What Is Trend Trading And How Does It Work?

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What Is Trend Trading And How Does It Work?

Trend trading is an investment strategy which focuses on creating a return based on the larger moves within a market. Traders find low-risk moments when to open positions and await the right time to close their positions and make a profit. Trend trading is not market-specific and can be used across asset classes, including cryptocurrencies and stocks. All you need is a good eye for patterns, a good understanding of risk management, and the discipline to see your strategy through.

Getting Down to the Brass Tacks

Trend trading, sometimes referred to as trend following, is a strategic decision based on market indicators. A trader would use these indicators to identify both the current and more importantly the future direction of the market. This practice is used by hundreds of traders who believe that markets act, to a certain extent, in a predictable manner.

Therefore, by using historical data and price movements they believe that they can predict what will eventually happen to the asset’s price.

Since this investment strategy is based on trends, not minor fluctuations, it is generally considered to be a mid to long-term strategy. Trend trading is normally preferred by swing or position traders, rather than day traders. 

How to Identify a Trend

candlestick chart

The most successful trend traders are those who are able to open positions as early as possible as close them right before the trend flips. To achieve this, traders rely on numerous pieces of information, starting with the opening and closing price of the asset. In general, trend traders focus their analysis on candlestick charts, as these provide the best visual representation of trends and fluctuations.

Normally, you can expect to come across three types of trends:

  • Uptrend – when the asset’s value increases, a trader would seek to open a long position, ideally selling at the highest price levels
  • Downtrend – when the asset’s value decreases, a trader would seek to open a short position, ideally selling at the lowest price levels
  • Sideways Trend – the rarest of the three types, often ignored by trend traders, a sideways trend takes place when the asset’s price is neither increasing nor decreasing in value

Consider Company A’s share price increasing by 50p, then decreasing by 25p, then increasing again by 55p, then decreasing again by 20p. This would be a sign of an uptrend.

Next, consider Company B’s share price decreasing by 100p, then increasing by 50p, then decreasing again by 150p and then increasing again by 25p. This would be a sign of a downtrend.

A Change in Trend

The easiest and simplest way to identify a change in trend is to locate a U or inverse U pattern on a chart. A U would signal a change from a downward to an upward trend, whilst an inverse U would signal the opposite. While in retrospect identifying changes in trends is easy, predicting upcoming changes is significantly more complex. To help you identify a change in trend, you can make use of several charting tools and indicators, available on a variety of trading platforms.

Indicators to Look Out For

Being able to perfectly time a trend is an edge which every trader dreams of, and over time several different methods have been developed to help identify possible trends. The following are examples of some of the most popular trend trading indicators available to all traders.

Moving Average Trend Indicator

The moving average (MA) indicator provides the average price of a given asset over a particular period. As a result, traders are able to see a smoother chart and identify trends more easily. While the choice of the period is completely up to you, the standard time periods are normally either 50 days or 200 days long.

MA indicators are considered to be lagging indicators, which means that while they are ideally suited to show you the current asset price trend, they offer no help to identify future trends. Used simply, when an asset’s price is above the MA, this is usually a sign of an upward trend, while a price below the MA would be a sign of a downtrend.

Relative Strength Index (RSI) Trend Indicator

The relative strength index (RSI) indicator is ideally used to identify assets which have been overbought or oversold, as well as the general price momentum. The RSI considers the average gains and losses over numerous periods of time, providing a result or either positive or negative price movements.

The RSI value is a percentage which does not exceed 100%. Values above 70% are normally a sign that an asset has been overbought, whereas an indication below 30% is a sign of an oversold asset. Trend traders watch out for these values as they provide a good indication of an asset’s price nearing maturity, and a strong possibility of a trend reversal.

While the RSI indicator is not a guarantee of an imminent reversal, it is commonly used by traders opening long positions when the price is oversold and closing positions once the RSI indicator exceeds 70%.

Average Directional Index (ADX) Trend Indicator

The primary function of the average directional index (ADX) indicator is to calculate the strength of a particular trend. The ADX scale runs from 0 to 100, with values over 25 indicating a strong trend. Normally used in conjunction with the directional movement index (DMI), the ADX provides the strength of a trend whereas the DMI provides its direction.

Double Bottom Indicator

The double bottom (DB) indicator is used to identify trend directions based on an increasing, short-term average. Normally, traders use DB indicators in conjunction with other indications, including the RSI and MA.

Google Trends

Google trends is an innovative way to predict market movements which only became possible thanks to millions of people using the search engine to find information on virtually any subject. In order to understand potential changes in the market, you should use Google trends to find how often people searched for a particular term or asset. You can then analyze the bearish term and bullish search volume to create an investor sentiment index.

How to Pick the Right Timing

Trend traders normally define picking the right timing for a trade as Catching a Wave. There are several ways to do this, but it is common to set up a short-term exponential moving average as well as a long-term simple moving average on both a daily and weekly chart. By doing this, you should be able to identify the overall direction of the trend. 

Next, keep in mind two important definitions:

  • Impulse Waves – wave-like price movements moving in the same direction of the trend
  • Corrective Waves – wave-like price movements moving against the trend

Count the number of these waves on a trend chart and you could identify the right opportunity to open a position with the trend (long) or against it (short). Naturally, this is just a theory, however, it has shown to occur frequently enough for traders to generate a positive return.

How to Start Trend Trading

etoro charts
Screenshots are shown for illustration purposes only. Actual product may vary.

If you would like to start trend trading, the first step is to select a platform which can provide you with all the necessary charting tools that you will require. There are numerous platforms available, each offering distinct features and functionalities, suitable for different types of traders. As an all-round trading platform, eToro offers a range of services and features catering to a diverse range of trend traders.

Opening an account with eToro is fast and simple, and apart from getting access to a free demo account, you can also make full use of the ProCharts section. Furthermore, eToro supports one of the most comprehensive ranges of payment methods and currencies, whilst also offering competitive trading fees.

Choose a Market to Trade

Before you start trend trading, you need to determine which market or markets to trade on. As traders gain experience, they tend to diversify their portfolio, investing in multiple markets, ideally using the same platform. This helps them gain exposure to more trends while using tools and features which they have become accustomed to.

eToro, for example, offers a diverse range of markets, spanning cryptocurrencies, stocks, commodities and many more. Using just one platform you can carry out market analysis and stay up to date with the latest news and developments.

Implement a Risk Management Strategy

An important factor when trend trading, is properly mitigating potential losses. Risk management is a crucial aspect of successful trading, but unfortunately, many novice traders overlook it. Most reputable trading platforms, including eToro, offer a variety of automatic limits which can keep your losses manageable. Some of these orders include:

  • Stop Loss / Profit Order – closes a position once an asset price has gone beyond a value which results in a pre-determined loss or profit for you
  • Price Limit Order – opens or closes a position once an asset price has gone beyond a pre-determined value

Advantages of Trend Trading

There are several advantages to trend trading, including:

  1. It doesn’t take up a lot of time, allowing infrequent monitoring and even more infrequent trades. Using risk management tools, your investment is almost on automatic, although occasional checks are strongly recommended.
  2. While trend trading requires some basic knowledge of chart analysis since the practice is normally based on long-term trends it does not require the same in-depth knowledge as other types of trades. Furthermore, decision-making is easier since it is based on longer planning rather than instant gut feelings.
  3. Trend trading is generally considered to be less risky than day trading, allowing the trader to focus time on different markets.

Disadvantages of Trend Trading

Naturally, trend trading is not a perfect science and does include certain cons, including:

  1. It is not suitable for traders who are not patient enough for trends to fully develop and eventually flip. Those looking for fast profits will probably struggle and close positions early.
  2. Trend traders need time to learn and develop their skills. Price indicators and all other charting tools are only as good as the trader using them, and no amount of analysis can guarantee a future result. Through experience, you should be able to make better decisions, but a learning curve will inevitably lead to some bad choices and losses of some capital.

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