So what is trend trading or trend-following?
Trend trading is defined as a market trading strategy, involving the use of various technical indicators that help identify the market momentum direction. The strategy is founded on the premise that the trading market has an element of predictability, which traders can analyse and use to their advantage. It is based on the idea that if traders ride the trend, then they can avoid losses. As such, they buy securities before the price goes up and sell them before the price goes down. Trend followers typically implement proper risk management strategies before investing. Such traders do not aim to predict or forecast a trend; they believe in following the existing trends and keeping an eye for any emerging trends in the market.
Identifying trends – types and examples
Trend trading strategies can help traders identify trends so early in a trade, that they can exit the market before the trend reverses. Trends are typically categorised into three types – uptrends, downtrends and sideways trends.
When the market price of a trade starts increasing in value, you can say that an uptrend is forming. Traders hoping to take advantage of an uptrend tend to enter a long position when the market begins to reach increasingly high price levels. For instance, if the share price of a company increases by Rs. 20, then declines by Rs. 10, and then rises by Rs. 25 and falls again by Rs. 15; the share price would be deemed to be in an uptrend since it is making both, higher highs as well as higher lows.
A downtrend begins to form when the market price of a security starts decreasing in value. In this case, trend traders would usually enter a short position, i.e., when the price of the security starts going down, typically to the lowest possible point. For instance, if the price of the security decreases by Rs. 50, then increases by Rs. 25, and then it falls again by Rs. 40, before rising by Rs. 10, you can say a downtrend is forming. As such, in a downtrend, the stock price falls to lower lows and lower highs.
3. Sideways trend
There are times when the market price of securities remains static. The price neither reaches higher price points or lower price points. Such a trend is known as a sideways trend. Most people involved in trend trading tend to ignore these trends. However, scalpers, seeking to benefit from extremely short-term movements in the market, tend to take advantage of a sideways trend.
Trend trading timeframe and traders
Although it is deemed as a mid to long-term strategy, trend trading can cover any timeframe. It all depends on how long a specific trend lasts. This trading strategy is popular among all kinds of traders – short, intermediate and long term, as well as swing and position traders. Swing traders are people who identify trends and ride it from the beginning to the end. In contrast, position traders tend to hold a trade throughout a prevailing trend by ignoring daily fluctuations.
The following indicators are regarded as the best trend indicators:
1. The Bollinger Band Indicator
The Bollinger band is one of the most widely used trend indicators, especially among retail traders. Introduced by the American Financial analyst, John Bollinger, these indicators have two uses – they show traders the trending conditions and they help measure market volatility. The Bollinger band indicator comprises three bands, which closely follow the assets’ price, with the middle band serving as a moving average, for instance, an Exponential Moving Average. The edges of the indicator follow the asset’s price while reflecting its volatility. The volatility reduces as the bands move closer, making a breakout imminent.
2. The Moving Average Convergence Divergence Indicator
The Moving Average Convergence Divergence Indicator, also known as the MACD indicator is one of the top trend indicators. This oscillating indicator fluctuates around zero and helps measure both trend and momentum. While the MACD indicator follows the simple moving average for calculations, it also incorporates several additional features that help you analyse the recent moving averages as compared to the older ones. It is better to combine the MACD indicator with other technical indicators, instead of using it as a standalone trend trading indicator.
The Moving Average Convergence Divergence (MACD) indicator helps traders find the average price of a security over a specific timeframe. The MACD trend trading strategy is one in which traders enter a long position, at a time when a short-term moving average crosses over the longer-term moving average. Conversely, traders may enter a short position if a short-term moving average crosses below the longer-term moving average. Traders generally combine the MA trend trading methods with other forms of technical analysis, which helps them filter out the signals. They may even look at price action to determine a trend.
Furthermore, moving averages also help with trend analysis. For instance, when the price of a security is above the moving average, it indicates the presence of an uptrend. In contrast, when the price of the security is below the moving average, it shows the presence of a downtrend.
3. The Relative Strength Index Indicator
The Relative Strength Index Indicator is another oscillating trend indicator that helps measure the excessive market sentiments for stocks that are trending. It does this by observing the average profits and losses over a few specific periods, typically 14 periods, determining whether the movements of prices are positive or negative. On the RSI indicator, assets are considered as overbought and oversold in the market, causing a trend to form. So if the indicator reads 70 out of 100, it means that an asset has been overbought, and a market correction is imminent. Conversely, if the indicator reaches a range below 30, the asset is deemed as oversold.
4. The On Balance Volume Indicator
The On Balance Volume indicator, also known as the OBV trend indicator, is another popular tool that assists in measuring a security’s volume trend. Volume is considered a significant complementary measure used for confirming price trends by determining if the trends are occurring on a low or high number of trades. Typically, if a high or low volume of trades is accompanied by an upward or downtrend, respectively, it is considered a supporting signal for that particular trend.
5. Simple Moving Average
A Simple Moving Average or Daily Moving Average aims to crunch past data into a single number to hide short-term volatility and gives traders an idea of the emerging trend. In other words, a Simple Moving Average helps traders get the signal from the noise. A Simple Moving Average is simply a moving average that gives equal weight to all the units in a particular range of time. If the range is 10 days, like our example above, then the trader needs to figure out the moving averages of 10-day blocks. Once the moving averages have been plotted on a graph, a simple line can be drawn to connect the dots. That line is the Simple Moving Average. The direction and momentum of this line can give the trader insights that can inform his investing choices.
There are other, lesser used indicators like the Average Directional Index trend trading indicator that helps analyse trends and momentum. This indicator predominantly measures the strength of a specific trend, while allowing traders to assess the price strength of the asset being traded. The estimation is done in both positive and negative directions. The ADX indicator comprises a line which fluctuates between zero and 100. If it indicates values between 25 and 100, you can say that a strong trend is occurring. Conversely, if the value of the asset falls below 25, a trend is said to be falling weak.
Another trend indicator that is followed by some traders is the head and shoulders strategy. The head and shoulders pattern signifies that a trend has reached its end and that a new trend is emerging. This pattern also works upside down. In it, the head represents the highest or the lowest price reached by a security, whereas the shoulder signifies two high or two low points.
5 trend-following principles to consider
- Buy securities at a high price and sell them at an even higher price
- Avoid making market predictions since it can cloud your judgement. Instead of losing objectivity and making fatal trading mistakes try to follow the price.
- Implement a proper risk management strategy by not risking more than a fraction of your trading capital.
- As a trend follower, you may not have a specific profit target. However, not having a specific target doesn’t mean you do not set a stop/loss target.
- Instead of sticking to one market place, you should enter into trades in various markets. Doing this can increase your odds or chances of capturing and following various trends.
Now that you know what trend trading is and the various strategies, you can apply them to your trades. However, you must master your strategies before applying them. Remember to use all the weapons you have at your disposal to analyse the trends – from research data to charts and candlestick patterns. You should also determine the markets in which to conduct your trades as well as your risk appetite. Implementing a risk management strategy is just as crucial as implementing any trading strategy. For more information on trend trading systems, reach out to an Angel One advisor.