Demystifying Trending Market Regimes: By Justin Paolini

“The big money is not in the individual fluctuations but in the main movements – that is, not in reading the tape but in sizing up the entire market and it’s trend” – Jesse Livermore

Trend-Following is a popular trading philosophy that has been around since there have been markets to trade.  There have been countless books, indicators, strategies built around the same concept of trend-following and it remains, to this day, potentially the “safest” strategy for retail traders to follow.

But many traders get caught up with indicators that “identify” a trend. Worse yet, most retail traders (as evidenced by positioning data) fight trends. It just seems that there is a lack of understand of what exactly a trending market is.

So in this blog post we will be demystifying the term “trend” and “trending”, and clarifying what exactly we’re talking about.

Trend is Price Breakout

Know this: any kind of trend is a price breakout of some sort. Let’s prove this.

Time ago, we reviewed the Turtle Trader’s method and created some EAs to replice their strategy. The turle traders would trigger trades off of breakouts, and then manage the trades with time stops and trailing stops.

Over the years, various alternative models have popped up but whether it’s based on Moving averages, Momentum, Self-Similarity, Choppiness, etc., it’s still all part of the same philosophy: buying or selling a breakout of certain high or low.

For example, the Rate of Change (ROC) is a basic measure of momentum and is calculated: (Close – Close(n periods ago))/Close(n periods ago).  Hence, ROC will be positive when the current close > close (n periods ago). Just look at the chart below: when momentum dips below 100, we’re pushing on the bottom channel (i.e. breaking below the 10 day low). When momentum comes back above 100, we’re pushing on the top channel (i.e. breaking the 10 day high).

By definition a trend is a series of higher highs & higher lows, and the trend becomes “evident” when it starts to breakout of recent price extremes. In academic terms it’s called “autocorrelation” or “serial correlation”. But I’ve never been strong in econometrics so we’ll just stick to “continuation” or “followthrough”.

Choppiness, Self-Similarity, RAVI – all the same concept

Most retail traders have trouble with simple concepts like these. They think (erroneously) that a functional trading model must be complicated in order to work. And this leads them towards more complicated indicators, adding clutter to their charts, but does nothing to enhance their performance.

To prove this point, let’s review some “Trend Filter” indicators that appear on TradingView: the Choppiness Index (invented by Dreiss, an Australian trader, in the 70s) and the RAVI (Rapid Adaptive Variance Indicator, created by Tushar Chande in the late ’90s).

They might appear different than simple “price breakouts” but as you can see from the charts, they are not.

The Choppiness Index basically tells you how much space was occupied by price oscillations within the lookback period:

  1. Calculate the Daily True Range
  2. Sum the past 14 days’ True Ranges
  3. Calculate the range (Max – Min) of the previous 14 days
  4. The 14 Day Sum/14 Day Range is the basic measure of fractal choppiness (Chop)
  5. Dreiss then normalizes it:  100*LOG(Chop)/Log(14).

It seems complex but all it is saying is this: when price is pushing beyond the range of the lookback period, it’s trending. When price is falling back within the range of the lookback period, it’s choppy/rangebound.

The RAVI is simpler to create:

  1. Subtract a long moving average (65 period is the standard) from a short moving average (7 period is the standard)
  2. Divide the difference by the long moving average.
  3. Take the absolute value of your result.

The Ravi is just telling you that, on average, prices in the near term are getting closer/further away from the longer term average price.

In the charts below, notice how the Choppiness Index drops (indicating LESS chop/more trend) as the RAVI also pushes it’s boundaries.

Charts created with TradingView

By now, hopefully you are convinced that trends are simply a price breakout of some sort.

Trade Trends, don’t Fade Them!

Despite the wealth of literature  on the benefits of trend trading, it seems most retail folks didn’t get the memo.  Myfxbook has a community outlook which is useful for viewing this repetitive dynamic:as price declines, retail traders augment their long exposure. When price rises, retail traders augment their short exposure like clockwork.

Most retail traders blow their accounts in 90 days. Be different and start with a different mindset.

Issues that Confuse Traders

The first question that might come to mind is: what trend is the right trend? What offers the best results? Unfortunately there are no shortcuts here. There is no “right” trend, there are just “various” trends based on the timeframe of reference. Monthly trends, weekly trends, daily trends, hourly trends, etc.

Most CTAs use something like a quarterly trend filter of some sort, so 60 days or 13 weeks. But that doesn’t offer much help because their objectives and capitalization are quite distant from that of a common retail trader. There are also hoards of shorter time-frame traders that take advantage of short-term trends. There are also traders who adopt various approaches at the same time.

So this leads to the next question: what trend is right for my objectives? If you’re approaching the markets either part time or you have only a limited amount of time during the day, then sticking to daily trends will be the better solution. Trade around your day job, and do not be stressed or pressed for performance. Let the trades come to you.

The Key to Profitable Trend Trading (on the Retail Side)

The major question now becomes: if it’s so simple to find trends, and they are all the same concept, then why is it not simple to trade trends?  There are a few answers to this question.

  1. The major trend-trading advocates  of the 70’s-80’s lived and traded in a trendy environment, with higher interest rates, a more fragmented global economy, less extensive exploitation of market edges. Markets are different these days.
  2. The sheer amount of trend-following strategies has definitely made it more difficult (although I do not have a direct way to measure this).

It takes more work nowadays, but it is still the better option for retail traders. Here are a couple of intuitions we’re exploiting at FXRenew:

a. Use Volatility to identify a potential new trend, or trend continuation BEFORE it happens. This is what we do as part of the End of Day Signals, and we have made available a simple indicator that can allow you to identify such occurrances.

b. Observe the volatility condition of the bar APPROACHING the breakout. It seems that strong inertia leading towards the breakout level enhances the odds of continuation. We take this into consideration in our London Open Signal setups.

(The ATR Volatility indicator is available here)

Over to You

Most robust trading models are simple (which doesn’t mean easy). They are based on timeless principles that stem from participant behaviour. So long as human interaction will sussist in the markets, we will see these patterns time & time again.

The key is to be patient, know which principle you’re exploiting, and bring in complementary information (volatility, fundamentals, etc.) to enhance the odds of your trade setups.

Good Luck!

About the Author

Justin is a Forex trader and Coach. He is co-owner of www.fxrenew.com, a provider of Forex signals from ex-bank and hedge fund traders (get a free trial), or get FREE access to the Advanced Forex Course for Smart Traders. If you like his writing you can subscribe to the newsletter for free.

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