Hello traders! This week’s Lessons From the Pros article goes back to one of my preferred trading techniques – trading where supply and demand intersect a clean trendline. To properly trade this strategy, you must first understand how and where to draw these lines.
In many of these newsletters you have been reading and (hopefully!) applying to your own trading, many of our instructors/writers have described in detail how to properly apply supply and demand zones. Basically, a supply zone or level is the origin of a sharp move to the downside, and a demand zone or level is the origin of a sharp move to the upside. For more in-depth descriptions of how to draw in these levels, go back in our extensive archives and refresh your memory. What isn’t discussed as often is trendlines.
There are two basic schools of thought on how to draw in trendlines. The first school says we draw off of the absolute highs in a downtrend, and the absolute lows in an uptrend. This takes into account the highest and lowest points on the candles we are drawing from. In markets with centralized exchanges like futures and equities, this technique is often preferred. The second school of thought says we are looking for the most touches of the trendline-at times disregarding parts of candle wicks and tails, but not drawing through candle bodies. In the spot forex market, a non-centralized exchange, this technique is often “better” as it gives us more trading opportunities. (A centralized exchange is one where everyone gets the same quotes from the exchanges, like the NASD or CME Group. A non-centralized exchange is where all trades/quotes aren’t reported to one place – your broker might actually have slightly different quotes and charts than my broker! This is one of the few quirks of the spot forex market.) The main rule of thumb for either technique is that it takes two data points to draw the trendline, and the third touch of the line is our trading confirmation.
In this chart, the black line represents the first described technique while the blue line represents the second. Notice that in the blue ellipse you had an opportunity to join this downward trend, while the black trendline didn’t give us the same opportunity.
In the following chart of the USDCAD, a downtrend began on June 3rd. By the time June 5th had arrived, we had the opportunity to recognize the trend and draw in the downward sloping trendline. Points marked “1” and “2” allowed us to draw in the line, while at points “3” and “4” gave us our trades at intersections. The two yellow zones are supply zones in this new downtrend. I did use a 60 minute chart to more precisely define these two zones, but am displaying them on a 120 minute to see the bigger picture.
As you can see, these intersections of the trendline and supply zones worked out to be pretty good trades! As always, your stop loss must go on the other side of whatever zone you are using to enter your trade, and your profit target will be at the next demand or supply (if long). Please note that you are not entering these trades near the beginning of the trend with this technique. The trend is already established, and you are attempting to join this new trend. Because of this, your profit targets will generally be smaller than if you get in nearer the origin of this new trend. However, the good thing about this technique is that your win/loss ratio should be better as you are waiting for a bit of confirmation before entering the trade.
Here is an example of the same technique on the long side. Again, drawing in the trendline off points 1 and 2, with possible entries at the intersections of the demand zones. At points 3, 4, 5, and 6, you had opportunities to join this uptrend, again with stops place below the demand zones and profit targets placed at the next level of supply.
While this technique might seem as though you are waiting around for hours or days to place trades, one must always realize that traders aren’t paid on the quantity of trades, but on the quality of our trades. I would rather place 5 trades a month to earn 200 pips than 50 trades to earn the same 200 pips!
Hope to see you at the next intersection!