Putting It All Together
When all three time frames are combined to evaluate a currency pair, a trader will easily improve the odds of success for a trade, regardless of the other rules applied for a strategy. Performing the top-down analysis encourages trading with the larger trend. This alone lowers risk as there is a higher probability that price action will eventually continue on the longer trend. Applying this theory, the confidence level in a trade should be measured by how the time frames line up. For example, if the larger trend is to the upside but the medium- and short-term trends are heading lower, cautious shorts should be taken with reasonable profit targets and stops. Alternatively, a trader may wait until a bearish wave runs its course on the lower frequency charts and look to go long at a good level when the three time frames line up once again.
Another clear benefit from incorporating multiple time frames into analyzing trades is the ability to identify support and resistance readings as well as strong entry and exit levels. A trade's chance of success improves when it is followed on a short-term chart because of the ability for a trader to avoid poor entry prices, ill-placed stops, and/or unreasonable targets.
Example
To put this theory into action, we will analyze the EUR/USD.
|
|
| Source: StockCharts.com |
| Figure 1: Monthly frequency over a long-term (10-year) time frame. |
In Figure 1 a monthly frequency was chosen for the long-term time frame. It is clear from this chart that EUR/USD has been in an uptrend for a number of years. More precisely, the pair has formed a rather consistent rising trendline from a swing low in late 2005. Over a few months, the spot pulled away from this trendline.
|
|
| Source: StockCharts.com |
| Figure 2: A daily frequency over a medium-term time frame (one year). |
Moving down to the medium-term time frame, the general uptrend seen in the monthly chart is still identifiable. However, it is now evident that the spot price has broken a different, yet notable, rising trendline on this period and a correction back to the bigger trend may be underway. Taking this into consideration, a trade can be fleshed out. For the best chance at profit, a long position should only be considered when the price pulls back to the trendline on the long-term time frame. Another possible trade is to short the break of this medium-term trendline and set the profit target above the monthly chart's technical level.
|
|
| Source: StockCharts.com |
| Figure 3: A short-term frequency (four hours) over a shorter time frame (40 days). |
Depending on what direction we take from the higher period charts, the lower time frame can better frame entry for a short or monitor the decline toward the major trendline. On the four-hour chart shown in Figure 3, a support level at 1.4525 has just recently fallen. Often, former support turns into new resistance (and vice versa) so a short limit entry order can be set just below this technical level and a stop can be placed above 1.4750 to ensure the trade's integrity should spot move up to test the new, short-term falling trend.
