Trend Trading: A Comprehensive Strategy Guide
Trend trading is when traders identify a price pattern in the market, and then buy or sell in order to profit from either an uptrend or a downtrend. Trend traders often rely on technical analysis, e.g. momentum indicators and moving averages (MA) and other tools, to find trend patterns. They also analyze charts to find areas of support and resistance.
Depending on the direction of the trend, traders may take a long position (if prices show an upward trend) or a short position (if they’re moving downward).
Trend trading is a sophisticated strategy that comes with its own risks, as there are no guarantees a trend will hold, and trends frequently reverse.
What Is Trend Trading?
Trend trading, sometimes called trend following, is an offshoot of technical analysis: using a set of tools and metrics to assess stock price movements over time. Technical analysis helps traders identify patterns to help them decide when it’s potentially a good time to buy or sell.
Traders may follow a trend over any period of time, including short- , medium-, and long-term trends.
A trend may go upward (a bullish trend), downward (a bearish trend), or sideways (a neutral or range-bound trend). Traders typically combine different types of analysis and technical tools to decide how best to profit from a trend, and how to manage the inevitable risk factors.
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Trend Trading Tools
Trend-traders leverage technical analysis tools in an attempt to identify whether stock prices are moving up or down, and how fast — then use that information to decide when to enter and exit stock positions.
Generally there is an assumption that prices will continue to move in one direction unless acted upon by an event or outside influence.
Think of it a bit like the laws of inertia in physics. In physical science, an object in motion or at rest will stay in motion or at rest unless acted upon by an outside force. The same theory is applied in trend trading, and when an outside force causes a change in a stock, this moment is called a pivot.
A trend trader will analyze price movement and trends to identify key factors influencing price movements, and to know which types of trading strategies may be most useful.
For example, if a trader believes that a stock price is on a downward trend, they might take a short position (a strategy known as short-selling), selling stock and potentially rebuying later at a lower price.
On the other hand, if a trader believes that a stock is on an upward trend, they might take a long position. In other words, they would buy a stock with the belief that it might increase in value over a certain period, and that they would be able to sell it at a higher price.
Technical Analysis and Trend Trading
Technical analysis uses price patterns to forecast future movement. It’s quite different from fundamental analysis, which examines a company’s financials, like its earnings and revenue. Professional technical analysts are called Chartered Market Technicians or CMTs.
Although the time-honored market adage holds that past performance never guarantees future results, technical analysts often take into account how market psychology, and sentiments like fear and greed, may influence trends or cause them to repeat over time.
Investor Behavior
That’s why traders, then, may consider not only price movements, but how investor behavior can have big effects on price patterns. Investors may react under certain conditions in ways that are similar to how they’ve reacted to them in the past.
Stock Charts
Trend traders typically organize their data with stock charts, including candlestick charts. These charts can cover a range of time frames, and show the patterns within the trader’s chosen period.
Momentum Indicators
Analysts can measure the strength of trends and movement in price by taking a look at momentum indicators. This indicator compares the most recent closing price to previous closing prices. The momentum indicator helps investors know whether the price of a stock is moving up or down, but, more importantly, it helps them know how fast it’s moving, which may provide insight into the strength of a trend.
In a stock chart, the momentum indicator is represented as a separate line from the price line.
Volume
Stock volume is a measure of the number of shares that are being bought and sold during a given period. Another way to look at volume is that it represents investor interest in a stock. The more stock being traded, the heavier the volume and the greater the interest.
Investors can look at volume as an indicator that prices are changing, and rising volume can be a sign that stock price is starting to move in a significant way.
That said, it is also possible that high volume can represent the end of a trend. For example, investors hoping to take advantage of a rise in a stock price may pile on just as the stock price is reaching its peak and about to fall.
Support and Resistance Levels
One of the patterns that analysts will look out for when looking at stock charts are certain thresholds at which stock prices tend to rise or fall. The support level is a point to which a stock will sink but won’t usually fall any further before rising again. It is essentially the level at which demand is strong enough to bolster the price.
Conversely, there is also frequently a price ceiling that stocks will hit that may cause prices to fall back down. This is the resistance level, the level at which selling is strong enough to prevent prices from rising. Investors may pay attention to these levels, choosing to buy when prices are near the support level or sell as prices meet the resistance level.
Moving Averages
Price movement over a given period of time can make a stock chart overwhelming to look at. The ups and downs of the line can be visually confusing and messy to look at. A way to simplify and show trends more clearly is by using a moving average.
This indicator focuses less on day-to-day movement and more on average price over time. A simple moving average (SMA) takes the sum of the closing prices over a given period of time and divides by the number of prices used. So if you were looking at a three-month period, you would add all the closing prices up over that period and divide by 90.
Recommended: Support and Resistance: A Beginner’s Guide
Types of Trend Trading
You might also notice that asset prices during rising and falling trends tend to move in waves. For example, a stock price during a rising trend might rise a little, then make a brief dip before rising again, and so on. The inverse would be true for falling trends.
The end of a rising wave is known as swing high. It’s the price peak before a downturn. The end of a falling wave is called a swing low — the low point before prices rise. Traders will often zero in on these moments, using them to their advantage, helping them make buy or sell decisions, or using them as key data points for other types of analysis.
Importance of Trend Identification
Trend lines are dynamic and frequently need adjusting. That’s because stock prices don’t move in a predictable fashion. Therefore, it’s important for investors to keep in mind that stock prices may move up and down away from the trend line and that doesn’t necessarily mean that the trend has ended. Often, additional analysis is needed.
Bullish Trends
You might hear rising trends described as “bullish” because of the way they’re moving forward. Typically during these periods, there is relatively low volatility. These periods are characterized by short pullbacks on stock price, which are also known as countertrends.
In general, however, the rising trend is a series of higher swing lows and higher swing highs, meaning the price is rising over time, despite the dips in price along the way.
Because of their low volatility, rising trends may be relatively easy for the average investor to trade in. That said, the countertrends tend to be short and shallow, which can mean it’s not always easy to know when to jump on board.
Bearish Trends
“Bearish” or falling trends are characterized by a series of lower swing lows and lower swing highs. In other words the wave pattern starts to reverse itself. The falling trend markedly differs from a rising trend because there is more volatility, and highs and lows are quick to follow each other.
Falling trends can be tricky for the average investor to negotiate due to their inherent volatility. Price movements and countertrends can be big, which can make them exciting to investors, but can also make it difficult to profit off the trend.
Neutral Trends
Neutral trends tend to represent a break between rising or falling trends during which stock price moves up and down in small increments during an extended period of time. This occurs as the price bounces back and forth between levels of support and resistance, with the range between the two possibly being more narrow than in a rising or falling trend.
Think of it a bit like ping-ponging between the floor and ceiling of supply and demand. At this point the price is moving “sideways,” and if you plot the trend lines they will look horizontal and flat.
Trend-Trading Strategies, Indicators, and Techniques
Here are a few of the most common trend-trading factors, strategies, and indicators that help traders take advantage of trends.
Essential Strategies and Indicators
• Breakout trading: In a market that’s displaying strong trends, either up or down, traders may look to see signs of a breakout, i.e. a change in the trend direction. One signal of a potential breakout is when previously known indicators of support and resistance now show a reversal. Depending on the momentum of the trend, this could signal a breakout.
• Retracement trading: Retracement trading occurs when there are temporary reversals in price that nonetheless present traders with an opportunity to place a trade, and take advantage of the price change when the trend resumes. Fibonacci retracements are a type of tool that some traders use to gauge the support and resistance levels for a certain stock price.
• Support and resistance trading: Trading within the bounds of known support and resistance lines is another common strategy. Support, as noted earlier, is where the price of an asset tends to stop falling and resistance is where the price tends to stop climbing.
For traders who want to take a long position, they might enter a position near a known level of support and exit within a known level of resistance. Traders interested in taking a short position, would do the opposite.
Real-World Examples of Trend Trading
Traders use trend lines plotted against a stock price chart as a sort of map to help them know when to make trades. Trend lines either connect swing lows or swing highs. The lines connecting swing lows represent uptrends, and the lines connecting swing highs represent downtrends.
As we’ve already mentioned, there can also be neutral trend lines that move sideways.
A typical chart might have multiple trend lines plotted against it, which can help traders identify opportunities to buy and sell. For example, there might be a long ascending trend line representing an upward trend in stock price.
A trader may look for short downward trends over the same period, and the points at which those short trend lines meet the long upward line could represent opportunities to buy.
The opposite may also be true — during a long downward trend, short upward trends may provide an opportunity to sell the stock position.
Important Technical Analysis Tools
As mentioned, it’s essential to employ more than one type of tool to support whatever trend trading strategy you’re using.
Stop-Loss Order
A stop-loss order is a tool investors use to help manage the risk that prices will fall. They work when you place a stop-loss order with a stockbroker, who will then automatically sell a stock when its price falls to a certain predetermined level.
For example, say you bought a stock during an uptrend at a swing low. You might then set a stop-loss order at that price — your purchase price — in case the stock price begins to fall. (A stop-loss order may execute at a price lower than the purchase price, even if it is set at the purchase price, so it is not a guarantee against losses.)
For longer-term trend trading, investors may set the stop-loss order further away from the purchase price to allow for some of the natural ups and downs that can occur during an uptrend.
Stop-loss orders help investors lower their risk by hedging against decreases in the prices of their holdings.
Momentum Indicators
One of the most important factors traders often try to identify within a trend is how strong the trend is, which helps them answer the question: Is it likely to continue? This factor is known as momentum.
Momentum indicators compare a recent closing price with a closing price from the past. The time span between the two closing prices can be any length, and the momentum indicator can be calculated using one of two methods.
The first way to calculate momentum is simply by taking the difference between the current closing price and the closing price from a previous period. When the resulting number is positive, the current closing price is higher than the previous price, and when it’s negative the current closing price is lower.
How far the difference is above or below zero is the indicator of how fast the price is moving. So a difference of 0.75 represents greater upward momentum than a difference of 0.45. Conversely, a difference of –1.50 would indicate greater downward momentum than a difference of –1.00.
The second way to calculate momentum gives you a rate of change. You divide current closing price by past closing price and multiply by 100. When the resulting percentage is above 100, the current closing price is higher than past closing price, and when it’s below 100, the current closing price is lower. How far above or below 100 is the indicator of momentum. A rate of 90%, for example, is falling faster than a rate of 95%.
Increasing or decreasing momentum can provide buy or sell signals to investors. When looking at a momentum chart, these signals may occur when the momentum line crosses above or below the zero line. Momentum can also be used to help validate trades based on other price movements.
Moving Averages
When you look at a stock price chart it can be a bit messy, and the jagged lines can be hard to read. A moving average provides a way to organize that data more smoothly by taking the average of past closing prices over a given period of time. This much simpler line can help investors spot trends more easily.
When a stock price is above its moving average, it can indicate upward trends. When it’s below the moving average, it can indicate downward movements.
Investors may encounter two different types of moving averages: simple moving averages (SMAs) and exponential moving averages (EMAs). SMAs are the basic average of closing prices, whereas EMAs give more weight to more recent closing prices and adapt more quickly to recent price changes.
Neither method is necessarily better than the other, though depending on the other strategies you’re using, one may work better.
Benefits and Risks of Trend Trading
The relative simplicity of trend trading may seem appealing to investors, but it’s always important to know the risks involved when using any strategy.
Advantages
At its best, trend trading offers traders a time-tested system for anticipating price movements. As such, it can help guide traders to enter or exit certain positions, perhaps helping to manage risk or maximize certain outcomes.
Trend analysis is somewhat adaptable as well. Traders, as well as investors, can base their trend trading strategy on a range of applicable data points. This may include market data, fundamental analysis, economic indicators, and more. In short, there’s no one way to do trend trading; it’s a matter of experience and skill.
Potential Risks
That said, trend trading offers no guarantees of success. Traders have to be disciplined in their analysis, and resist the impulse to make decisions based on sudden price movements.
In addition, trend trading as a methodology cannot possibly take into account all market movements, never mind external factors. For that reason, experienced trend traders must learn to use a combination of tools when looking for trend confirmation, and accept a certain degree of risk.
Last, trend trading is based on historical data, i.e., past performance. While many traders believe that insights into an asset’s future movements can be gleaned this way, others debate the merits of this strategy.
Getting Started With Trend Trading: 5 Steps
It’s relatively easy to start trend trading, and many platforms provide a learning environment that simulates actual trend trading in order to help you get the hang of it. Here are a few steps to help get you started:
1. Start by opening an account that enables DIY trading.
2. Identify what you want to trade. It’s possible to take positions in a range of markets, but less experienced investors may want to start by mastering one.
3. Decide how you want to manage risk. Commonly, trend traders might use a combination of stop-loss and different types of limit orders to minimize losses.
4. Take advantage of demo testing where available. This enables you to build skills and confidence before investing in the markets.
5. Start trading, and be sure to monitor your positions and adjust as needed.
The Takeaway
Which strategy you use when buying stocks or other securities ultimately depends on your experience and understanding of different tools and techniques. If you’re a hands-on investor, trend trading is a strategy that might help you identify when to buy and sell individual stocks. Other investors may be interested in a more hands-off approach, buying mutual funds or index funds that hold large portfolios of securities that don’t require active trading strategies or technical analysis.
Ready to invest in your goals? It’s easy to get started when you open an investment account with SoFi Invest. You can invest in stocks, exchange-traded funds (ETFs), mutual funds, alternative funds, and more. SoFi doesn’t charge commissions, but other fees apply (full fee disclosure here).
FAQ
Is trend trading a good strategy?
Trend trading can be an effective strategy, especially for experienced traders who are skilled at using various technical analysis tools. While there is always risk involved in trend trading, it might be more risky for investors who don’t understand all that’s required to anticipate price movements of various assets.
Can trend trading be profitable?
It’s possible that trend trading might be profitable, and that the careful use of technical analysis could provide an advantage when making trades. But trend trading is a high-risk endeavor, and it’s not guaranteed to deliver a profit.
What is the key to trend trading?
The key to trend trading is to use a range of technical analysis tools that give you more confidence in identifying trends and executing trades.
How do I become a trend trader?
Study the markets and assets that you want to trade, learn to read price charts, and begin trading slowly in order to master the tools you need for the types of trades you plan to make. A good trend trader also knows how to manage risk, and is familiar with different types of stop-loss and limit orders that can help minimize losses.
Photo credit: iStock/ArtistGNDphotography
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