If you have been following us on LuckScout, you know that we trade through following the strong candlesticks patterns and their combination with Bollinger Bands.
Most of the trade setups we take are reversal trade setups. We take the continuations trade setups too, but under some special conditions and while a too strong trade setup forms on a consolidation which is formed on a strong trend (I am explaining it below).
After the candlestick pattern’s strength, and the Bollinger Bands breakout, the location where the candlestick pattern is formed is very important for us. For example, when a too strong reversal candlestick pattern forms on a too strong trend and while the trend is still too strong, we ignore the trade setup, because it is too risky to go against the trend while it is still strong. However, when a too strong reversal candlestick pattern with a strong Bollinger Band breakout form where the trend is exhausted, we take the trade setup, because it is not too risky to go against the trend when it is exhausted.
Now, the question is how we can say that a trend is exhausted or is still strong and potent and it will be too risky to go against it?
That is the question I am asked almost every day, because many of you still have problems to distinguish whether the trend is still strong or has become exhausted. Although I have already written several articles and analysed too many sample trade setups to show you how to locate a too strong candlestick pattern with a strong Bollinger Bands breakout on an exhausted trend, I am going to explain about this topic more in this article. However, it will be great if you read those articles first. Please refer to this article and read all the articles listed in it.
Now, I am going to explain about the trend strength in the markets, and then explain how and when a trend becomes exhausted. I am going to support my explanation with some examples. Although we don’t use any indicator to measure the trends strength or exhaustion, I will introduce some of the most famous indicators that are used for this purpose, and will tell you which one is the best. Maybe novice and inexperienced traders want to have these indicators on their charts at least for a while to know whether the trends are still strong, or are getting exhausted. Of course, the price chart talks by itself and we don’t need any indicators to know whether the markets is trending or ranging.
Markets Strong Trends
One of the most famous features of the currency market is the ability of creating strong and continuous trends. The other markets, including the stock market, usually don’t form such strong trends that the markets forms. There are some exceptions in stock market that I show you here to have a comparison with the trends we have on the markets.
Google’s stock uptrend is one of the strangest on the stock market. It has been trending up almost continuously since September 2004 that Google entered the New York Stock Exchange. It has been going up from $49.95 to $607.22 and it seems it will go even higher:
Another example from a strong trend in stock market belongs to Apple. Its strong uptrend was started almost from December 2009 that it broke above the $27.70 resistance level. Although it went down from September 2012 to June 2013, but it is a while that it has kept on going up to continue its strong trend:
Google and Apple are two examples of the too strong trends on the current stock market. They are exceptional in the history of stock trading. Microsoft did the same long time ago and formed a too strong uptrend from 1986 to 1999, but went down after that and formed a ranging market for several years. It is since March 2009 that it has started going up again:
American Online (AOL) is also another exception. The great decision they made on February 2011 to buy Huffington Post for $351 million, saved the company from bankruptcy. AOL share went up from $12 on September 2011 to $50.77 on January 2014:
Although there are too many other strong companies, they have not been able to form such trends. Most companies are going sideways for several years. Look at Yahoo stock which has been moving sideways almost since 2001:
Google, Apple, Microsoft and also what AOL did recently are just exceptional trends on the stock market. Such trends form usually once in the history of a company, and they never become repeated again. However, too strong trends on the markets are what we see with different currency pairs sometimes several times per year. Look at the most recent trend EUR/USD has formed on the daily chart since 2014.05.08:
You can locate tens of trends like this with different currency pairs on different short and long time frames. Compared to the stock market, currency market trends are much much stronger and more profitable.
Currency Market Trends Strength And Exhaustion
Now, let’s get back to our discussion which is about the currency market trends strength and exhaustion. As I told you, forming a too strong candlestick reversal pattern with a strong Bollinger Band breakout is not enough for us to take a position. Where the pattern is formed, is also very important. For example, when a too strong Dark Cloud Cover or Bearish Engulfing Pattern that are strong bearish reversal patterns, sell signals or short trade setups, form on a too strong uptrend, we don’t go short, because it is too risky to go short on a too strong uptrend and while the trend is still strong, even if the candlestick pattern is too strong.
For example, a too strong Bearish Engulfing Pattern formed by 2012.09.06 candlestick on GBP/AUD daily chart while there was a too strong uptrend. Although the 2012.09.06 candlestick was a relatively strong bearish candlestick and it formed a strong Bearish Engulfing Pattern, as it is formed right on a too strong bull market, it has to be ignored. This is true that GBP/AUD went down for a few candlesticks after that, but we never know. We have to take the strongest and safest trade setups:
What do I mean when I say the uptrend was too strong?
Look how strongly the price has been going up for several consecutive candlesticks (below). Such a strong upward movement means bulls have the full control and they will not give up so easily. As you see, the price went down after the 2012.09.06 Bearish Engulfing formed, but it was stopped by the Bollinger Middle Band and went up strongly again:
Several days later, another strong Bearish Engulfing Pattern forms on GBP/AUD daily chart by 2012.10.08 candlestick. The difference was that this time the uptrend was not as strong as it was when the 2012.09.06 pattern formed, because although the small bearish movement that formed after the 2012.09.06 pattern was not that strong, it could be known as an exhaustion signal indicating bulls were not as strong as they were used to be. After the small bearish movement (1st exhaustion signal), another small exhaustion signal formed (2nd exhaustion signal) that was stopped by Bollinger Middle Band, and the uptrend was continued for a few more candlesticks, but then the 2012.10.08 pattern formed. Look how the price collapsed after this pattern formed (the big red arrow on the below chart), compared to the time that the 2012.09.06 pattern formed. Now you see the difference. The 2012.10.08 pattern formed when the uptrend was exhausted, but the 2012.09.06 pattern formed when uptrend was still too strong:
So, when a too strong candlestick pattern with a strong Bollinger Band breakout forms somewhere, we should also look for the exhaustion signs formed before the candlestick pattern. The exhaustion sign can look different on different charts. They should be able to assure you that the trend is not too strong anymore and can reverse after a strong reversal signal.
Is there any guarantee that the market follows a too strong trade setup that has formed on an exhausted market?
Of course not. It is possible that the trend keeps on following the same direction it has been following, for several more candlesticks, even when there are some good exhaustion signs. However, we have to do our best to take a trade setup that has a lower risk. To lower the risk, it is better to take the too strong trade setups that are formed on the exhausted trends. Although there is no guarantee that these trade setups work 100% of the time, it is still safer to take them, compared to the trade setups that form right on the too strong trends.
Now, let’s take a look at a long trade setup formed on a bearish market.
On 2010.10.25, a strong Doji with a strong Bollinger Lower Band breakout closed on GBP/AUD daily chart. It was confirmed by the next candlestick. That was a strong long trade setup, but the problem was that it was formed right at the bottom of a too strong bear market while no signs of exhaustion was formed before (the big red arrow at the left side of the below chart). Therefore, the price made some too small bullish movements (the green arrow), and then kept on going down very strongly. That is why we have to avoid the reversal trade setups that form right on the strong trends.
This is what the trend strength and exhaustion mean. A trend is still too strong when no exhaustion sign is formed on it. The first exhaustion sign that forms on a strong trend means that the trend is not as strong as it was used to be. It can still keep on following the same direction for such a long time, but the second exhaustion sign will appear sooner than later. When the trend goes to a range and starts moving sideways, it means it is too exhausted. If the range to be continued for a long time, then the price will change the direction and will go against the trend most probably.
This is something that happened on GBP/CAD daily chart on 2014.08.06. There was a too strong uptrend already formed on the chart (the big green arrow on the below chart), and then the market started moving sideways and formed a range (the middle red arrow). The range was continued and it became longer than what a typical consolidation has to be. Therefore, when a too strong Dark Cloud Cover formed while the market was moving sideways, the price collapsed for over 800 pips (the big red arrow at the right):
On LuckScout, we compare all the short trade setups we locate with this short trade setup, because it is the typical sample of a short trade setup that we take.
What if the market doesn’t keep on moving sideways for a long time and just forms a consolidation?
Then unlike what happened with GBP/CAD in the above example (the uptrend reversed and the price collapsed), the trend will be continued after forming a strong trade setup. This is something that occurred on CHF/JPY weekly chart:
Like GBP/CAD strong uptrend on the daily chart, there was a too strong uptrend on CHF/JPY weekly chart. After the 2013.12.29 candlestick closed, the uptrend stopped going up and formed a consolidation. Five weeks ago, a long trade setup formed above the consolidation support line, and so the uptrend was continued. If the market had kept on moving sideways like what GBP/CAD did, then the uptrend would have collapsed after a strong short trade setup:
Hope what I have explained so far is clear enough. As you saw, the price chart is enough to know whether the trend is strong or is exhausted. You can easily know whether you can go against the trend, or you have to wait for a continuation trade setup. However, there are some indicators that can help you know whether the trend is still strong or exhausted, or is about to get exhausted. If you have any problems to distinguish the trend strength or exhaustion, and you can not see the exhaustion signs, you can add these indicators to your charts till you become experienced and skilled enough to know the trends behaviour.
MACD is one of the strongest trend indicators for all markets. Let’s add it to the above charts and see whether it can show the trend strength and exhaustion or not.
Below is the GBP/CAD daily chart I showed you above. As you see, while the uptrend is still too strong, MACD histogram is moving above the zero level and forming higher highs. However, as soon as the uptrend is stopped and the price starts moving sideways, MACD bars break below the zero level and start forming short bars below and above this level. When the price is moving sideways no long MACD bars form on the chart and also you don’t see those strong highs and higher highs anymore. When MACD is sending you such a signal after a strong uptrend, you have to get ready for a too strong short trade setup to go short:
Below is the CHF/JPY weekly chart:
Same story here again. When the uptrend is strong, MACD bars form above the zero level and are long and strong. However, after forming a MACD Divergence which is a strong reversal signal, the price starts moving sideways and MACD bars become much shorter. In spite of having a strong MACD Divergence, we will never go short when there is no too strong short trade setup formed by the candlesticks. Instead, we wait for the trend continuation setups while the consolidation is still short enough to be known as a consolidation, and has not become a too long ranging market like what you saw with GBP/CAD:
There are some other trend indicators like Average Directional Index or ADX, and also different kinds of moving averages, but as they don’t work as strong as MACD, I am not going to waste your time by them. If you are supposed to have a trend indicator on your charts, MACD is the best one.
I also wrote an article about slower settings of MACD which is what you may want to try (below charts). Please note that on both of the below charts (CHF/JPY weekly and GBP/CAD daily chart), the trade setup formed exactly when MACD bars had became too small compared to the time that the price was trending and going up strongly. With CHF/JPY, it meant the trend wanted to be continued after a while that the market has been slow (consolidating), and with GBP/CAD it meant the trend wanted to reverse after a while that the market has been ranging and moving sideways.