What is trend trading or trend-following?
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Trend trading because trend is your
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 analyze
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 categorized into three types –
uptrends, downtrends and sideways trends.
1.
Uptrend
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.
2.
Downtrend
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.
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 analyze
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 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 analyze 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.
Final
word:
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 analyze 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.
Wise investing
Knowledge is growth
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