Successful trading relies heavily on good data and market intelligence to help a trader realise gains.
When the price of a security moves in a trajectory, it is usually due to underlying conditions and factors that prompt it to take a direction. Despite the character of financial markets to have an element of unpredictability, there still is a method to the madness. Essentially, markets are guided by fundamentals and technicals and, therefore, lend an element of predictability when seen through an analytical prism.
What is Trend Trading?
Active trading can be demanding and requires varying strategies to deal with the different situations in the market. But one that takes a practical and data oriented approach is trend trading.
Using a mix of historical trends and recent price movement, trend trading is a technique that uses these to make a prediction of the price movement. With this approach, a trader can move in to take an informed decision to use trends to make a trade. This strategy helps him use trends to take a position on security where he can expect gains.
The foundation of trend trading is based on the strong technical analysis required to understand the direction in which the market is moving. Such analysis uses tried and tested technical tools and indicators like chart patterns, oscillators and trend lines.
Trend Trading in Action
To put trend trading to work, traders just have to monitor the market and find securities that have entered a trend that can be confirmed using the past behaviour of its prices. Once identified, you should enter at the point where the trend is only forming to build. From thereon, it is a matter of holding on to your position till the trend peaks and begins to reverse.
Meanwhile, using the technical analysis, keeping a watch out for any indication of a reversal of the trend can help you be prepared to exit your position to keep gains high and risks low. It is important to differentiate a temporary blip or a retracement from an actual reversal of the trend to ensure you do not drop out of an otherwise beneficial position.
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Identifying a Trend
The purpose of adopting a trend trading strategy is to enable a mechanism of detecting a trend quickly and then utilise it to the fullest and exit the position before its reversal.
For this, the background data that helps identify a building trend lies in various points like the opening and closing prices and the range of trading done. These are processed and analysed to chart out the wave that pinpoints the highs and lows of a trend that is building.
As a trader looking to use this as a strategy, the trends you must watch out for are threefold. These are the directional trends based on the price movement that can be divided into three categories.
- Upward trend
- Downward trend
- Sideways trend
An uptrend or upward trend is associated with an increase in the trading price in the market. This uptrend can be seen in prices, say of stocks, which keep rising. There could be momentary falls but these are followed by recoveries that see it climbing higher.
A downtrend or downward trend is useful for traders who want to benefit from a falling price of an asset and plans to take a short position. Unlike the uptrend, here the motive is to cash in on the lows getting lower. There could be a momentary recovery but the overall trend is for the price to keep lowering.
The sideways trend is a run that is uncertain in its upward or downward movements but also does not test the highs and lows. This phenomenon does not interest or provoke the typical trend trader who would much rather look for an uptrend or a downtrend. But those with a much shorter trading strategy, like scalpers and range traders, are on the lookout for opportunities to make a quick profit here.
Three Types of Trends
As a trader, you would want to trade with momentum and increase the odds of a favourable outcome. Identifying a strong trend is the prerequisite that every trader should have.
All trends are not similar; some trends work better to trade breakouts and some to trade pullbacks. So, how do you identify a trend, whether it is strong, healthy or weak and gauge its strength?
The 3 types of trading trends are:
- Strong trend
- Healthy trend
- Weak trend
During a strong trend, the buyers are in complete control with no selling pressure. A strong trend suggests little to no pullback on their price, barely retracing beyond the 20MA. It is better to trade on a breakout by entering on the lower timeframe.
In this type of trend, the buyers are still in control, but with the presence of selling pressure. This type of trend has a decent retracement usually towards the 50MA, which provides an opportunity to hop on board the trend. The best way is to enter on a pullback.
Here, neither buyers nor sellers have control of the market but buyers are at advantage over the sellers. A weak trend happens when there is a steep retracement in the market. Under such circumstances, it is best to enter the trade at support and resistance levels.
Trend Trading Strategies – Three Top Indicators
Now that we know how trend trading works, the next step is to these primary trends. Most of the trends trading strategies use technical indicators. Let us take a look at the top three trend trading indicators.
Moving average (MA)
A moving average indicator is used to find the average value of an asset over a given time frame. Taking an average of the prices will remove the random price fluctuations, smoothening the price data, and producing a single line that can help traders to identify trends.
There are different types of moving average indicators - the commonly used ones are exponential moving average (EMA) which gives more importance to recent data, and the simple moving average (SMA) that assigns equal weight across all prices.
Relative strength index (RSI)
The relative strength index is a momentum oscillator that helps traders to identify whether an asset is oversold or overbought. It basically measures the speed and change of price movements over different time periods.
Average directional index (ADX)
The average directional index is used to determine the strength and direction of a trend – whether the trend is moving up or down and whether it is worth following or not. Often known as the ultimate trend indicator, ADX registers trend strength whether price is trending up or down.
Pros and Cons of Trend Trading
Trend trading, conceptually, is a powerful strategy and a popular tool used by traders across various market types. But it has its fair share of pros and cons which merits a closer look.
Pros of trend trading
It is obvious that trend trading has caught on and shown results given its efficient use of data and offering solutions that guide a trader to a better rate of registering a profit. It is strong on analytics and blends historical performance with the current trajectory to predict a repeat occurrence.
This approach of getting a past performance to repeat itself also means lesser chances of failure as there has been a precedent. This greatly reduces uncertainty and points to a more positive risk to reward ratio.
The universal nature of trend trading makes it relevant and adaptable to multiple markets. Be it stocks or forex or any other form of financial trading, data analytics is used widely and mapping trends and following them is a generic process.
The data oriented grounding of trend trading eliminates any emotional connect that could be risky in an unpredictable trading situation. It can also inculcate a culture among traders to be more data driven and objective.
Cons of trend trading
For all its strengths, even trend trading is not without its weaknesses. It still is not always guaranteed to give positive results. There can be market conditions so volatile and unpredictable that even a well analysed trend can fail, at times.
Trend trading is not ideal for those looking for a quick killing on the market. A quick tip that can be useful in intraday trading or scalping can land a good profit but trend trading is not about instant gratification. There is a gestation period where there is a slower but sure trajectory of gains that needs time to build up.
So, what are the takeaways from this review of trend trading and its various strategies that can help with successful trading?
Trend trading leverages on technical data and identifies trends based on past history and current performance to project a direction that future trading could take. This approach is a good attempt to enter a trade with a better risk to reward possibility whatever the market you are in.
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