Trend trading explained
In simplest terms, trend trading is about buying and selling securities in the direction of the trend.
Normally a price trend is detected with the technical indicators. These indicators are used in two primary ways. 1) to identify the direction of trend; and 2) to measure the strength of the trend.
Trend trading can be applied to different time frames. For positional traders, trend trading involves daily or weekly positions. Intraday traders focussed on trend trades that are much shorter in duration.
How easy is trend trading? Let’s find out.
How to identify a trend for trend trading
Trend trading requires you to identify trends. Ideally, the trend indicators should detect price trends as early as possible – so that you can ‘ride’ the trend as soon as practically possible.
‘Wait a minute,’ you may ask, ‘What type of trend are we talking about?’ In terms of direction, trends move in the following ways:
For example, Segro Plc, a UK-based property security, exhibits a long-term uptrend whereby prices move steadily higher over time. Characteristics of an uptrend include: Higher highs, higher lows, regular and short consolidations. What is the best course of action here? Buy and hold.
When a security keeps depreciating, it is said to be in a downtrend. Characteristics of a downtrend are: Lower lows, lower highs, short and sharp rebounds. One good example would be Intu (INTU), which is suffering from a persistent drop in share prices.
When a market price is neither trending up or down, it is ranging sideways. Hence we called it sideways trend. During a sideways trend, you will see prices bound on both sides. In terms of supply and demand, it is said to be in equilibrium. A good example is Johnson Matthew’s (JMAT) weekly chart. Prices have ranged in between 2,200 and 3,800p with failed breakouts on either side.
Seven Tips on Trend Trading
- Watch for diverging trends between different time frames. For example, a stock may exhibit a long-term uptrend but is current stuck in a medium-term downtrend. This can create confusing trend determination. In this case, you have to stick to the system. Plan ahead and ride it out.
- Trend measurement depends on the technical indicators you use. The most frequently used trend indicator is the moving average. Calculating a moving average involves averaging past prices to create a smoothed trend line. But it is a lagging indicator and not predictive. Others use the so-called ADX or breakout method. In most cases, trend indicators have its ups and downs. Learning as much as possible about the indicators you are using: Advantages and pitfalls.
- The more important thing about trend indicators is not to vary the parameters too often. Once you decide to use a particular indicator, stick to it and be consistent about the parameter values. For example, you can fix three trend indicators as follows:
- Long-term – 150 or 200-day exponential moving average (ema)
- Medium-term – 100-day ema
- Short-term – 50-day ema
- Trend indicators are seldom used alone. They are often used in tandem with momentum indicators or pattern recognition. Once you have a few combinations, the system can become complex. It is best to have the fewest moving parts as possible. Backtest the overall system if possible, paying particular attention to three things:
- Past drawdown
- Past volatility
- Signal reliability
- In most trend methods, there is the possibility of ‘whipsaws’. This means that prices are not trending consistently. Sometimes up; sometimes down. This is then filtered back to trend indicators, which then move all over the place. In this case, one either reduces the position size of each bet or move aside from trading.
- Diversify into multiple markets when trend trading. This is because not all securities will trend together. Sometimes, bank stocks trend upwards. At other times, government bonds or gold trend downwards. Therefore, it is best to have signals coming from a wide variety of uncorrelated markets. Start from a market that you are familiar with, before moving onwards into other markets.
- A risk management strategy is a must when trend trading. This is because of
- Trend failures – Trend aborted halfway
- Trend reversals – Sharp counter-trend moves driven by random factors
- False Trends – Signals not translated into trends
A trend – even consistent ones – can show any of the above at any time. Good trend traders will there utilise both stops and limits to protect their trades. Stops will ensure that small losses do not grow to account-killing losses. Remember, no system is going to be 100% accurate at catching every trend.
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Jackson has over 10 years experience as a financial analyst. Previously a director of Stockcube Research as head of Investors Intelligence providing market timing advice and research to some of the world largest institutions and hedge funds.
Expertise: Global macroeconomic investment strategy, statistical backtesting, asset allocation, and cross-asset research.
Jackson has a PhD in Finance from Durham University.