Rule 3 – The trend and momentum of the higher time frame determines the direction and therefore the action taken on the lower time frame.
Using Apple Inc. (AAPL) from 1990-1991, this daily chart shows three arrows. The first points to where the trend on this time frame turns bearish. In this case, we would be looking at the hourly chart (lower time frame) for shorting opportunities while bearish conditions exist on the daily chart. Then, in the 4th quarter of 1990, the up arrow reflects the change in trend using the crossover and slope of the 18 MA and the 40 MA lines.
During this time, using Rule 3, we would only take buy signals on the hourly chart.
I would like to point out that the slope of these two MA lines were rising at about the same rate, almost parallel, with a comfortable distance between them. These are the characteristics of a strong trend. I will discuss momentum indicators later in the book that will help with this determination. However, having the ability to recognize a strong trend and its momentum using only price and MA lines is a clear advantage when you are trying to decide which higher time frame trends to play.
Our odds increase when the higher time frame trend (daily, in this case) and the trigger time frame (hourly) are in agreement. Finally, the last arrow signals the daily trend reversing to the downside again. At this point, we would be down on the hourly chart looking for high probability sell signals.
The higher time frame tells us there is a trend with good momentum and the pullbacks along the way provide an opportunity to find an entry on the trigger time frame. Your odds of finding winning trades, whether long term or short term, will increase significantly by using this rule. There will be many examples throughout the remainder of this manual of how to put this rule into practice.