Basic Concepts of Trend Trading
As a trader, you might have come across the term “the trend is your friend.” Trend trading is perhaps one of the oldest and a safe way to trade the markets. Just as there are many different ways to bell a cat, so it is with trend trading as well.
You can trade the trends by using the help of technical indicators. The most common ones are the moving average, MACD, Average Directional Index (ADX) indicators. You can also trade the trends by making use of price action techniques such as trend lines, chart patterns and so on. Regardless of which methods you use, success with trend trading comes out of practice and experience. In this article you will learn all there is to know about trend trading. We start by covering the basics and understanding what a trend is. The next step is to know how to spot a trend and finally we look at how you can trade the trend.
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What is Trend Trading?
Trend trading is nothing but trading the security or an instrument in the direction of the trend. The reason why trend is your friend is because by taking a position in the direction of the trend, you are trading with the majority of the traders. Thus, the chances of going wrong or being stopped out is less compared to other methods of trading.
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Although trend trading is simple, the confusion comes from the fact that there are different ways to interpret the trend. For example, one trader might look at the daily chart and determine that the trend is down.
Another trader can look at the same chart but on a one-hour time frame and argue that the trend is up.Both are right in some ways. It can be easy to fall into the trap of looking at the market from a isolated point of view. Thus, it makes sense to take the broader perspective. The question is of course, understanding how trends work and spotting a trend in the market.
The Advantages of Trend Trading
Trend trading has significant advantages compared to other forms of trading. Trend trading is probably the easiest even for beginners to trading. While there might be many arguments about counter-trend trading or scalping, the benefits with trend trading far outweigh other forms of trading.
The benefits of trend trading can be seen by the fact that there are numerous trading strategies. The most popular of course is the Turtle Trading Strategy. There are of course many other strategies that are equally popular, but nothing comes as close to the Turtle trading method which was made famous decades ago.
With trend trading, the most important part to remember is that you are trading with the majority. Thus, the risks are low. But of course, success with trend trading depends on how you take a position, at which point of the trend do you enter a trade and what are your take profit levels when you are in the position. The key to understanding these questions depends on how well you know and can interpret the trends.
The 3 Types of Trends – Uptrend, Downtrend and Sideway Trend
Trends are broadly classified into an uptrend and a downtrend. As the names suggest, an uptrend is where prices are bullish and reaching new highs. A downtrend is where prices are falling or bearish and reaching new lows. Depending on what the prevailing trend is, traders can either go long (or buy) into an uptrend or a bull market or go short (or sell) in a downtrend or a bear market.
The third way is of course the sideways market or the sideway trend. As the name suggests, in the sideways market, prices tend to turn flat, neither going up or down. This is where traders tend to make the biggest mistake. It is never advisable to enter a trade when the markets turn sideways. The first chart below shows an example of all the three trends within a single time frame.
The above chart shows a very simple depiction of a trend. First, we have the uptrend where prices rise rapidly reaching a high. Then almost immediately, price falls back posting lower highs. Finally, we have the sideways market which is the most dominant in the above price chart. Here, prices simply oscillate up and down within a range. As you can see, if you were to go long or short, chances are that your trade would have hit some losses. To spot a trend, it is important to know the characteristics of the trend itself. This is done usually by looking at what price is doing.
How to Spot a Trend or determine the trend?
Spotting trends can be easy and requires a bit of practice. In an uptrend, price tends to rise (obviously). But this is also characterized by the higher lows and higher highs that are formed in this uptrend.
In Figure 2, we have an example of an uptrend. Here, you can see that price has been rising gradually. Notice the peaks and troughs that are shown by the horizontal lines. Each of the subsequent highs and lows should be higher than the previous highs and lows.
Higher Highs = Uptrend.
Lower Lows = Down Trend.
In the next example, we have an illustration of a downtrend. It works similar to the uptrend. We identify the new lower lows and new lower highs in price. In figure 3, we can see that price has been steadily declining. Notice how in this downtrend, price has been making lower highs and lower lows? At every point in the downtrend, price continued to bounce back from the decline but only made a high that was lower than the previous high, while making new lows that were lower than the previous lows in the downtrend.
How to Trade the Trend Effectively?
Trading a trend is very simple. It can be classified into 3 points.
- Identify the trend
- Confirm the highs and lows in the context of the trend
- Enter when the previous high or low is breached
Identifying the trend is something that we have already covered previously. Once you determine the trend, the next step is to plot the previous highs and lows which become our reference point.
So, for example if you spot a downtrend, then you would look for a lower high and then wait for price to break the previous low (and ensuring that a lower high is also formed) and go short. Likewise, if you spot an uptrend, then you would look for a higher high and wait for price to break this previous higher high (while ensuring that higher low has been formed) and you would go long on the market.
The chart below gives an example of where you would enter a trade and where you can place your stops. The same concept applies for an uptrend as well. As for where to place your profit levels, you can either use a 1:2 risk reward set up or manage your positions so that you book profits regularly within the trend.
We are not at the end of this sharing and hope that you realized that trend trading is very simple and can be easy to master. This is especially useful for beginners in trading. You can apply the concepts of trends to any market, from forex to futures and stocks.
Given the simplicity of trend trading, traders can spend time to understand how trend trading works. Once you have the experience you can quickly build your own technical indicator or even price action based methods for a successful trend trading strategy.