Last Updated on May 25, 2022 by Neera Bhardwaj
As a trader, you buy and sell a company’s shares to profit. To trade profitably for a longer time, you need to be aware of smart trading strategies based on information derived from technical patterns, trends and charts. One such strategy is known as trend trading. In addition to being the most commonly followed set of trading techniques by professionals in equity trading, trend traders also use price action to determine a trend’s direction and potential shift.
In this article, we will take a closer look at trend trading and the micro-concepts it entails.
Table of Contents
Understanding trend trading
As the name suggests, trend trading is a market trading strategy that uses several technical indicators to identify market momentum. It is based on the core premise that trading patterns in the stock market are predictable.
Traders can thus analyse it strategically and use it to their best advantage. Experts in trend trading, for instance, evaluate gains by analysing the momentum of an asset in a specified direction. When the price of an asset moves steadily upwards or downwards, it is a sign that a trend is forming. Therefore, if a security is trending upward, a trend trader would take a long position and vice-versa.
Traders who use this strategy often operate on take-profit or stop-loss. This way, they can lock in profits and avoid substantial losses if the trend reverses.
Types of trend trading
With trend trading strategies, you can identify trends early on in a trade. This insight can help you to enter or exit a trade before a trend reverses. Trends are categorised into three types – uptrends, downtrends and sideways trends.
Uptrend
When the market price of security begins to increase in value, it indicates the formation of an uptrend. Traders usually use uptrend to enter a long position.
Downtrend
When the market price of security begins to decrease in value, it indicates the formation of a downtrend. In such a situation, traders would usually enter a short position.
Sideways trend
A sideways trend is formed when the market price of securities remains static or range-bound. In other words, the prices neither touch high points nor low points.
Traders usually tend to ignore such a trend. However, scalpers, who intend to benefit from extremely short-term movements in the market, make the best use of a sideways trend.
Strategies and indicators of trend trading
Let’s decode the indicators that traders use to identify trends:
The MACD trading indicator
The Moving Average Convergence Divergence (MACD) indicator helps traders to find the average price of a security over a specific timeframe:
- Traders use this indicator to enter a long position, usually when a short-term moving average crosses over the longer-term moving average.
- Traders may also enter a short position if a short-term moving average crosses below the longer-term moving average.
Moving averages are used for analysis, and traders usually combine the MA trend line with other forms of technical tools to determine a trend. This combination also helps to filter out the signals.
Let’s suppose the price of a security is above the moving average. This indicates the presence of an uptrend. In contrast, if the security price is below the moving average, it is a sign of a downtrend. Traders may watch for trend lines when planning to short or long a stock.
The RSI trading indicator
The Relative Strength Index (RSI) trend trading system is a strategy that identifies the momentum of prices and along with oversold and overbought signals. Traders can ascertain the RSI by observing the average profits and losses over a few specific periods, usually 14 periods. This further determines whether the movements of prices are positive or negative.
RSI is usually referred to in the form of a percentage, fluctuating on a scale from 0 to 100. When the indicator moves above 70, and below 30, the market is said to be overbought and oversold, respectively.
For example, you may wait for the RSI to drop below 30 to enter a stock. This indicates a long position, assuming the overall uptrend stays intact. The indicator shows that the price is pulled back currently and should rise again in alignment with the overall uptrend.
You could, therefore, potentially exit when the RSI rises above 70 or 80 levels. Trend traders use these levels as an indication that a trend may be moving close to its maturity.
The ADX indicator
To analyse trends, traders also use the Average Directional Index or ADX momentum trend trading strategy. The ADX indicator primarily measures the strength of a given trend. It allows traders to evaluate the security’s price strength in both positive as well as negative directions.
The line on the ADX indicator fluctuates between 0 and 100. If the indicator shows values from 25 to 100, it indicates a strong trend. However, if values fall below 25, it indicates a weak trend.
Trendlines and chart patterns
A trendline is drawn along swings – that may be high or low. A trendline is a line that indicates a possible area where the price may pull back in the future. Some traders buy during an uptrend, i.e. when the price pulls back and then bounces high off, giving a rising trendline. Similarly, some traders buy during a downtrend, when the price falls, generating a declining trendline.
Finally, trend traders also analyse chart patterns, such as flags or triangles. These determine the potential continuation of a trend. For instance, if the price rises aggressively and forms a flag or triangle, a trend trader will look at signs when the price breaks out of the pattern to signal a continuation of the trend.
In closing
To profit from stock trading over the long term, one should master technicals, fundamentals and strategies. Trend trading is a popular strategy that helps traders assess the emotion riding in the market and the sentiment of the investor, and take positions accordingly. Trend trading analyses the trend and signals the direction of the movement of the market. Thoroughly research the market and understand your risk appetite before dipping your feet in stock trading.
