What Is Trend Trading?
Trend trading is a trading strategy that seeks to profit by analyzing an asset’s movement in one direction. A trend occurs when the price moves in one general direction, such as up or down.
When a security is heading higher, trend traders get into a long position. Higher swing lows and higher swing highs describe an upswing. Similarly, trend traders may choose to initiate a short position when an asset is going downward. Lower swing lows and lower swing highs describe a downtrend.
- Trend trading is intended to capitalize on uptrends, in which prices tend to reach new highs, or downtrends, in which prices tend to make new lows.
- An uptrend is characterized by a succession of higher swing highs and lower swing lows. A downtrend is characterized by a succession of lower swing highs and lower swing lows.
- Trend traders use various tools, like as trendlines, moving averages, and technical indicators, in addition to swing highs and lows, to assist determine trend direction and perhaps generate trade signals.
Four Commonly Used Indicators In Trend Trading
Understanding Trend Trading
Trend trading methods are based on the assumption that a security will continue to move in the same direction in which it is presently moving. Such techniques sometimes include a take-profit or stop-loss provision to lock in profits or avert large losses if a trend reversal occurs. Short-term, intermediate-term, and long-term traders all employ trend trading.
Traders utilize price movement as well as other technical indicators to assess trend direction and when it may alter.
Price movement traders examine price changes on a chart. They want to see the price advance above previous highs during an uptrend, and they want the price to remain above preceding swing lows during a downtrend. This demonstrates that, despite the price bouncing up and down, the general tendency is upward.
The similar idea is used to downtrends, with traders looking to see whether the price makes lower lows and lower highs overall. When that no longer occurs, the downtrend is in doubt or gone, and the trend trader is no longer interested in keeping a short position.
Trend Trading Strategies
There are several trend trading systems, each using a unique set of indicators and price movement methodologies. A stop loss should be utilized to limit risk in all tactics. A stop loss is put below a swing low that happened previous to entry, or below another support level, in an uptrend. A stop loss is often put slightly above a former swing high or above another resistance level in a downtrend in a short position.
When searching for trend trading chances, traders often use a mix of these tactics. A trader may wait for a breakthrough above a resistance level to suggest that a move upward is underway, but will only initiate a trade if the price is trading above a specified moving average.
These techniques include taking a long position when a short-term moving average crosses above a longer-term moving average, and taking a short position when a short-term moving average crosses below a longer-term moving average. Alternatively, some traders may look for price crossings above a moving average to indicate a long position, or price crosses below the average to indicate a short position.
Moving average tactics are often used in conjunction with another kind of technical analysis to filter out signals. This might entail examining price movement to assess the trend, since moving averages offer weak signals when there is no trend; the price just whipsaws back and forth across the moving average.
Moving averages are also utilized in statistical analysis. When the price is above a moving average, it might serve to suggest the presence of an uptrend. When the price is below the moving average, it might serve to detect the presence of a downtrend.
There are several momentum indicators and tactics available. An example of trend trading would be searching for an upswing and then utilizing the relative strength index (RSI) to suggest entry and exits.
A trader, for example, may wait for the RSI to fall below 30 before rising above it. If the broad rise continues, this might indicate a long position. The signal indicates that the price has retreated but is now beginning to increase again in line with the broader uptrend.
When the RSI climbs over 70 or 80 and then falls back below the targeted level, the trader may decide to quit.
Trendlines & Chart Patterns
A trendline is a line drawn at the swing lows or highs of an uptrend or downtrend. It depicts a potential location where the price may fall in the future.
During an upswing, some traders would purchase when the market drops down and then rebounds higher off of a rising trendline, a tactic known as buying the dip. Similarly, during a downtrend, some traders choose to short when the price climbs to and then falls away from a descending trendline.
Trend traders will also look for chart formations that suggest the possible continuance of a trend, such as flags or triangles. For example, if the price rises strongly and then forms a flag or triangle, a trend trader would look for the price to break out of the pattern to indicate that the uptrend will continue.
Trend Trading Chart Example
The Alibaba Group chart below offers numerous instances of how trends may be studied, as well as some possible trades based on chart patterns and the trend.
Image by Sabrina Jiang © Investopedia2021
The price begins in a downward trend before breaking through the falling trendline and climbing above the moving average. This does not imply that the trend is positive. Before evaluating the trend up, trend traders would often wait for the price to reach a higher swing high and a higher swing low.
The price has continued to rise, confirming the new uptrend. The first chart pattern is formed when it pulls back and begins to climb again. The price breaks higher out of the chart pattern, indicating the possibility of a long position.
The upswing continues apace, producing two new chart patterns along the way. Both of these provided chances to initiate a long position or to add to an existing one (called pyramiding).
The price rises further, but then begins to show warning indications. For the first time in a long time, the price falls below the moving average. It also establishes a lower swing low and breaches a short-term ascending trendline.
Following that, the price reaches a new high before falling down below the moving average. This is not normal upswing behavior, and trend traders would generally avoid going long in such scenarios. They would also attempt to exit any remaining long positions.
The price continues to bounce around the moving average, with no apparent trend direction visible on the chart. Finally, the price begins to decline. Trend traders would be out of long positions and avoiding new ones, as well as seeking for opportunities to take short positions.
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