Understanding Top Down Analysis in Trading

Top-down analysis means filtering out the best currency pairs or financial assets by using trend analysis on higher timeframes and then applying technical tools on lower timeframes to find the best and high-probability trade setups.

In this post, I will explain how to use top-down analysis and find the best trades. So, read this article until the end and do not miss any step.

I will break this top-down analysis into four steps to make it easy for you:

• Filter out currency pairs using simple trend analysis on a higher timeframe.
• Open a lower timeframe and find a price reversal level.
• Find a reversal chart pattern or any other technical pattern.
• Open a trade with a stop-loss.
• Use a higher timeframe for the take-profit level to get the maximum risk-reward ratio.

Now, let me explain it to you step by step so you can also perform top-down analysis daily to get a high winning ratio.

01 Higher Timeframe Trend Analysis

For HTF trend analysis, we first have to select a higher timeframe. As I will be explaining here for intraday traders, we will use the 4-hour or 8-hour as a higher timeframe, and we will take the 15-minute and 5-minute as lower timeframes.

So, if you are a forex trader, you should first choose currency pairs with low spread rates because, in intraday trading, we cannot trade currency pairs with high spread rates.

Next, open each currency pair one by one on a 4-hour timeframe and check for a simple trend using ‘higher highs and lower lows’ analysis.

We will use ‘higher highs and higher lows’ for a bullish trend and ‘lower lows and lower highs’ for a bearish trend.

At this step, you just have to figure out the trend patterns. If you are finding it difficult to spot the trend in any currency pair, then you should skip that one. We will only pick currency pairs with a clear trend. If there are no higher highs or lower lows forming, then you should not trade on that day.

For example, I have shown you a few images of currency pairs where you can check how I confirmed the trend on the higher timeframes.

In CHFJPY, there is a clear bullish trend. This is because there are at least two higher highs and two higher lows forming. So, we can shortlist this pair for trading on a lower timeframe.

I also analyzed other currency pairs where there was no clear trend, so we should leave these pairs for further scanning or trading. We will not look for any trade setups in these currency pairs.

02 Lower Timeframe Analysis

As we have chosen the CHFJPY currency pair because there is a bullish trend on the higher timeframe, we will open a lower timeframe on it, either 15 minutes or 5 minutes.

As the price always moves in the form of two waves, first it makes an impulsive wave and then a retracement wave. We always have to trade the impulsive wave after a retracement.

Now, first, use the Fibonacci retracement tool and determine the price retracement level. The price should at least retrace to the Fibonacci golden zone (50-61.8). From this level, we should start looking for reversal patterns.

Remember that determining the price reversal zone is important. You can use the Fibonacci golden zone, a support/resistance zone, a supply/demand zone, or a flag limit zone, etc.

In the CHFJPY currency pair, as you can see, the price retraced to the Fibonacci golden zone. So, from this level, we should look for any reversal chart pattern.

03 Find the Trend Reversal Chart Pattern

Now, in the CHFJPY, we will look for any trend reversal chart pattern, such as the head and shoulders pattern, the broadening pattern, etc. These patterns will confirm that the trend is going to change on the shorter timeframe, and an impulsive wave is about to form next. This is the wave that we should trade.

In the CHFJPY, a broadening pattern is forming. It’s also known as a stop-loss hunting pattern. This is an indication that the price is going to change the trend.

04 Open the Trade

You can also check the screenshot above; after the broadening pattern, the price made a higher high and a higher low, showing that a new trend is starting. So, buy here using a candlestick pattern or chart pattern.

Here, I have seen a harmonic pattern, so I will use it to open the buy trade and place my stop-loss below the swing low. You can also place the stop-loss below the previous higher low.

05 Use a Higher Timeframe for Take-Profit Levels

Now, open the higher timeframe and draw a line on the last higher high made by the price. This will act as a take-profit level because the price is making higher highs, so the next one will also be a higher high.

Using a higher timeframe for the take-profit level helps us increase the risk-reward ratio of each trade. This will also help us stay profitable in the long run.

One take-profit level can cover a number of stop-losses.

The Bottom Line

This top-down analysis strategy will surely help you in trading. But remember that this is just a method, and you can use it with any type of trading strategy. I have just shown you top-down analysis using simple chart patterns or candlestick patterns, but you can also use other technical tools.

Our main focus is to align the trend on different timeframes and then trade on lower timeframes only in the direction of the HTF trend. This will also save us from trading in choppy markets. We first filter the currency pairs based on trend and then trade with our strategy.

There is no strategy that works everywhere. The environment of the market is the most important. So, first find trending markets and then apply your trading strategy there to get high-probability trades.

If you have any questions, don’t forget to ask in the comments.

Thanks