Trends have a repeating pattern of a strong impulse wave in the trending direction, then a smaller correction against the impulse wave, followed by another impulse. The trend trader’s job is to isolate the strong impulse wave to determine the trend, spot corrections against that impulse, and then make a real-time trading decision when there is evidence to suggest the pullback is ending and another impulse (trend direction) is beginning.
The method below will help you identify trading opportunities, and also push you to take trades when most other amateur traders aren’t even thinking about it (or are taking trades in the opposite direction). This is how you get the best some of the best prices, which leads to the lower risk and higher reward trades.
How to Spot Trading Opportunities – 1. Understand Trends
Before spotting trading opportunities, you must first understand trends.
An uptrend occurs when the price is making higher swing lows and higher swing highs. Fairly common knowledge, but don’t take it so lightly. This is telling you that the waves in the trending direction (what we call impulses) MUST be bigger than the corrections. If a correction is bigger than an impulse, it violates the “higher swing low” rule, thus our uptrend is in jeopardy.
With this information, we can now make some assumptions. Mainly, as long as a correction stays above the prior swing low in an uptrend (the low of the last correction) then the trend is up, and we are looking for potential long trades. This is because we always want to be trading in the direction of the overall trend.
Downtrends occur when the price is making lower swing highs and lower swing lows. Therefore, the impulses to the downside MUST be larger than the corrections higher. If a correction is bigger than the last impulse, it violate the “lower swing high” rule and the downtrend will be in jeopardy. Consider short positions anytime a correction is below the high of the prior correction.
At all times you must know in which direction the impulses are moving, because this is your trending direction and the direction you want to trade in. During a correction, you must remind yourself that you will only trade in the direction of the impulses, and you are just waiting for an opportunity to get in on the next impulse.
For more on this topic, see: Trading Impulsive and Corrective Waves – These two types of waves create the overall market structure, and therefore being able to tell the difference between them is the difference between taking high probability trades or low probability trades.
How to Spot Trading Opportunities – 2. Await a Trade Trigger
Assume the trend is down–the waves to the downside are larger than the corrections (higher), which means the corrections are not reaching the high of the prior correction (because the impulse in between the two corrections is bigger).
In this downtrend situation, the dialogue in your head should be something like this: “As long as this correction stays below the high of the last correction, I am waiting for a trade trigger to generate a short trade signal.”
The example below will help clear this up, but first, we need to the discuss the “trade trigger.” A trade trigger is a specific condition that occurs within a certain context and tells you to act.
In our case. We have a downtrend, which means our trade trigger must occur while that downtrend is in effect (the correction you are watching is below the high of the prior correction)–that is our context.
The trade trigger is what tells you exactly when and where to get short, given the context. Trade triggers could include High Probability Engulfing Patterns, consolidation breakouts, an indicator level or indicator crossover, or any other precise occurrence which doesn’t happen that often, but when it does, it tells you it’s time to get into a trade.
For our purposes, we’ll use a consolidation breakout. In our example the trend is down. We are watching for corrections
higher, which must stay below the prior correction high. Our trade trigger requires a pause or consolidation (let’s say a minimum of 3 price bars) during the aforementioned correction. If that consolidation occurs, there is a potential trade trigger if the price drops back below the low of the consolidation.
Enter a short trade immediately.
Figure 1 shows a downtrend, along with comments on the context and trade triggers. The first trade is an example of the consolidation breakout, the second trade utilizes another type of trade trigger.
Figure 1. Trend Trading with Context and Triggers – EURUSD 15 Minute Chart
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The same goes for long trades. Watch for higher highs and higher lows. As long as the corrections stay above the low of prior corrections, watch for trade triggers. When a trade trigger occurs, in the direction of the trend, enter long.
How to Spot Trading Opportunities – 3. Stops and Profit Targets
For a downtrend trade, the stop loss goes slightly above the high of the consolidation (1 or 2 cents in the stock market, 1 or 2 pips in the forex market, if day trading). Target can be a multiple of risk; for example if the risk on the trade is $0.10 or 10 pips, a target could be set at $0.20 or 20 pips (2:1 reward to risk, or some other ratio which works for your market). For establishing targets you could also use a Fibonacci Extension tool.
For an uptrend trade, the stop loss goes slightly below the low of the consolidation, and the same targets guidelines mentioned above can be applied here as well.
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How to Spot Trading Opportunities – Final Word
Always have a dialogue running through your head about what you will do based on various developments. Stipulate to yourself what has to occur for the trend to be in place, and stay in place. As long as the trend remains in effect, watch for trade triggers which will initiate trades in the trending direction. Always know what your trade trigger will be, and if triggered, where your stop and target will be (at minimum know your stop loss). Also, monitor anything that will negate the trade trigger. For example, if the trend is down, but a correction moves above the high of a prior correction, then the trend is in question, and you wouldn’t use this strategy.
As defined here, the strategy is subjective. For example, what highs and lows do you consider relevant? Sometimes a tiny lower high may occur, but overall the price is still making higher highs. Is this tiny lower high relevant? It depends on what time frame you are trading on, and ultimately how many trades you want to make. Define your exact rules for trading in the your trading plan, so you never have to second guess yourself while trading.