FX tends to trend

Posted by Scriptaty | 12:35 AM

Foreign exchange prices tend to be highly trending, which is why many newcomers to the market have big gains in their early days. You probably know someone who says he bought the Euro when it was around 85 cents in October 2000 and held the long position until yearend 2004, when it was trading at $1.3390. Warren Buffett is one of the folks who got into this trade (about midway through it), reinforcing the idea that it’s respectable to trade forex when you have identified a big-picture trend.

For the rest of us mere mortals, though, it’s very hard to identify a big-picture trend. We get caught up in the hurly-burly of daily and weekly movements, and even in the best-behaved uptrend those moves are sometimes counter- trend. And even if we could identify a big-picture trend and had the self confidence to stick to it, most of us don’t have the capital to sit out those counter-trend periods. In fact, Buffett-style trend-following is quite rare and pretty much confined to well-capitalized managers who are not using much leverage, if they use any at all. It is a monthly chart of the Euro from October 2000 to spring 2005. In hindsight, the uptrend is clear, but it’s also clear the Euro moved downward, at least nine times. If you came to believe in the big-picture trend, to trade it was not necessarily a sure winner — you could have gotten in just as one of those down moves was starting. Any number of charting techniques can be used to identify a strong trend.

At the simplest level, a series of higher highs and higher lows can be said to constitute an uptrend. The chart shows a linear regression line. Another useful concept is the moving average, which tracks the move and smoothes confusing little jigs and jags.

The steeper the slope of the linear regression or moving average, the stronger the trend. In fact, once a strong trend is in motion, just about any moving average will capture it.