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How to Establish a Directional Bias

FX Scouts By Jeffrey Cammack Updated: September 24, 2019
How to establish directional bias
Source: Getty Images

One of the most challenging questions a trader has to answer is: Should I be buying or selling?   Traders establish directional bias by studying high-level charts, support and resistance levels, price action and the overall market trajectory.  We know from Dow Theory that the market will continue to move in that same direction, until something equal or greater may cause a reversal or a break in the trend.

Directional bias plays a significant role in “counter-trend” versus “trend following” strategy. Ultimately directional bias will help a trader identify the direction of the market trend.

Once a directional bias is established, a trader will have more confidence in executing a trading strategy that is planned and not reactionary or emotionally driven.

Developing a Directional Bias

A thoroughly prepared trade includes establishing directional bias, and this is a two-part process:

  1. Forecasting the direction the price will move in (up or down).
  2. Identify the trigger conditions or the trading rules that will confirm your market bias.

It’s not enough for a trader to only establish a directional bias in the market. A trader will also need to have some trading rules to confirm the market bias otherwise there is no opportunity to establish if the bias was correct.  Confirming directional bias is an excellent habit to have, and it will improve the success rate of trades.

A successful trading strategy is more about the way we think, rather than it is about a trade entry technique or trading plan.   At the conclusion of this process, we confirm the directional bias and then open a trade under the right conditions to make a profit.

Directional Bias through Price Action

The easiest way to establish a directional bias is through price action analysis. If prices are moving higher, making higher highs and higher lows, traders should buy. If prices are moving lower, making lower lows and lower highs, traders should sell.

As a check on our assumptions, some trigger conditions need to be set to confirm the perceived directional bias.  These checks can either be a personal strategy or use an existing indicator like Forex Momentum.

Directional bias to sell - USD/JPY Daily Chart
Figure 1: USD/JPY Daily Chart

Establishing Directional Bias through Moving Averages

Directional bias can be concluded through the use of technical indicators such as the Moving Averages. In technical analysis, the 200-day moving average is considered to be one of the most powerful moving averages. If the price is trading above the 200-day moving average, traders should form a directional bias to buy, and if the price is trading below the 200-day moving average, traders should form a directional bias to sell.

Sell below 200 MA - AUD/USD Daily Chart
Figure 2: AUD/USD Daily Chart

Conclusion

The process of developing a directional bias needs to be simple.  If it becomes too complicated, it threatens to add complexity to an existing trading strategy.  Ultimately, having a directional bias will force trading in the direction of the predominant trend.  A trader needs to abstain from opening a trading position where the market has no clear directional bias.

Trading Forex and CFDs is not suitable for all investors and comes with a high risk of losing money rapidly due to leverage. 75-90% of retail investors lose money trading these products. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money.