How to Anticipate Trends

08/19/2014 9:00 am EST

Focus: FOREX

Despite a popular misconception, traders can not actually predict market trends, but Mihai Milea of XTB UK does outline how a trader can use historical patterns to, at least, make an educated guess.

One common misconception with forex trading is that traders are able to predict trends. In other words, they use technical analysis to determine when the market is going to move in a particular direction. Unfortunately, nothing could be further from the truth—traders try to anticipate trends by looking at patterns that have resulted in market movements in the past, but they can’t actually predict what will happen with any certainty.

There is no such thing as a guaranteed profit

In reality, this makes complete sense. If traders could predict market movements accurately, then they would make huge amounts of money on every trade—which is clearly not the case. However, what they can do is to use signals and indicators to determine if the market is likely to move in a particular direction based on past performance. However, there is no guarantee that this will happen, so successful trading is all about maximizing profitability when trades succeed, and minimizing the downside risk when they don’t.

An example of trend anticipation

Consider a currency pair, such as EUR/USD. If the price of the currency pair starts to rise compared to historical performance, there is a distinct possibility—but no certainty—that this may be the start of an upward trend.

One good way of measuring this is to look at the exponential moving average (EMA) over a longer and shorter timer interval—for instance, 10 days and 20 days. The 20-day EMA shows the long-term performance of the currency pair, whereas the 10-day EMA indicates recent activity. If the 10-day EMA rises above the 20-day EMA, then an upward trend may be gathering momentum. Similarly, if the 10-day EMA falls below the 20-day EMA, then a downward trend may be developing. In both cases, this can be used as a signal to enter the market—taking a long position in the first case and a short position in the second one.

Limit risk

Because traders cannot predict the market—they can only anticipate likely direction—it becomes very important to manage risk. For instance, in the case above, placing a stop at the 20-day EMA will limit losses if the trend does not develop or reverses quickly. Similarly, it is important to lock in profits once you are ahead—using a trailing stop that follows the price movement is a good way of doing this.

Avoid emotion

One reason that investors get into trouble when trying to anticipate trends is that they become emotionally attached to their trade once the position is open. Chasing losses in the hope of a reversal is a perfect example of this—lowering your stops after you open your position is an excellent way of losing money. Because of this, it is important to lay out your complete trade strategy before you enter the market—and then stick to your strategy no matter what.

By Mihai Milea of XTB UK

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