EUR/USD Trend Trade and Why It Worked

06/19/2012 6:00 am EST

Focus: FOREX

Huzefa Hamid

Senior Analyst, DailyForex.com

Huzefa Hamid, contributor to DailyForex.com and The Forex Room, reviews a recent trade that used effective trend line analysis on multiple time frames to spot the set-up and target effective profit and stop levels.

The beginning of a new trend is often where the largest moves happen because at that point, the new market sentiment has to be strong enough to overcome the previous trend. However, because there will still be a large number of traders who believe in the previous trend, the beginning of a new trend is often volatile, which leads to many traders being stopped out prior to the price moving in the predicted direction.

That means that we, as traders, have to select good entry points when we believe the previous trend is over and a new trend is beginning.

See also: In Forex, Trend’s Not Always Your Friend

This week, we’re going to look at an example of a trade I took on the EUR/USD that used a couple of trend lines to find the entry and potential target.

For several weeks from the end of April to the end of May, EUR/USD had been trending down nicely. On an hourly chart, I picked out several points to mark out the trend. (For clarity, I have shown the same trend lines on both a four-hour chart and one-hour charts.)

chart
Click to Enlarge

I could see two key trends: 1) a shallow one marked in red; and 2) a steeper one marked in blue.

Similar trend lines can be seen on the hourly chart:

chart
Click to Enlarge

Now, as expected, price broke the steeper (blue) trend line. Why do I say “as expected?” Because when a trend line is especially steep, price eventually breaks it to retrace or pull back. Excessive momentum can’t be held indefinitely.

NEXT: The Long Entry Opportunity for This EUR/USD Trade

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My view of the EUR/USD at this stage was this: I was not sure whether the price had bottomed out and was about to move into a new, upward phase, but I believed that once price once broke the steep trend line, it would at the very least move up to the longer-term shallow (red) trend line. The shallow trend line may hold or it may get broken.

Therefore, with the assumption the price would in the near term move up to the red trend line, I wanted to find an entry for a long position. To do this, I zoomed using the five-minute chart.

chart
Click to Enlarge

On the five-minute chart, the break of the steep (blue) trend line wasn’t a nice clean break. In fact, it broke it and then ranged about in quite a messy fashion. But eventually, I felt that I could see a series of rising supports.

I was satisfied that price was looking to move up to the shallow (red) trend line and I entered after price had marked another minor low. I kept a 25-pip stop that covered a retrace to the previous few lows.

When the price moved up 55 pips from my entry, I exited the trade simply because I had covered over double my risk at that point. I was happy that I had gotten more than a 1:2 risk/reward ratio on this trade. However, this trade did in fact move up to the shallow trend line, as predicted, and the entire move was over 90 pips.

Trading trend lines in this manner is one of the most basic concepts in technical analysis and has been written about in books for decades. Today, the fundamentals and politics of the euro are unique to any currency in modern history. However, as the conditions surrounding the markets have changed, these basic trend line concepts still work and work very well. The reason is that while circumstances have changed, the core principles of the markets have not.

The fundamentals and news create the sentiment amongst the players in the market, and that sentiment and the attached emotions are translated into price action. That is the basis of why technical analysis works as well today as it did over a century ago.

In summary:

  1. Very steep trend lines eventually break because excessive momentum can’t continue indefinitely
  2. You can trade the break of a steep trend line if you have enough room against the longer-term trend
  3. As with any trade, its success should be measured compared to how much you have risked

By Huzefa Hamid, contributor, DailyForex.com, and co-founder, The Forex Room

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