Technical Analysis Series: Directional Bias

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Please note:

I am not a financial advisor. I do not and will not offer financial advice. This article is strictly for entertainment purposes only. Please consult a regulated professional in your jurisdiction before putting any capital at risk.

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TABLE OF CONTENTS

Part 1: What Is Directional Bias?

Part 2: Constant vs Situational Directional Bias

Part 3: How Directional Bias Affects Trade Selection & Trade Management

Part 4: Tools for Directional Bias

Part 5: Conclusion

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Part 1: What Is Directional Bias?

A directional bias is formed when a speculator has an explicit expectation of direction in a given market.

Directional bias can also be thought of as a probability enhancer. In the presence of a bullish directional bias, long setups are more likely to be successful than they would be otherwise. In the presence of a bearish directional bias, short setups are more likely to be successful than they would be otherwise.

Put simply, a directional bias tells a speculator which direction to favour (and which direction to avoid).

It is important to mention time frames. This article is going to cover high time frame directional bias i.e. bias derived from daily/weekly/monthly price charts.

That said, virtually all of the tools that I am going to discuss are applicable to lower time frames as well. The difference is that a high time frame directional bias may set a directional preference for the next days or weeks whereas a low time frame directional bias may set a directional preference for a trading session or trading day.

The value in having a system that caters for directional bias should hopefully be quite clear.

1. Probability enhancer for existing directional trade setups
2. Avoid counter-trend trades
3. Improve target selection and trade management of positions that are confluent with the directional bias (fancy way of saying hold on to longs when the market is bullish/hold on to shorts when the market is bearish)

What’s the ‘elevator pitch’ summary of acting on a directional bias?

In the presence of a bullish directional bias, dips are for buying and levels of resistance are anticipated to fail.

In the presence of a bearish directional bias, rallies are for selling and levels of support are anticipated to fail.

One final note: this article is aimed at technical traders. Technicals are far from the only way to derive a directional bias. Traders can also have a longer-term directional bias based on fundamentals (especially in traditional markets). Using fundamentals to form a directional bias is beyond the scope of my competences (which are strictly limited to lines and shapes on candlestick charts).

I’d suggest following David Belle and Miad Kasravi for more on fundamentals.

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Part 2: Constant vs Situational Directional Bias

It’s helpful to separate directional bias into two categories:

1. Constant directional bias
2. Situational directional bias

A constant directional bias is when a trading system will (virtually) always offer a directional preference.

In other words, one can almost always derive from the chart whether to look for longs and avoid shorts or look for shorts and avoid longs.

A straightforward example is deriving directional bias from price relative to a certain moving average value. Price will almost always be above/below it and so there will always be a directional bias present.

A situational directional bias is when a trading system will only offer a directional preference under specific circumstances.

In other words, in the absence of specific circumstances, both long and short positions are equally tenable. A straightforward example is price decisively closing below a daily level of support/above a daily level of resistance.

I don’t think one needs to necessarily choose between the two variants, but most trading styles tend to align closely with one more than the other. For example, a more mechanical trend-following trader is likely to prefer a system that offers a constant directional bias. On the other hand, a more discretionary level-to-level trader is likely to prefer a system that does not always offer a directional bias (thus allowing for more flexibility).

As with many things in trading, experience and personal preference will dictate the suitable choice.

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Part 3: How Directional Bias Affects Trade Selection & Trade Management

The purpose of this section is to provide you with a rough framework for how a directional bias may affect trade selection and trade management.

Directional Bias and Trade Selection

As mentioned, one of the benefits of trading with a directional bias is that it filters trade selection. In the presence of a bullish directional bias one will give preference to long positions and in the presence of a bearish directional bias one will give preference to short positions.

That much is obvious.

But what about taking positions that are in the opposite direction to the directional bias i.e. looking to be a seller where there is a bullish directional bias and looking to a buyer where there is a bearish directional bias?

Most solutions take one of two forms:

1. Positions that are against the directional bias are disallowed completely. Pretty simple, and the logic is straightforward. For example: if there is strong evidence that the market is likely to move up, then sell setups are less likely to succeed and they are also a potential distraction.
2. Positions that are against the directional bias must meet more stringent requirements. This is the more nuanced of the two options. It still allows the trader to take counter-bias positions, but there must be very strong reasons for doing so. Typical examples: a setup with a particularly high expectancy, a setup offering higher logical R:R than what would be required on average, a scalp setup that would be barely visible on the high time frame chart, et cetera.

As with the section on constant vs situational directional bias, I don’t think one is inherently better than the other. Experience and personal preference will dictate one’s approach. Personally, I do take some counter-bias positions but only if a couple very specific low time frame setups form.

It also makes sense for beginners to be stricter and avoid trading against a directional bias to start with.

Directional Bias and Trade Management

Traders always seek to maximise returns from their winning trades. It can be bittersweet closing a position at its original and predetermined target only to watch the market continue in the same direction without offering a clear opportunity to reenter the position.

The benefit of trading in tandem with a high time frame directional bias is that a trader is more likely to a) select appropriate targets; b) manage the trade better/be able to filter out intraday noise more effectively.

Think about it this way: if the weekly chart offers a bearish directional bias and the intraday chart presents a sell setup, it makes sense to premise one’s target on the weekly chart as opposed to some intraday trouble area.

Note: by trouble area I mean nearby support levels if in a short position/nearby resistance levels if in a long position i.e. as the ordinary English reading would suggest; an area where one’s position might run in to trouble.

I strongly recommend reading this discussion between Tom Dante and I on first trouble areas.

To put it more crudely: if the weekly chart looks like it’s going to drop a massive, steaming log then the chances that the market is going to turn on an hourly support aren’t particularly high.

So how does a high time frame directional bias affect trade management?

1. The target(s) for a trade should be derived from high time frame charts, not intraday trouble areas.
2. Intraday trouble areas are still useful for trade management (specifically adjusting stop loss based on price action, new technical structures, and so on).
3. Intraday trouble areas are anticipated to fail as the directional bias unfolds.
4. Broken intraday trouble areas provide for excellent compounding opportunities as price makes its way to the high time frame target.

These are by no means rules or principles set in stone. This is what works for me personally.

That said, the overarching theme that is applicable in all cases is that in the presence of a high time frame directional bias, key trade parameters should be based on high time frame charts and management should be conservative enough to allow the high time frame idea to unfold.

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Part 4: Tools for Directional Bias

The purpose of this section is to give examples of various tools you can use to derive a directional bias. It is not exhaustive by any means; the goal is to pique your intellect and encourage self-study.

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Moving Average Crossover

I’m not going to spend terribly long on this section because it’s fairly straightforward and probably one of the most widely-covered trading topics on the internet.

The basic premise is to use two moving average values, one greater than the other. When the shorter period average crosses above the longer period average that is bullish/when the shorter period average crosses below the longer period average that is bearish.

The logical question is which values to use for such a setup? I will paraphrase a colleague of mine and BitMEX leaderboard trader Nyuu who argued that it’s harder to find moving average values that don’t work than it is to find those that do.

That said, refining specific value(s) to your market on certain time frames and turning that into a strategy is difficult.

No free lunches.

Nevertheless, some examples for your further testing/research:

50/200

13/48.5

9/18

10/20

This setup works particularly well for trend-following systems (for obvious reasons).

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Price Relative to Moving Average/Trend Tool

Very similar premise to crossovers.

Directional bias is derived from the positioning of price relative to a (set of) moving average value(s) or trend tool.

By trend tool I mean the endless class of trend-following indicators such as Ichimoku Cloud (yes, it’s also dynamic support/resistance, whatever), Guppy, and so on. These tools often come with their own specific entry triggers and I’ll leave you to research those; they’re quite flexible.

As mentioned, the basic premise is very similar to moving average crossovers.

A bullish directional bias exists when price is above the moving average(s) and/or when the trend tool triggers a buy signal/a bearish directional bias exists when price is below the moving average(s) and/or when the trend tool triggers a sell signal.

Example: Moving Average Ribbon (by NeoButane) on ETH/USD 12H time frame.

I could litter this section with perfect hindsight examples of a certain moving average value or tend tool giving perfect signals on a given time frame, but reality is quite different:

1. There is no gold standard per se. Different tools will work better/worse than others in a given market on a given time frame. It is not a one-size-fits-all approach, but rather requires back and forward testing.
2. Moving averages and trend tools work best in trending conditions (duh) and will necessarily give false signals and get chopped in ranging conditions. Unfortunately, trading isn’t quite as simple as slapping an indicator on a chart and trading around it.

Some examples to play around with:

Ichimoku Cloud (can gather the basics from my video here)

Guppy

Moving Averages (as per previous section)

Moving Average Ribbons

Two key takeaway points:

1. There’s no perfect tool. Just like moving averages, this approach will require testing, refinement, experimentation, and so on. Hence why I haven’t thrown in a bunch of convenient hindsight examples of perfect signals in a specific market. That would be disingenuous and a poor representation of the truth.
2. Understanding price action and specifically understanding market structure helps a lot. Moving averages and trend tools derive their data from the price chart (sometimes in a very delayed fashion depending on what tools and time frames you’re using). Being able to identify a range-bound market and shifts in market structure will filter a lot of noise and lead to more judicious use of these tools.

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Market Structure Shift

High time frame shifts in market structure often kick-start trending environments and set a clear bias as to whether to buy dips or sell rallies.

If the term market structure means nothing to you, I once again recommend this article by C3P0.

The basic premise is that higher highs (and higher lows) set a bullish directional bias and lower lows (and lower highs) set a bearish directional bias.

Inevitably a discussion follows as to whether to use the wicks or bodies to ascertain whether a break in market structure has taken place.

There is an easier way: just use a line chart. Alternatively, it doesn’t really matter whether you use candle highs/lows or closes as long as you’re consistent. I prefer candle closes i.e. higher high close/lower low close.

The way I personally look at market structure is as follows:

A close above a deep and significant high time frame swing high (thus forming a higher high) sets a bullish directional bias i.e. I look to buy dips.

A close below a deep and significant high time frame swing low (thus forming a lower low) sets a bearish directional bias i.e. I look to sell rallies.

Example: Weekly bullish break in market structure in ETH/USD.

Example: Weekly bearish break in market structure in ETH/BTC.

Three additional points:

1. If you’re sat staring at a chart and wondering whether a swing high/low is valid or significant enough, it probably isn’t. The best ones really jump out and a break in structure is virtually unmistakable. The obvious ones also work best.
2. There’s some debate as to whether a bullish break in market structure has to be preceded by a higher low/a bearish break in market structure has to be preceded by a lower high. I don’t think it matters too much as long as you’re sticking to key, significant highs/lows. That said, the preceding higher low/lower high is certainly a good factor of confluence.
3. People expect the market to move in straight lines as soon as there is a shift in market structure. Sometimes it does, but that’s not something to be relied upon. It’s worth bearing in mind that a shift in market structure sets the directional bias, and retracements (and/or momentum entries) in the direction of the bias are where the actual trades form.

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Support/Resistance Structure Break

Price breaking significant support/resistance structures can also offer a directional bias.

The basic premise is that price closing below high time frame support structures sets a bearish directional bias and price closing above high time frame resistance structures sets a bullish directional bias.

I’ve deliberately used the term ‘support/resistance structure’. It doesn’t matter whether you trade regular support/resistance, supply/demand, trendlines, whatever else.

If buyers didn’t step in where they should have and/or have been overrun, that’s bearish regardless of which technical tool(s) you use. If sellers didn’t step in where they should have and/or have been overrun, that’s bullish regardless of which technical tool(s) you use.

Example: high time frame resistance break in XBT/USD signalling upside continuation (retracement and momentum entries shown).

Example: high time frame support break in ETH/USD led to a sharp decline.

Three additional points:

1. As mentioned, I’ve offered examples of support/resistance structures breaking in the form basic horizontal support/resistance levels. The same applies to whatever technical tools you use to ascertain where buyers/sellers should be stepping in. For the purposes of directional bias, there’s no difference between a key resistance being broken and a key supply zone being engulfed, for example.
2. When dealing with key high time frame levels, support/resistance breaks for directional bias will often form in tandem with market structure shifts (covered in the previous section). Shifts in market structure that form as a result of high time frame support/resistance structures breaking offer powerful directional bias setups.
3. It is entirely plausible (and indeed often the case) that the market does not pull back exactly to the support/resistance structure once it is broken before continuing in the direction of the break. This does not affect the directional bias. To be clear: the bias forms once the structure is broken; price is under no obligation to retest the structure itself. Indeed, depending on the market, a trader might have to look for momentum as opposed to retracement entries when a key high time frame structure is broken given the violence of the subsequent move that usually follows.

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Support/Resistance Structure Flip Failure

Broken support is anticipated to act as resistance. Broken resistance is anticipated to act as support. When these support/resistance flips do not materialise, traders assuming continuation in the direction of the break are caught offside.

The basic premise is that broken support failing to act as resistance sets a bullish directional bias and broken resistance failing to act as support sets a bearish directional bias.

Broken yearly support (anticipated resistance) fails to do its job leading to strong bullish continuation in XBT/USD.

Broken resistance (anticipated support) fails to hold leading to a retest of the level before a decline in USD/CHF.

Three additional points:

1. How much time and space passes between the break and the retest of a structure prior to its failure is largely immaterial. In the Bitcoin example, resistance quite clearly failed despite the time and space between the break and retest. In the Swissie example, the failure at the level is more like a false breakout given how quickly price was accepted back below the highs. In essence it does not matter, the logic is the same: broken support failing to flip to resistance is bullish and broken resistance failing to flip to support is bearish. It’s a trap either way.
2. As in the previous section, price is under no obligation to retest the level/structure that failed to flip. It’s excellent when a retest does take place and it provides for very clear risk definition (stop placement), but if the market is riding on a lot of momentum then the retracement will be much more shallow. That’s fine. As a reminder, the bias is set as soon as the level fails. Whether it gets retested or not is a separate question.
3. Broken support failing to flip to resistance/broken resistance failing to flip to support is a very malleable principle. Range deviations, Quasimodo setups, reclaimed levels, and all that good stuff fall under the same logic.

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Part 5: Conclusion and Further Study

Some points to tie this all together:

1. A good trading system is one that offers a directional bias, be it constantly or under specific circumstances. The benefits of trading with a high time frame bias are plentiful, but boil down to two things. First, knowing whether to look to be a buyer and anticipating resistance to break or whether to look to be a seller and anticipating support to fail. Second, taking higher probability trades with more logical targets and improved management.
2. A trading system can offer either a constant or only situational directional bias. Indicator-based and trend-following tools will almost always offer a directional bias. Price action-based tools such as market structure shifts and price behaviour around support/resistance structures will not always offer a directional bias.
3. There is no magic indicator or moving average value on a certain time frame that will generate the perfect signal every time. False positives are common, especially in ranging markets. The onus is on the trader to test and refine their strategy and tailor it to their market(s). Learning some price action basics will help filter a lot of noise when it comes to using trend-following tools.
4. The basic price action stuff works really well. Market structure, support/resistance continuation, support/resistance reversal, and so on.
5. The different tools outlined in this article are not exhaustive. A fortiori, they’re not mutually exclusive. For example, a strategy might wait for a fast-moving bearish MA crossover to get out of longs and then a bearish shift in market structure to confirm the directional bias and start looking for shorts. That’s just a random example off the top of my head, but the more important point is that there’s scope to merge trend-following tools with price action. One needn’t necessarily choose one over the other.

Tom Dante has some excellent stuff on directional bias. I don’t use those specific methods myself, but they’re logical and will get you thinking along the right lines. Check out his webinars here.

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