Trend Trading: What it is & How to do it

7 thg 6, 2023

What is trend trading?

Trend trading or trend following is a trading strategy that involves identifying the direction of a prevailing trend in the financial markets and then buying or selling assets following that trend.
Trend traders tend to use technical analysis tools, such as moving averages (MA), trend lines, and momentum indicators, to determine trends in the market. They will look for patterns in price movements and analyse charts to establish areas of support and resistance.

Once they identify a trend, trend traders usually enter a trade in the direction of that trend, and the goal is to ride the trend for as long as possible. As a trend trader, you may enter a long position when the price moves upward or a short position when the price is trending downward.

Different types of trends

Trend followers may want to be aware of several types of trends:

1. Secular trends: Secular trends are long-term trends that last for years or even decades. Structural changes in the economy or changes in demographic are some of the factors that influence these trends.
   
2. Primary trends: Primary trends are shorter-term trends that last for months or a few years. Changes in the business cycle or political or economic events usually cause them.
   
3. Secondary trends: Secondary trends are shorter-term trends that last for weeks or a few months. Changes in investor sentiment or technical factors typically cause them.
   
4. Intermediate trends: Intermediate trends are shorter-term trends that last for days or a few weeks. Changes in the supply and demand for a particular asset or changes in the level of volatility in the market usually cause them.
   
5. Minor trends: Minor trends are very short-term trends that last only a few days and are the bread and butter of day traders and swing traders. News events or changes in the level of trading activity in the market usually cause them.
   

How to use a trend-trading strategy

Traders may use a combination of trend-trading strategies, depending on their style and risk tolerance.

Moving averages
This strategy uses the moving average (MA) indicator, which measures an asset’s average price over a specified period.

A trader may look for a “golden cross” signal; this occurs when a short-term moving average (e.g. 50 days) crosses above a long-term moving average (e.g. 200 days). This signal could indicate that a bullish trend is shifting upwards.

Trend lines
Trend lines connect the highs and lows of an asset’s price movements. They are straight lines that connect two or more price points on a chart, representing the direction and slope of a trend.

Trend lines can pinpoint the direction of a trend. Traders can also use them with other technical indicators and candlestick patterns to spot potential trading scenarios. For example, a trader may look for a bullish chart pattern, such as a double bottom, to form near an uptrend line, which may indicate a bullish momentum.

Trend momentum

Momentum indicators measure the strength of a trend. They can help traders identify potential entry and exit points.

The indicators used are:

1. Relative Strength Index (RSI): This measures the speed and change of price movements. It oscillates between 0 and 100 and is typically used to identify overbought and oversold conditions. A reading above 70 indicates an overbought condition, while a reading below 30 indicates an oversold condition.
   
   
2. Moving Average Convergence Divergence (MACD): The MACD is a trend-following momentum indicator that consists of two lines: the MACD line and the signal line. When the
   
   
3. MACD line crosses above the signal line, it indicates a bullish trend. In contrast, a cross below the signal line shows a bearish trend.
   
   
4. Stochastic Oscillator: The indicator compares an asset’s closing price to its trading range over a specified period. It oscillates between 0 and 100 and is typically used similarly to RSI - to identify overbought and oversold conditions.
   

Trend-trading example


The chart above highlights activity over a few weeks and shows the 9-day moving average and 21-day moving average, trendlines and the RSI indicator below.
When the RSI falls below 30, indicating that the asset is oversold and a trend reversal is likely, we see a cross of the 9 and 21-day moving averages, which also signals a potential bullish trend reversal. A trend trader may have decided to buy the asset since two indicators confirm the reversal and follow the trend until RSI shoots above 70, suggesting that the asset is overbought.

Why choose trend trading?

1. Suitable for various markets: Trend trading can be applied to multiple financial markets, including stocks, currencies, commodities, and indices, making it a versatile strategy.
   
   
2. Capitalise on market momentum: ​​ The basic idea behind trend trading is to identify the market’s direction and then take positions that align with the direction of the trend.
   
   
3. Adaptable for various time frames: Trend trading can be used for multiple timeframes. Therefore, it may suit many strategies, from day trading to swing trading.
   

Risks of trend trading

*False signals: One of the downsides of trend trading is that it can generate false signals, leading to losses. Trends can be short-lived, and price movements can be volatile, making it challenging to accurately identify the trend’s direction.

*Lagging indicators: Trend trading often uses lagging indicators, such as moving averages, which may not accurately represent the current market situation. When a trend is identified, it may have already been in place for some time, and the price may have moved significantly.

*Risk of trend reversals: Trends can reverse at any time, and traders who have taken long or short positions based on the trend may suffer significant losses if the trend reverses.

How to start trend trading

The key steps involved in trend trading include:

Identifying trends: The first step in trend trading is to find out the direction of the trend. This can be done by analysing price charts and looking for higher highs and higher lows in an uptrend or lower lows and lower highs in a downtrend. Traders can also use technical indicators such as moving averages and trend lines to highlight trends.

Selecting entry and exit points: Once a trader identifies the direction of the trend, the next step is to choose entry and exit points. Entry points can be determined using technical indicators such as momentum oscillators and chart patterns.

Managing risk: Risk management is essential to trend trading. Traders can use appropriate position sizing and risk management techniques. For example, stop-loss orders can be used to limit potential losses. Traders should note that ordinary stop-losses do not protect from slippage, while guaranteed stop losses do; however, they usually incur a fee.

Backtesting and demo trading

Backtesting involves testing a trading strategy on historical data to see how it would have performed in the past. This allows traders to evaluate the strategy’s effectiveness and make necessary adjustments before risking real money in the markets.

Backtesting helps traders identify the strengths and weaknesses of their strategy and refine their entry and exit points, risk management, and position sizing.

Demo trading, on the other hand, involves using a simulated trading account to practise executing trades based on a trading strategy. This allows traders to gain real-world experience without risking real money. In addition, demo trading helps traders to develop confidence in their approach, practise managing risk, and to become familiar with the trading platform they plan to use.

Summary

In summary, trend trading is a widely employed and adaptable trading strategy focusing on capitalising on market momentum by identifying and pursuing prevailing trends.

Traders can ascertain trends and evaluate their potential potency using technical analysis tools, such as moving averages, trend lines, and momentum indicators. Furthermore, by recognising the distinct types of trends – secular, primary, secondary, intermediate, and minor – traders can adapt their strategies for varying market conditions and timeframes.

Trend-following strategies may use moving averages, trend lines, and momentum indicators to establish entry and exit points while assessing a trend’s strength. The versatility of trend trading allows its application across diverse financial markets, including stocks, currencies, commodities, and indices.