The prices in the financial markets do not move in a linear fashion. Generally, a large price movement follows a corrective move in the opposite direction.
The price movement creates patterns that regularly emerge on the charts. Traders analyze these patterns and predict the future price movement. The price pattern analysis is the foundation of the technical analysis.
In modern-day trading, traders have discovered scores of patterns. In this article, we will go through two of the most distinctive patterns of trending markets, the higher highs, and lower lows.
If the price of a financial instrument is repeatedly making higher highs it indicates an up-trending market. In a classical uptrend, the closing of a particular candle remains higher above the previous closing.
Likewise, the low also remains above the low of the previous candle. That is why the pattern is referred to as higher highs higher lows. The higher highs indicate the rising demand that causes the bullish momentum. The higher lows then further indicate the buying intensity whenever the price falls back due to profit booking.
The lower lows on a chart indicate a downwards trend. Typically, in a downtrend, the closing of a particular candle remains lower than the closing of the previous candle. The highs will also continue to trim and remain lower than the high of the previous candle.
Such a pattern is referred to as Lower Lows Lower Highs. The pattern essentially means that the market is oversupplied and selling pressure leads the bearish momentum. The lower highs in the pattern indicate further selling pressure whenever the falling price starts to recover.
Trading Strategy Using Higher Highs and Lower Lows
There is a general consensus among the trading community that it is best to trade in the direction of the direction. This requires establishing the trend and there can’t be a better way to establish it than analyzing the higher highs and lower lows. In this article, we will create a simple yet effective trading strategy to trade both up trending and down trending markets using higher highs and lower lows.
Establishing the Trend and Planning your Entry and Exit
The first thing in this strategy is to establish the trend. The rule to establish an uptrend is to have at least 3 higher highs. Likewise, to establish a downtrend a minimum of 3 lower lows are needed.
There are mainly two types of trends, uptrend, and downtrend. If an uptrend is established, we will take a long position when the market retraces from the third higher high towards the second higher low. The stop-loss in this strategy will be below the second higher low.
If a downtrend is established we will take a short position when the market retraces from the third lower low towards the second lower high. The stop-loss in this strategy will be above the second lower high.
The exit or take profit will be based on the emergence of a reversal pattern after placing your entry. Remember, a reversal pattern indicates that an ongoing trend is likely to pause and change its direction.
The exit strategy will also depend on your style of trading. For example, if you are trading on a 1-hour time frame you may consider existing after a profit of 40 to 50 pips. Similarly, if you are trading on a daily scale you may exit your trade after making a profit of 60 to 80 pips.
To see the strategy in action, let’s take a look at the GBP/USD chart below which is set to a 1-hour time frame. The uptrend is established using three higher highs. Based on our strategy, we will take a buy position when the market retraces after the third higher high. The buying entry-level is labeled near 1.36100. The stop loss for this trade will be below the second higher low which is around 1.3570.
Now let’s take a look at the chart below to see the performance of our strategy. You can see, soon after placing the buy entry, the market resumed the uptrend and moved towards 1.3670 where a bearish engulfing pattern appeared and signaled a downwards movement. Closing the trade at this level gives a profit of nearly 60 pips which is an ideal return on a 1-hour time frame.
The same strategy is applied on the EUR/JPY chart below. The downtrend is established by identifying three lower lows. Soon after the third lower low, the market is retracing towards the second lower high. Based on our strategy the selling entry-level is labeled near 1.3190. The stop-loss for this trade will be just below the second Lower High (1.3220).
Now let’s take a look at the next EUR/JPY chart. Following our short entry, the EUR/JPY once again resumed the downtrend and dropped towards 131.30 where a corrective pattern again starts to emerge. Closing the trade at 131.30 results in a profit of nearly 40 pips.
Five Useful Tips To Analyze Higher Highs and Lower Lows
- Use angled trend lines to establish the trend and consider at least 2 to 3 candles to confirm a higher high or lower low.
- It does not always happen that a new high or low is created the very next day. Therefore it’s not necessary to have consecutive candles confirming a new higher high or lower low.
- It’s generally a good practice to first analyze the market on a bigger time scale and then gradually scale down to a lower time frame. It gives a better insight into the strength of the trend and reduces the possibility of a fake-out.
- Beware of the oversized candles that appear due to high volatility. If the size of the candle is 2 to 3 times of the previous candle it could be an indication of a reversal. You can ignore the oversized candle only if the next couple of candles are formed in the direction of the original trend.
- If a new high or a low is not made for an extended period, this could be an indication of a consolidation phase that can lead to a potential move in either direction.
The higher highs and lower lows are two important patterns to predict the direction of the market. The ability to analyze these patterns gives a trader the upper hand to spot the trend and place high probability trades.