Trend Trading System Design

When setting up a trend trading system, it is generally a good idea to review the trend bias from different perspectives. Just as with legal or medical advice, you‘ll want to get a second opinion before making a decision. Therefore, you will want to look review different methods for determining trend biases, combining them in different timeframes. To learn more, check out this video, or continue reading below:

Primary, Secondary and Near Term

A classic analogy to illustrate how one may look at trends in different time-frames is by comparing them to tides, waves and ripples of the sea. The primary trend represents the tide, the secondary or intermediate trends are the waves that make up the tide, and the minor trends behave like ripples on top of the waves.

A market tide can last for more than a year, often several years. The secondary trend represents corrections in the primary trend and can last between a few weeks and several months. These corrections retrace between one third and two thirds of the primary trend. However, a 50% retracement, or half the range, is the rule of thumb. The minor or near term trend will last anything from a couple of days to a few weeks, representing fluctuations in the intermediate trend.

Trend Bias Alignment

Generally, important setups will occur when two or more timeframes show the same bias, thus confirming one another. However, a more important point is that two independent types of trend analysis should be applied. Below we describe one based on price action and market structure (HH, HL, LH, LL), the other a classic price calculation, comparing momentum with volatility.

Swing Trend Analysis

Swing Trend Analysis determines an up-trend by locating continuous higher highs and higher lows. A trend change occurs whena prior swing low is broken, setting a lower low. A down trend is characterized bycontinuous lower lows and lower highs. In order for the trend to change back to a bullish structure, a price break above the prior swing high has to occur. In a trend trading system, the Swing Trend Analysis would look at what the market has been doing in the past and what it needs to do in the future in order for the bulls or the bears to maintain their position.

Comparing Momentum and Volatility

Of course, a trend trading system should avoid scenarios where the market is moving back and forth in a sideways move. Perry Kaufman’s Efficiency Ratio indicator, a.k.a. Fractal Efficiency, can determine whether you’re in a trending or range bound scenario.

Basically, the Efficiency Ratio compares momentum with volatility. In a perfect trend, where all bars close in the same direction and do not overlap, the Efficiency Ratio will show avalueof 100. In a sideways market without momentum in either direction, Efficiency Ratio readings will move towards a value of 0.

To make a distinction between trending or range bound scenarios, the Efficiency Ratio applies a chop threshold. When the market is moving back and forth, alternating between up and down closes, it will fall below the chop line, establishing a sideways market.

Finally, the threshold value, distinguishing between trend and chop adjusts automatically. Specifically, it will be lower for longer lookback periods and a higher for shorter timeframes.

As can be seen in the example below, the Swing Trend indicates an new up-trend in a 30 min. chart, aligning with the Efficiency Ratio reading in the lower timeframe 3 min. chart. The trend trading system gives us no output when the Efficiency Ratio reading drops below the chop threshold.

Trend Trading System: Long Setups

The main objective of a trend trading system is to locate the middle chunk of a larger move. Therefore, the trend should not have advanced too far. Accordingly, the Zerolag Oscilator comes with normalized histogram values. These thresholds are designed to avoid setup that that occur when the trend has advanced too far, or when the trend is likely to have peaked (over the top).

The below example displays the Zerolag Oscillator. For long setups we need to have histogram values above the zeroline for long setups. Once the histogram has crossed to the upside, we’re looking for an adverse move as indicated by the whitehistogrambars. The new trend is challenged by an adverse price move, i.e. a short-term oversold scenario. If buyers are taking advantage of the dip, getting in at lower prices in the new up-trend, it will indicate a trend continuation scenario. Traders are then likely to align themselves with momentum, whereas those caught on the wrong side will close out their positions.

Under these circumstances, the Zerolag Oscillator plots a Key Retracement Signal. A trend trading system may then place the stop a few ticks below the setup bar, or the signal bar, whichever has the lowest low. Subsequent trend challenges, with fresh trend confirmations can be used to add to the position. The stop is then be re-adjusted, and again placed a few ticks below the setup bar, or the new signal bar, whichever has the lowest low.

The color of  the Zeroline is also important as it pulls the information from the Efficiency Ratio.Therefore, in a long scenario, we want to have a green Zeroline. A cream colored plot indicates a choppy market and would block long setups for a trend trading system if activated.

Trend Trading System: Short Setups

In a down-trend we need to have histogram values below the zeroline in order to evaluate short setups. Again, the color of the Zeroline is important as it will tell us the Efficiency Ratio trend reading. In the below example we see a cream colored zeroline, indicating a sideways market, just prior to the short setup. Again, a cream colored plot would indicate a sideways market, effectively blocking trend trading system setups if activated. However, in this case, the continuation move, following the adverse move, was very powerful, moving the Efficiency Ratio reading into a downtrend.

The yellow histogrambars, preceding the continuation move, signal the adverse move we’re looking for. The sellers then took advantage of the short-term overbought, getting in at a discount in the new downtrend pushing the continuation move (Key Signal). A trend trading system should then place the stop at the setup high, or the signal bar high, whichever is highest.

Above, there’s no secondary retracment signal, only an absenceof sellers following the strong initial down move. When there‘s no trend continuation after 3 yellow setup bars,  gray and black colored bars will appear. This indicates that sellers are not taking advantage of a second opportunity to enter the trade effectively disqualifying the secondary retracement setup.

The Open as a Directional Filter

A number of systems also rely on the regular open for clues on directional bias. Specifically, it is used as a directional filter, permitting long trades when the market is trading above the regular open and short positions when trading below. However, rather than using the regular open specifically, the first minute of trading is less arbitrary than simply going with the first tick of the session. A lot happens during the first minute of trading and using that range will give you a more stable trend bias for the session.

Improve Probability with Key Support Resistance

Once a key support / resistance level is tested and subsequently broken, it will often signal a directional move. Above, we saw this with the overnight high and because traders who got “trapped” shorting resistance, they will try to get out at breakeven. Therefore, a trend trading system should anticipate demand from these positions to help form support.

Above, the first minute of trading is plotting near the overnight high, then a testing the overnight low, before a long Key Signal plots on top of the regular open. By taking this setup however, we‘d benefit from an early entry, but trading headwindinto the first resistance level, i.e. the overnight high. There‘s simply not enough space here to justify the risk because the distance between the initial stop loss and the first resistance level barely has a 1:1 risk reward ratio. Therefore, the later tailwind scenario is preferable as the stop level to aligns with the overnight level once it has become support.

There are various approaches for determining support / resistance. Key levels include the overnight high, low, regular open, yesterday’s high low and close, in addition to Session Pivots and VWAP levels. These are objective support resistance levels that the majority of traders agree and execute on and previously discussed here.

It’s generally a good idea to have the high and lows of the night session on your charts. They’re more recent support resistance levels than yesterday’s price action and often work as the first point of reference during the US regular session.

Trend Trading System: Next Steps

A trend trading system should:

  • Align trend bias in different timeframes
  • Use independent approaches for locating trends, for example
    • Swing Trend Analysis
    • Comparing Momentum and Volatility (Efficiency Ratio)
    • Above / Below the Regular Open
  • Have a specific method for determining trend continuation
  • Account for key / support resistance levels

To register for a free trial of the tools described above, please use this form. The Efficiency Ratio is available from our NinjaTrader Indicators Library. Follow-up tutorials on how to apply the above concepts using Bloodhound and Blackbird from SharkIndicators is available by registering via the below form:

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