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Multiple Time Frame Analysis Explained
Hello traders! This week’s newsletter is coming to you from sunny Dallas, Texas. In fact, this is my last newsletter from Dallas as I just sold my home and am moving out to Colorado. The reasons for this are too numerous to go into here, but after 20+ years in one place I think it’s time to move on! Speaking of long term time frames, this week we will look at the benefits of using more than one time frame chart to trade.
You may have heard the phrase multiple time frame analysis in some of our newsletters, trading books or even websites you’ve used in your search on how to trade – this topic is hardly new. I’d like to give the basics on multiple time frame use this week.
In general, we recommend traders use three or even four different time frames to study the charts and determine “where and when” they should trade. For this newsletter, I’ll only use three time frames. One of the first questions people ask when we discuss multiple time frames is, “ how far apart” or “different” should the charts be, meaning what time frames should I use? The common rule of thumb between time frames is a ratio of 4, 5, or 6. For example, when using a 60 minute chart, the next time frame down would more than likely be a 10 minute (60 divided by 6) or a 15 minute (60 divided by 4.) When looking for the next time frame up, use the same ratio, so very often from a 60 minute time frame a trader would go up to the 240 minute chart. There isn’t a right or wrong answer as far as the specific time frames to use, but please stick with the 4, 5, or 6 ratio.
Why this ratio? Well, it wouldn’t make much sense to look at a weekly chart, and then move directly to a 5 minute chart – the information is just too far apart; likewise, it wouldn’t make sense to look at a 15 minute chart and then go down to a 10 minute chart – the information is too close together.
So, what is the purpose of each time frame? Usually, our largest time frame tells us the trend that the “big boys” are on pushing our currency pair. If the institutions are pushing prices higher, I want to look to go long in demand. If the institutions are pushing prices lower, I’m looking to short in supply. Sideways markets are tougher, and we’ll save those for another time.
In this weekly chart of the AUDUSD, you can clearly see that the strong downtrend ended near the beginning of 2016. Since then, it looks as if the institutions have been pushing this pair higher. You would have to go all the way back to 2009 to find the demand zone that caused this reversal! So, our largest time frame here is showing an uptrend. So, what next?
We move down a time frame using our ratio-from a weekly, logically a daily would come next. Since we have determined the big picture uptrend, we want to join this trend by going long in a demand zone. (Yes, we have to be patient and wait for a pullback in price, as we never buy things when they are expensive!) I prefer to buy things on sale, when they are cheap, in demand.
If we stopped right here, a trader could place an entry order to buy at the top of our zone at .7488 with a stop loss below the 66 pip wide zone, so perhaps risking 70 pips. With our suggested 3:1 reward to risk ratio, a profit target of 210 pips at .7698 would make sense. (The target of .7680 is marked in green. The stop wasn’t marked for clarity on the chart.) Now, there isn’t anything wrong with this trade, but using our multiple time frame strategy, if we use one more time frame I think we could make this trade even better. So, which time frame chart should we use? Using our ratio, going from a daily it makes sense to use a 240 minute chart.
In this example, I am waiting for the price action to pull back to demand to go long. Remember, our big picture was in an uptrend, and now I need a smallest time frame downtrend to happen so I can “time my entry”. However, I don’t define the downtrend in your typical way – I am only looking at the individual candles as they approach the zone. As long as there are LOWER HIGHS, I must wait. As soon as a candle forms a higher high than the previous candle, that is my trigger to hit the buy button. If the lower highs continue to take price all the way through the demand zone, I won’t buy to enter this trade – hence, no loss. Sometimes waiting for this small candle pattern to happen allows me to get a much better price, occasionally cutting my risk in pips in half. And if you are still paying attention, when the risk in pips is cut in half, I can double my original position size! Which could mean much more money in your pocket if the trade goes your way.
In this AUDUSD example, by waiting for this pattern to develop your entry would have been at .7473, improving the original price by 15 pips. Not bad for a little patience!
So there you have it. By using multiple time frame analysis, you should look to join the big players in their direction; and by using the smallest time frame in the way described, perhaps even get better entry prices.
Until next time,
Rick Wright – rwright@tradingacademy.com
