Trend is Your Friend, Even When It’s on (Over)bought Time

by on January 13, 2014 5:01 am BST

An old trading adage is the “trend is your friend,” and traders should live and die – hypothetically speaking, of course – by this. Time after time, traders make money with trend trading because trends represent a heard mentality which is a strong psychological aspect in humans. Humans do not like to naturally go against the heard and feel more comfortable when performing the same tasks as their peers, and this is true in trading.

This is why trends can go on for extended periods regardless on whether the trend is going against rational though because humans are irrational creatures. However, there are a small group of traders that are strict contararians. They go against the trend no matter what the circumstance based on technical indicators they learned from the beginning.

Novice traders have particular rules, mostly in technical analysis that tend to be “golden rules,” ingrained into their minds. They covet such principles regardless of their effectiveness because it is one of the first things they learn when trading. The problem is that beginning traders will hold onto these principles even when they hurt their trading success.

The relative strength index (RSI) is on almost every technician’s chart because it almost becomes a habit. Typically, the RSI is a calculation of historical price that suggests that an asset is “overbought” from 70 and above and “oversold” from 30 and below.

I have had countless debates with traders, nearly all self-taught retail traders, who continuously short once they consider it overbought and go long when they consider it oversold based on indicators. They push price action and trend to the side and rely on indicators. That is a no-no.

Traders must access the trend and price action because almost all of the available indicators lag price. Indicators support analysis and should not be the thesis of a trade.

Personally, my RSI is set up 75/25 opposed to the traditional 70/30 because forex can trend in overextended territory for a while (AUDUSD anyone?) before the trend reverses.

Take GBPJPY. The shaded area shows with the RSI indicated an overbought condition. From the breach of 70 and into the 80s, the pair increased 826 pips before coming down. The trend also never changed.

1D Chart of GBPJPY; 826 pip advance in overbought territory

1D Chart of GBPJPY; 826 pip advance in overbought territory

So, it is important for traders to put to bed their old principles because markets are dynamic. They always change. The vast majority of indicators were created 30 and 40 years ago, and the same principles may not apply. It is not that they don’t work, necessarily, but they need to adapt to today’s market.

Price action always takes first priority in trading.