Trading naked is a term commonly used in financial markets. With the advent of computing technology and trading platforms, the use of technical indicators have grown exponentially to the point that most traders no longer follow price action and rely solely on indicator signals. The primary drawback to such a strategy is that almost every indicator or oscillator is derived from prices, and is therefore lagging in nature, which results in their buy-sell signals being generated long after a price move is already in place.
Dow Theory Revisited
Followers of the century old “Dow Theory” reckon that everything that there is to know about an underlying market is included in price, making the use of indicators redundant. The Dow Theory defines a trend as a series of rising swing lows (uptrend) or falling swing highs (downtrend). A trend is nothing more but the broad direction in an underlying asset. Prices do not travel in straight lines, and have a tendency to retrace after a strong move. The position and direction of these retracements were used by Charles Dow, and subsequently, Robert Rhea, while defining a trend. The below given charts explain how to identify the trend in a market by simply looking at price.
Within every trend, there are periods of retracement, which provide traders the opportunity to enter in the direction of the main market move. To locate a retracement, we switch to a lower time frame chart and first seek a contra-trend move unfolding. In case of the major trend being up, this is confirmed by the formation of lower swing highs on a shorter time frame chart. Our task now as traders is to wait for this pullback to end. Traders can enter long at the break of the last pivot high on the lower time frame, which will also signal the resumption of the upward trend. In case of the dominant trend being downward, the ideal place to initiate a short position is the end of a contra-trend rally on the lower time-frame, signalled by the formation of a lower pivot low.
Long Trade (part 1/2)
Let’s look at an example to understand how to find trading opportunities within an uptrend.
The 1-hour chart of USDCHF shows the formation of a series of higher swing/pivot lows. This indicates the trend is up. The idea now is to wait for a sign of weakness on a lower time frame within this uptrend.
Long Trade (part 2/2)
On the 5-minute chart, a pullback is first plotted, the end to which is marked by a break above the last major swing/pivot high. Traders can enter long here, with a stop-loss set just below the last trough on the 5-minute chart
Short Trade (part 1/2)
The following charts of EUR/USD illustrate how to isolate short opportunities within a downward trend.
The hourly trend is down as depicted by the consecutive lower swing/pivot highs. The bias is bearish, and we shift to a 5-minute chart to establish short positions on a counter-trend bounce back.
Short Trade (part 2/2)
On the 5-minute chart, the formation of successive higher pivot lows indicate that a secondary rally is taking place. We wait for this rally to end, and initiate short positions on the break below the last major pivot low, as portrayed in the following chart.
Trading financial markets is laden with innumerable uncertainties. This makes the process complex. Traders should desist from further complicating the situation by filling their charts with 5 or 10 indicators. This will yield nothing but “analysis paralysis.” All one needs to successfully operate in the markets is price and volume. Knowledge of trends, charts patterns, support-resistance lines and candlestick bars is more than sufficient to consistently generate positive returns, no matter the underlying asset and time frame.