget about this sharing. So if you’re a discretionary price action trader, I have a few tips to share with you on when not to ride a trend.
Let’s get started.
1. When the higher timeframe is overextended
Let’s say you enter a trade on the daily timeframe and you happen to realize that on the weekly timeframe, the market is overextended.
What I mean by this is, let’s say the market on the weekly timeframe is in an uptrend as well, where it goes up then pulls back, goes up then pulls back and goes up to a high point.
Over here, you don’t want to be looking to ride a trend because chances are, the market will make a pullback. So this is the first thing to pay attention to, whether the market is overextended and is it far away from an area of value.
Because if it is, then you don’t want to ride a trend, but instead, just capture a swing and get out before the market makes a pullback.
Because if you think about this, when the higher timeframe like the weekly, makes a pullback, then on the lower timeframe let’s say, the daily timeframe, it’s going to be a much deeper pullback.
This is something you must be aware of. A pullback on a weekly timeframe will be a much deeper pullback on the daily timeframe. And if you go down to the 1-hour timeframe, it could be even a downtrend altogether.
So the first thing is – don’t look to ride a trend when the higher timeframe is overextended.
2. Don’t look to ride a trend when the currency pairs have a mean-reverting characteristic
This is more applicable to the forex markets. I’ve done backtesting and research on this and what I found was, for example, a currency pair like AUD/CAD has a mean-reverting behaviour.
This backtest idea was from Andrea Unger, so full credits to him. And what I did was that I ran a backtest on AUD/CAD, so whenever the price breaks above the previous day high, I’ll go long and hold until the price breaks below the previous day low, where I’ll exit the long trade and go short.
I keep doing this and what happened was that for the AUD/CAD currency pair, the equity curve is downward sloping over time when you apply this breakout strategy to it. So it lost money over time.
The reason is simply because AUD/CAD is not a trending market. In other words, it’s not a market that has momentum which follows through. On the daily timeframe, whenever it breaks above the previous day high, chances are it will reverse down lower.
On the flip side, for pairs like GBP/USD and GBP/JPY, these are momentum currency pairs that whenever they break above the previous day high, will tend to have some follow-through. When I applied this same strategy on these pairs, they have an upward sloping equity curve.
What is this got to do with riding trend? Simple. If you trade mean-reverting currency pairs like AUD/CAD or GBP/CAD, they tend to reverse at the previous day highs or lows, so bear that in mind.
I would say it’s much more advisable to just capture one swing in this type of mean reverting forex pairs. That’s just a little bit of an additional tip for you.
3. You shouldn’t be riding trends when you’re not willing to give back profits
Here’s the thing, if you want to ride the trend in the markets, there’s absolutely no way ahead of time to know when and where the trend will end exactly. You might get it right once or twice, but 80% of the time you will get it wrong.
Let me ask you, how many times have you taken profit at the highs thinking that the market can’t go up any higher and then next week when you look at the charts, the market broke out even higher and went even higher in your favour?
Do you get my point? So you have to be willing to give back open profits to ride a trend and the way we do it is that we use a trailing stop loss.
For example, if you went long and want to ride the uptrend, you can use a 100-day moving average to trail your stop loss.
If the price closes below the 100-day moving average, then you’ll exit the trade. But if it only pulls back but hasn’t broken below the 100-day moving average, you’ll continue to hold the trade.
That’s how you’ll use a moving average to trail your stop loss. And the nature of a trailing stop loss is that you have to be willing to give back open profits to ride a trend. If you’re not willing, then it’s pretty much impossible to ride a trend.
4. You have to be willing to stomach the volatility
Trend following is a robust and profitable, proven trading strategy that has worked over the last few decades. But the reason why not many traders can trade it is because they can’t stomach the volatility.
Imagine this, let’s say the market breaks out higher, you catch a trend, and your account is up by maybe 20%. But remember, I said earlier that to ride a trend, you have to be willing to give back open profits and you’re going to use a trailing stop loss.
The market could be up 20% and you’re up by 20%. But as you trail your stop loss, you know that it’s not the time to exit your trade yet, you can exit only when the price hits your trailing stop loss.
But what could happen is that the market could reverse all the way down and hit your trailing stop loss. And instead of making a 20% profit, you might only get out with a 2% profit.
So you’ve technically lost 18%. This is the type of volatility that you have to expect. As a trend follower, your open P&L is going to swing up and down.
In the grand scheme of things, you will make money, but every day, when you look at your P&L, it can swing up and down. And that’s the nature of this trading methodology.
You have to ask yourself honestly if you can handle that volatility. But from what I’ve seen, most traders cannot handle it. They want something consistent, something fixed and that’s why trend following is a simple trading strategy that’s not easy to execute consistently.
With that said, let’s do a quick recap…
You should not ride a trend when:
- The higher timeframe is overextended
- Certain markets or currency pairs have a mean-reverting characteristic like AUD/CAD
- You’re not willing to give back open profits
- You can’t stomach the volatility
With that said, I have come to the end of today’s episode and I will talk to you soon.