Trading strategies
Trend trading: strategies, indicators, and examples
Trend trading is a popular style for speculating on the markets over the long term. Discover a variety of trend trading strategies and indicators that you can use.
What is trend trading?
Trend trading is a strategy that involves profiting by looking at the momentum of the asset when it moves in a specific direction, whether that be upward, downward, or sideways.
You can think of trend trading as taking the path of least resistance - if the market is rising, you will take a long position, and if it is falling, you will short sell.
This helps to break trends into primary and secondary movements. The primary trend describes the overall long-term movement. Then there are secondary trends, which are short-term fluctuations.
So, while some trend traders will take a wider position, you can also be a swing trader in a trending market - speculating on smaller highs and lows.
While the terms are often used interchangeably, following the trend is a slightly different strategy, where the trader will try to ride the entire underlying trend - from start to finish - instead of also looking for opportunities in smaller fluctuations.
How can you identify the trend?
To determine the trend, it is common to use trend lines. These are lines drawn on the price chart.
There are three main types of trends:
Uptrends
Downtrends
Sideways trends
To identify an upward trend, you need to connect two low points on the chart. If the line slopes upward, you will have an upward trend consisting of higher highs and higher lows. In this case, traders may consider taking a buy position to benefit from the upward trend.
To identify a downward trend, you would connect two peaks on the price chart. If the line slopes downward, you will have a "downtrend". It will consist of lower highs and lower lows. In this case, traders may consider short-selling in the market.
But you can combine highs and lows to find horizontal lines instead. This is known as a "sideways trend" or a market trapped in a defined range. In this case, you can take a buy or sell position to speculate on smaller fluctuations between these two lines.
How do you know that the trend has ended?
The clearest way to know a trend has ended is when a reversal occurs. This happens when the price of the asset starts moving in the opposite direction for an extended period. It usually occurs at a support or resistance point.
It is important to ensure that a reversal occurs, not just a temporary bounce, otherwise, you may end up exiting the trade too early. It is advisable to use indicators to assess whether the market is retracing or reversing, such as the Fibonacci retracement tool.
You should always attach an exit order to your position - such as a take profit or stop loss - which will automatically close your position when it reaches the specified profit or loss level. Risk management is just as important as your trading strategy when opening and closing positions.
Trend trading strategies
Trend trading strategies help determine how and when to trade - identifying new trends as early as possible, confirming them, and then exiting the market before a trend reversal.
Most trading strategies are based either on technical analysis - such as indicators and price action - or fundamental analysis as their foundation. While some others rely on a combination of both.
While trend trading itself is considered a strategy, it is often integrated with aspects of other methods, depending on the type of prevailing trend and the type of analysis to be conducted. All strategies should be used with a suitable risk management plan.
There are four common strategies for trend trading:
Breakout trading
Retracement trading
Support and resistance trading
News trading
1. Breakout trading
Breakout trading is typically used in markets with very strong trends that consistently reach higher highs or lower lows.
The idea is to identify known support and resistance levels - where the market has previously reversed direction - and study the momentum behind the current movement. If there is strong momentum at these levels, it may indicate that the market will break out of the range and a new trend will form.
2. Retracement trading
Retracement trading is more common in trends that are in the middle of strength and weakness - where they have some momentum periods, but they also have some counter-trends.
These temporary changes in the trend can provide ideal entry points for traders, allowing them to enter at a more favorable price and then benefit from the ongoing trend.
Correction traders must ensure that a full reversal does not occur and tie stop-loss losses to their positions to manage this risk.
3. Range trading
Range trading is common when there is a weak trend, which tends to happen in sideways markets that trade between known support and resistance lines.
If you want to buy a trade, you will enter the market near a known support level and exit near a known resistance level. If you want to sell a trade, you will do the opposite; open at a resistance level and close at a support level.
4. News trading
News trading focuses on fundamental factors such as corporate earnings, macroeconomic conditions, and breaking news, which affect the public's perception of the asset.
For example, you might decide that if a company has reported profits for four consecutive quarters, it is likely that its stock price will continue to rise as long as it maintains steady returns. Upon announcing the fourth quarter results, if they are positive, you would take a long position.
You will hold your position until its profit numbers turn negative - which can take months or years.
This system relies more on fundamental analysis than indicators, making it more suitable for individuals who do not wish to learn technical analysis. However, there is no harm in confirming your decisions using other tools.
Common indicators for trend trading
Common indicators for trends include moving averages and momentum indicators like the Relative Strength Index and Bollinger Bands.
Let’s take a look at each one of them.
Moving averages
The moving average (MA) calculates the average price of the financial instrument over a specific period - common choices are 9 days, 14 days, 50 days, or 200 days, but you can choose what suits your strategy.
To use the moving average in trend trading, you need to look at whether the price is above or below the average. If it is below the average, the price is likely to reverse upward into a new uptrend, and if it is above it, you are likely facing a downward reversal in a downtrend.
For example, if you want to enter a buy position, you might wait for the market to rise towards the 50-period moving average. Once the price and the indicator converge, you will wait for a candle closure in your favor before entering on the next candle, giving you a chance to confirm the upward trend.
Traders will then need to set a stop-loss below their entry point, to complete the trade if the market falls in a downward direction instead of rising again.
It is important to remember that the moving average is a lagging indicator, meaning it only shows what has happened, not what is about to happen. Therefore, it is preferable to use a moving average as part of a trading system.
Many traders place multiple moving averages of different lengths on the price chart and watch for crossovers. This strategy relies on waiting for the crossover of slower and faster moving averages as buy and sell signals. For example, if a 9-day moving average crosses above a 21-day moving average, it may be a buy signal.
Relative Strength Index (RSI)
The Relative Strength Index (RSI) is popular among trend traders as a momentum indicator. This means it measures the strength of specific trends and provides insights into whether there is enough strength behind the movement to continue or if it is too weak and will reverse.
The Relative Strength Index (RSI) measures the speed of buying by buyers and selling by sellers. It measures the average days the market closes higher compared to the days it closes lower, rating this on a scale of 1 to 100.
If the reading is below 30, this indicates that the market is in an oversold state. This usually coincides with reversal points, where more buyers see it as a sign of a declining asset price.
If the reading is above 70, this indicates the opposite, meaning the market is in an overbought state, and sellers are likely to flood the market, leading to a reversal of the upward trend.
The Relative Strength Index (RSI) can be used as part of a correction strategy. If there is an upward trend, but the RSI drops below the level of 30 before rising again, this may indicate the continuation of the overall upward trend. The indicator shows that the price has retreated to an oversold area but is rising again in line with the current trend. We can observe this on the chart below for the S&P 500 index price.
As with any indicator, it is important to understand that these signals are not 100% accurate and may give false signals. Therefore, it is essential to link any positions with risk management tools, such as stop-loss orders, trailing stop-loss orders, or guaranteed stop-loss orders.
Bollinger Bands
Bollinger Bands are another popular tool for identifying overbought and oversold levels.
The tool consists of three lines:
Middle band - a 20-day simple moving average
Upper band - the simple moving average plus twice the daily standard deviation
Lower band - the simple moving average minus twice the daily standard deviation
When the price of an asset drops below the lower band of the Bollinger Bands indicator, it can be seen as a sign that prices have fallen to very low levels in a downtrend and a reversal to a new uptrend may be about to begin.
When the price is above the upper band of the Bollinger Bands indicator, the opposite is true: the market is in an overbought condition, preparing for a downward reversal. For example, in this chart, we see the price jumping out of the upper band, beginning a downward trend.
You can also use Bollinger Bands in a weak trend, such as a range-bound market, where the price is likely to bounce between the upper and lower bands.
Many trend traders use Bollinger Bands as a guide for entering and exiting, more than as an indicator of the trend itself. The market can remain in overbought and oversold conditions for long periods.
For example, if the trend is downward, you could open a sell position when reaching the upper band. If the market is trending downward and reaches the lower band, you would not open a buy position until you are sure the trend has completely reversed. However, you can use the lower band as a guide for setting a stop-loss order.
This is why it is always important to use a combination of indicators and analysis tools to confirm signals and protect trades using risk management measures.
Trend trading with price action
The opening and closing prices of each candle can provide traders with a significant amount of information that can be used to identify new trends and reversals of current trends.
Focusing on the price chart, rather than attaching indicators, is known as price action trading.
Common price patterns to watch for are ascending and descending triangles, both of which are continuation patterns - indicating that the trend will continue after a brief struggle between buyers and sellers.
The ascending triangle appears in an uptrend. It shows when the market enters a brief period of consolidation, where price movements form a horizontal line at swing highs and an upward-sloping trend line at swing lows. The two lines form a triangle.
The pattern indicates the continuation of the original uptrend, and the price will break through the horizontal resistance line, so you can buy. If the breakout does not happen and the market declines, the pattern will have failed. Traders are advised to place a stop-loss order below the recent significant low to manage the risk.
The descending triangle pattern appears in a downtrend, displaying the opposite - a flat support line connecting swing lows, and a downward-sloping resistance line connecting lower highs. It is advised to open a sell position if the market drops below the support line.
The pattern would have failed if the market had risen instead, and you would have placed your stop-loss above the recent significant high.
What are the risks of trend trading?
There are some risks associated with trend trading that you should be aware of before entering any position:
Reversal risk. Trend trading is based on the assumption that recent price movements will continue in the same direction. However, there is always a risk of trend reversal, causing losses for traders who are on the wrong side of the trade.
Overbought/oversold risk. When trends persist for long periods, it can lead to assets entering an overbought or oversold state, meaning their prices may be inflated or undervalued based on their fundamentals. This can lead to price corrections, potentially causing losses for trend traders who do not apply risk management.
False signals. As with any indicator-based strategy, trend trading can be susceptible to false signals, meaning that price movements may not accurately reflect the underlying market sentiment. This can lead traders to take positions that do not align with the overall trend, resulting in losses.
Volatility risk. While trend trading tends to focus on long-term trends rather than minor fluctuations, market volatility can make it difficult to predict price movements, increasing the risk of sudden fluctuations that can cause losses.
You can manage your risk using stop-loss orders that automatically close your positions at specified loss levels, and take-profit orders that lock in any profits you may make.
You should always start practicing a new strategy first in a risk-free environment, such as a demo account.
Frequently asked questions about trend trading
What is the best time frame for trend trading?
Trends can appear on different time frames - you may see a downward trend on the weekly chart and an upward trend on the hourly chart. Therefore, the best time frame for trend trading entirely depends on your specific trading style. If you are a swing trader or investor, you may focus on weekly or monthly trends, and if you are a day trader or fast trader, you may look at trends on an hourly basis.
What is the counter-trend trading strategy?
Counter-trend trading is a strategy for predicting trend reversals, taking a position opposite to the current trend to capitalize on its change. Like trend trading, this involves analyzing chart patterns and indicators to find opportunities.