Trend Trading: How Does it Work?

Trend trading can be an outstanding way to profit from big market moves without having to spend a lot of time on your PC.

Trend traders identify trends as well as find low-risk entry points from where they hold on to their position until the trend reverses.

This style of trade can be highly profitable, given enough diversification, proper risk control strategies and the discipline to stick to the system.

A trend can simply be defined as a sustained movement of price in one direction. This can take place in any financial instrument.

Trends tend to occur in forex markets, stocks and futures.

Time frames don’t affect their occurrence and the longer the time frame, the bigger and more profitable trends will be.

Components of Trend Trading

The best thing with trend trading is that similar trading systems can work across numerous markets. I.e. trend following systems work exceptionally well with stocks, as well as with futures and forex, with no modifications whatsoever required.

This owes to the fact that most markets trend and the trading strategy is strong. All that the strategy needs is:

  1. A low-risk point of entry
  2. An exit rule that gets you out if the trend changes
  3. A way to identify when a trend is in place
  4. An initial stop loss to get you out if you make a mistake, or when you’re wrong

With these components in your trading strategy, combined with proper risk management policies, then you are on your way to having a profitable trend trading system.

However, there’s no guarantee of your rules being profitable.

Trend trading works well in stock markets, future and commodity markets, as well as foreign exchange (forex) market and other forms of currency trading.

trend trading

What is a Trending Market?

A trending market can be defined as a market whose price generally moves in a single direction.

In an uptrend, trends are usually noted by ‘higher lows’ and ‘higher highs’ whereas, in a downtrend, trends are noted as ‘lower lows’ and ‘lower highs’.

When trading with a trend based strategy, traders pick out the major currencies together with any other currencies utilizing the dollar because these pairs have a tendency to trend and are more liquid than other pairs.

Liquidity of a currency pair matters when it comes to trend trading strategies. The liquid a currency pair is the more volatile it is.

When a currency exhibits more movement, the opportunities for the price to strongly move in one direction as opposed to moving within small ranges increase.

The Characteristics of Trending Markets

Trending markets move strongly in the direction of the trend.

It’s then followed by a consolidation period or counter-trend retrace before the next leg in the trend’s direction.

This is a common pattern in a forex chart, and you are likely to find it in any trend you come across.

Typically, the majority of the traders will make some money during the periods of strong directional trend movements.

They then continue trading as the market takes a break from the trends and consolidates.

This is the period when traders give up all the gains they made when the movement of the market was aggressive.

Learning to identify the parts of a trend will help you avoid overtrading during these periods and give you a better prospect of making profits when the movements are strong.

Trend Trading Case Example:

trend trading, trending market

From the image above, you can see an uptrending market which consists of strong upward moves followed by consolidation periods and shallow retracements before the uptrend resumes.

The diagram further shows that a trending market moves in spurts.

It will move towards the direction of the trend, stall to take a breath before another leg in the direction of the trend.

Trends vary, and none of them will be the same as the other. However, a general pattern can be seen and traced out.

The pattern can be described as a strong move towards the direction of the trend, followed by a consolidation period or a retracement in the other direction.

These retracements occur when the potential for the probability of entry within the trend is high.

Before the trend resumes, the market will often retrace to the level approximately its previous swing point.

These swing points are the support in an uptrend and resistance in a downtrend.

When you look at the above chart, but this time, focusing on the marked support levels.

The support levels came as a result of the market retracing lower within the structure of the broader uptrend.

Take note of the stepping pattern left behind by the swing points in the uptrend.

Watch out for price action signals that form near these levels to rejoin the uptrend as the market retraces back to these support levels.

In addition to focusing on naked price action, you can also make use of the technical tools learnt from previous articles to know when a currency pair is trending and when it’s not.

Trend Trading Indicators

Moving Averages

Moving averages tend to “smooth” price data by creating a single flowing line.

The line represents the average price over a period of time.

Whichever moving average the trader opts to use is determined by the amount of time or the time frame in which the trade is executed.

The 100-day, 50-day and 200-day moving average are the preferred choices by most investors and long-term trend followers.

There are numerous ways that the moving average can be utilized.

First is by looking at the angle of the moving average. If the movement is horizontal for an extended amount of time, then the price will be ranging, and not trending.

On the other hand, if the moving average line is angled up, an uptrend is in progress.

However, moving averages do not predict. They only show the progress of the price over a period of time.

Crossovers can also be used when applying the moving averages.

By plotting a 50-day and a 200-day moving average on your chart, a buy signal will occur where the 50-day crosses the 200-day line.

A sell signal will occur when the 50-day drops below the 200-day.

The time frames can be changed to suit your individual trading time frame, or when you are comfortable.

When the price crosses over a moving average, it qualifies to be used as a buy signal, and it is used as a sell signal when the price crosses below a moving average.

Since the price is more volatile than the moving average, this method is prone to having more signals.

Moving averages can also offer resistance or support to the price.

Moving Averages

Moving Average Convergence Divergence (MACD)

Moving average convergence divergence (MACD) is regarded as an oscillating indicator that fluctuates above and below zero.

It also serves as both a trend-following and a momentum indicator.

A basic MACD strategy involves looking at the side which the MACD lines lie on the histogram below the chart.

Potential buy signals arise when the MACD moves to a point above zero, and below zero for potential sell signals.

Relative Strength Index (RSI)

This is another oscillator, but because its movement is contained between zero and 100, it provides some information that is different from what MACD provides

A good way to deduce this indicator is by examining the price as ‘overbought’ when the indicator in the histogram is at a value greater than 70, and viewing the price as ‘oversold’ if the indicator is at a value below 30.

The price has the ability to reach 70 and beyond for prolonged periods when there is a strong uptrend and downtrends can stay at 30 or below for prolonged periods too.

Oversold and overbought levels can be accurate occasionally; however, they may not give most signals on time for trend traders.

Another alternative is buying nearly oversold conditions when the trend is up and placing a short trade close to an overbought condition in a downtrend.

If for instance, the long-term trend of a currency pair is up. A buy signal will occur when the relative strength index (RSI) moves to a point below 50 and then back to above 50.

This essentially means there have been pullbacks in price, and the trader is buying once the pullback has halted and the trend is resuming.

50 is used as a level because the RSI typically does not reach 30 in an uptrend unless there’s a potential reversal underway.

A sell trading signal will arise when the trend is down, and the RSI shifts to a point above 50 and then back below the point.

Final Thoughts on Trend Trading

Always take advantage of trends when they occur

Nothing is ever concrete, especially when it comes to trends.

You do not know for how long a trend is going to last, and it’s, therefore, advisable to grab the opportunities as soon as they occur.

Typically, markets will trend for about 25-35% of the time and become unpredictable for the remaining time.

Learn how to spot a trending market so as to get the most out of it by getting on board as soon as possible. This is the only trick.

Trend trading should take up about 70% of all the trades that you take

The remaining percentage may consist of counter-trend trades or rather trades in range-bound markets.

Before trying to counter-trend, learn how to trade with near-term trends.

This is because trading with the trend has a higher probability of success when compared to trading against it.

Trend trading is one of the easiest ways to make money in the forex market.

However, markets don’t always trend, and you may be forced to try other alternatives (like trading ranges) or wait for it to trend again.

But remember, patience always pays when it comes to trend trading and waiting for the trends may be worth your while.

 

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