A significant portion of traders have incomplete knowledge of why trends form in the Forex market.
The purpose of today’s article is to show how a far more complete understanding of trends can be acquired by learning to be proficient in reading the psychology of the traders participating within the market.
First we will discuss the three phases that accompany each trending movement, then we will take a look at the process taking place behind the scenes that causes trends to manifest in the market.
The Three Phases
All trends in the Forex market consist of three phases.
Note: My definition of trend is a price movement from one point to another without a significant pull back or consolidation taking place during the movement.
Phase 1 – Imbalance
The first phase in each trend is created by one set of orders coming into the market which are greater in size than the current orders causing the trend.
Example:
If EUR/USD is in an up trend, it means overall there are more buy orders coming into the market than sell orders. For the market to move lower, traders would need to place sell trades which are bigger in size than the traders placing buy trades who are causing the market to advance higher.
If enough sell orders come into the market eventually all the buy orders will be consumed and the market will not be able to continue moving higher. With the buy orders being overwhelmed by the sell orders the market price will begin to decline.
Note: The imbalance phase occurs at the beginning of every trend in the market no matter what time frame the trend is occurring on.
Phase 2 – Liquidation
Liquidation is a term used to describe what happens when a trader closes a losing trade. Typically this is by the market hitting their stop loss, but in a lot of cases traders end up closing their trades manually due to other market reasons.
The liquidation phase is a result of the imbalance that occurs in the first phase.
The resulting movement created by the order imbalance in phase 1 makes traders who had trades placed in the opposite direction to which the imbalance occurred to close their positions at a loss.
These traders who are closing their losing trades, add more sell orders into the market which further propels the decline in the market price.
Note: The duration of the movement generated by the liquidation phase is entirely dependent on how many traders had trade trades open counter to the direction of which the imbalance occurred.
Phase 3 – Awareness
Phase 3 is termed the awareness phase.
This phase is a consequence of the market movement generated by the first two phases. When the first and second phases are complete the market will have moved far enough for traders to identify the current movement as a new trend, which leads them to begin placing buy or sell trades.
Quick Recap
Phase 1 is always caused by one set of orders coming into the market which are bigger in size than the orders causing the current trend.
Phase 2 begins when the traders caught on the wrong side of the market start closing their trades at a loss due to the imbalance created by phase 1.
Phase 3 is traders becoming aware that a new trend is taking place due to movement created by phases 1 and 2.
Summary
Trends are essential for traders to be able to make money in the Forex markets. Without a trend, obtaining profit would not be possible which is why correct understanding of how trends are created in the market is essential in your ability to not only make profits, but to time trade entries and exits.
Although it is impossible for anyone to predict the exact point when a trend will begin and end, knowing how and why they form can aid a great deal when analyzing the markets.
If we can grasp how different traders interact with the market by placing and closing trades, it is possible to figure out when the banks are likely to enter their own trades, and for anyone that has been trading Forex for a reasonable amount of time will know, understanding how the banks trade is the key to making consistent profits when trading.
by Christopher Webb
You can learn more about three phases of trend on http://www.forexmentoronline.com/.
