This post originally appeared in FutureSource’s Fast Break Newsletter, where Tim Chilleri is a regular contributor on various futures trading topics.

Trend trading is a popular method of trading but it is critical that you develop and use a framework to execute the trade.  The goal is to place yourself in a position to capitalize from a forming trend and get on the right side of the trade early.  I utilize this type of trading as an intuitive, rules-based discretionary trade.  This means that I attempt to understand the dynamics and psychology in the marketplace and use specific rules to manage my risk.

We will discuss a 1-2-3 set-up that gives you a framework for determining potential trends.  While this is a retrospective exercise, I believe it highlights the usability of this framework that you can take advantage of in other markets.  Without understanding the framework and without an example, it is difficult to learn how to search for these types of opportunities.

Let’s examine the core of a 1-2-3 trend trade:  fundamental analysis, technical perspective, and how news affects the market.

#1 Fundamental Analysis

Simply put, we are searching for a dislocation in supply and demand.  In order for a new trend to begin, a major underlying change in demand, supply, or both must occur (rare case to have both altered at the same time).  To illustrate, imagine a ball rolling down a hill in one direction.  Now imagine that ball hitting a rock that alters it direction by 20 degrees.  At the bottom of the hill, that ball will be in a significantly different place had the ball not hit the rock (the dislocation).  Dislocations form because perception of the underlying marketplace changes:

1. Demand for buying increases (new buyers push markets higher as supply is steady)
2. Demand for selling increases (new sellers push markets lower as supply is steady)
3. Supply increases causing prices to fall (demand stays steady)
4. Supply decreases causing prices to rise (demand stays steady)

These dislocations typically happen very quickly and can be unexpected.  The “unexpectedness” occurs because someone is trading on information you don’t have.  This creates an asymmetry of information.  Those in the “know” are early adopters while those out of the “know” either:

1. In the trade already and the position moves in their favor (eg, getting lucky),
2. Their position moves against them, or
3. Do not participate in the move as they do not know the information.

In order to successfully identify dislocations, you need to fundamentally understand how that market operates.  For example, if the market is an agricultural commodity, you need to be aware of the demand and supply dynamics.  Is the crop just being planted? Is it in harvest? How is the weather affecting it? What factors will affect demand? Supply? At the end of the day, you cannot be reactive to potential unknowns (in my view, unknowns equate to risk).  You should be proactively thinking about how a market can become dislocated.

#2 Technical Perspective

Does the current technical perspective support my hypothesis that we are at the beginning of a new trend? Different traders use different analysis to give them different levels of comfort.  Personally, I like to layer different types of analysis to give me the confidence to trade an idea.  There are several that I find useful:

1. Market Profile:  Gives me a visual for understanding of where trading has occurred in a market.  Simply put, Market Profile is a graphical organization of price and time information.  This input gives me an idea where a market will accept buying/selling and where it will not.  It helps me to understand if markets are trading in a fast (vertical) market or a slow (horizontal) market.  During fast markets, the market quickly moves directionally.  When viewing price levels on the price histogram, it looks like there is a “hole” as there are few contracts traded at the various levels.  Markets can trade very quickly through these levels as no value is established at each price and continues the directional move.  During slow markets, I look for tight, range-bound channels to develop.  I will track the number of contracts traded at a certain price over a given session using a simple histogram.  During slow markets, we’ll see trading within a specified range-bound price level.  Thus, over time, “value” is established as those prices are accepted by the market.  Graphically, it results in a “fat” area because the high congestion of contracts trading in that area.
2. Moving Averages:  What are the 14, 50, and 200- day moving averages doing? Are we close to a crossover at any level? Again, a lot of traders use this information and trade off of it.
3. Volatility:  Are we seeing range expansions or contractions? Do markets seem on edge? (I always imagine what it would feel like if we were trading in a pit in open outcry.  Are traders comfortable and quiet or is there a trading frenzy?)
4. Formation:  What is it? Horizontal channel? Vertical Market? Are we breaking out of a horizontal channel into a directional move? Have we formed a diagonal channel? Pennant formation? Double top/bottom?
5. Fibonacci Levels:  Gives me an idea of potential support and resistance areas.  Markets never move in straight lines and they can be useful to give you an idea of where a market can rise/fall before pausing to digest the price move.  Regardless of whether you think it is useful, many other traders look at them, which may help form market perception.  Furthermore, it may help you understand where long and short traders keep their stops.

In my opinion, technical analysis is much more of an art than a science.  There are times when it seems to work well and other times when it does not.  Remember, technical indicators and formations are digesting price information that has already happened.  It is very important to remember this but at the same time, since so many traders use them, it is important not to disregard them.  Technical indicators/formations can help us understand what has happened and potentially, what may occur- at the l very least, it helps give some context as to how the market has recently traded.

#3 News

How does news reflect the market’s sentiment? Said another way, how does the market perceive the news? If you believe we are in a breakout trade to the upside, good news should push markets higher.  Likewise, neutral/poor news will be brushed off without much of an effect to the downside- thus, the trend continues.  Likewise, on the downside, poor news should reinforce a lower market and neutral/good news is brushed off.

Now that we have a framework for how this trade works, let’s examine the March 11 Euro market.

#1 Euro Fundamental Analysis

Those following the world economy know the problems of Europe.  To begin, there high levels of sovereign debt for countries throughout the continent – from Greece and Spain to Ireland and Portugal.  Many believe there are more ticking time bombs waiting to come out of the shadows to announce their debt problems.  For example, last week there were rumors of France’s debt being downgraded.  In December 2009 through May 2010, the Euro began a slide of roughly 3000 points or 30 cents.  During this fall, the market was very concerned about several European governments remaining solvent, which precipitated the sell-off.  A factor in determining the value of a currency can be traced to its creditworthiness.  Think of it like a credit rating for an individual.  High credit worthiness equates to good credit and low interest rates to borrow at.  Bad credit, or the worry that the borrower can’t pay it back results in borrowing of higher interest rates and a lower credit.  This is similar to an entire country.  Good credit and low debt typically spurs value in the currency.  Poor credit and high debt typically leaves a country with lower value versus other currencies.

While the ECB (European Central Bank) and others helped stem liquidity worries and kept governments solvent, the Euro bounced off the May 2010 lows.  However in reality, they simply “kicked the can down the road”.  Instead of structurally addressing any real issue, they applied temporary fixes to keep governments running.  I used this information to understand that at some point down the road, the market would again worry about these same issues.  As such, it was only a matter of time until a major market dislocation occurred and the market moved into a new direction.

By looking at the daily chart of the March 11 Euro on Thursday, November 4th and Friday, November 5th.  The euro fell over 400 points (or 4 cents) in two sessions, which is a substantial move lower in the currency market.  This tells me that over this timeframe, the markets perception changed.  The 400-point move should have had bells, whistles, and lights flashing at your trading terminal.  A major dislocation has occurred.  New demand for sellers clearly emerged as longs exited and short sellers initiated new positions.

Click Chart to See Full Size

#2 Euro Technical Perspective

In October 2010, the Euro market seemed to have stabilized after the run up from March 2010.  I viewed this transition as a period of indecision for the Euro currency.

1. By utilizing Market Profile, it became evident that market traded in a comfortable horizontal channel.  The more time a market spends in the channel, the more likely a breakout to the upside or downside is coming.  (Since the backdrop of the market was worried about Euro zone problems, I was more interested in a break of the downside support).  Once the market broke 400 points in two trading sessions, I became very interested in constructing a trade to the downside as the market began trading fast (directionally).  While I was alert that a major dislocation had occurred, I was watching for a daily close below the horizontal channel.  This tells me that the market is now willing to trade outside the channel at new (lower) prices.  This begins to satisfy our criteria that the technicals support our hypothesis of a new directional move in the market.
2. Moving Averages:  Let’s examine the 14, 50, and 200-day moving averages:

   

   Click Chart to See Full Size

   The red is the 14-day moving average, the blue is the 50-day, and the green is the 200-day.  Many trend traders will use various moving averages so it is important to be aware of them.  As we can see they cross over giving you support that the market may be moving lower.

3. Volatility:  Volatility goes through an expansionary phase, as the daily ranges (difference between the daily highs and lows) are significantly higher than previous sessions.  This supports our hypothesis that we are entering a directional move to the downside.
4. Formation:  While this has been a retrospective exercise, it is important to recognize formations as they unfold.  Once the horizontal channel was broken, we could establish a downward trend.  Trend lines can be effective measures of support and resistance.



Click Chart to See Full Size

5. Fibonacci Levels:  While never perfect, this type of analysis can be used to provide an additional level of data to understand potential targets and retracement levels and dynamics in the market.  The more experience and time you spend watching Fibonacci levels in different markets, the more useful this analysis will be for you.  With that said do not blindly anticipate that Fibonacci levels will provide exact stops and starting points for markets.

#3 Euro News

At the same time prices are being hacked lower, news stories begin to turn up the heat for the downside of the Euro.  On Monday, November 8th, the Portuguese and Irish government bond spreads hit their highest bps (basis points) in the Euros lifetime with Irish 10-year bond and the German Bund widened to 557 basis points while the Portuguese 10-year versus the Bund expanded to 450 bps.  The ECB was forced to answer tough questions regarding the record high Irish bond spread, and the ever-widening bond spread of the other highly indebted EU members like Greece, Spain and Portugal.

Throughout this recent downturn, Ireland and Portugal were in the spotlight.  Meanwhile, Greece is pretty much old news, and now it’s Ireland’s and Portugal’s turn taking heat from widespread investor skepticism.

Deficit figures from Euro stat in October only add to the pessimism.  According to Eurostat, Ireland’s budget deficit was the highest among EU members at 14.4% of GDP last year, ahead of Spain at 11.1% and Portugal at 9.3%.  Even in the United Kingdom came in with a deficit of 11.4% of GDP.  Looking forward, Ireland’s deficit is set to rise to 32% this year, a modern European record.  Furthermore, the debt projection is even dimmer for Portugal and other European Union countries.  Remember, the European Union has 27 member states with 16 utilizing the Euro as a single currency, with Germany at one end of the fiscally responsible spectrum and Greece and Ireland at the other end.  As such, each economy had various needs.

Even last week, the Chinese stepped in to buy Portuguese debt only to see the euro head lower in that trading session.  This tells me that the market brushed off neutral/positive news.  Furthermore, on December 23rd, Fitch Ratings agency downgraded the country’s debt one notch from AA- to A+.  All this information is analogous with lower prices as the market becomes more fearful and reinforces our fundamental and technical perspective.

Conclusion

To re-iterate, this has been a retrospective exercise designed to apply certain types of framework.  We reviewed a 1-2-3 set-up covering fundamental analysis, the technical perspective, and how news can reinforce a trend.  It is important to be aware of the fundamental factors in a futures market and how these factors can lead to dislocations.  We reviewed a few key technical themes includes Market Profile, Moving Averages, Volatility, Formation, and Fibonacci Levels.  Each of these requires time to understand what they are designed to do and how comfortable you are using each one.  As you can experience trading, the more useful technical indicators become as you understand how to effectively leverage them and what the shortfalls are.  Lastly, we saw negative news for the euro reinforce a lower trend satisfying the 1-2-3 requirement.  Europe will continue to face debt and funding issues as time moves forward.  By creating a straightforward framework, you can effectively manage your risk and put yourself in situations to capitalize off the changing sentiment of the Euro currency.

Please contact me directly using the Daniels Trading website if you would like to learn more about how to effectively construct a futures and/or futures option trade and learn important risk management techniques.  I also encourage you to register for our special offer for the dt Insider Market Advisory, which provides trade analysis with daily fundamental and technical market overviews.