Trend trading is a trading style that attempts to capture gains through the analysis of an asset’s momentum in a particular direction. When the price is moving in one overall direction, such as up or down, that is called a trend.
Trend traders enter into a long position when a security is trending upward. An uptrend is characterized by higher swing lows and higher swing highs. Likewise, trend traders may opt to enter a short position when an asset is trending lower. A downtrend is characterized by lower swing lows and lower swing highs.
Key Takeaways
- Trend Trading captures uptrends, where the price tends to make new highs, or downtrends, where the price tends to make new lows.
- An uptrend shows higher swing highs and higher swing lows, while a downtrend shows lower swing highs and lower swing lows.
- Trend traders use tools like trendlines, moving averages, and indicators to identify the trend direction and trade signals.
Understanding Trend Trading
Trend trading strategies assume that a security will continue to move in the same direction as it is currently trending. Such strategies often have a take-profit or stop-loss provision to lock in profit or avoid significant losses if a trend reversal occurs. Trend trading caters to short-, intermediate-, and long-term traders.
Traders use both price action and other technical tools to determine trend direction and when it may be shifting.
Price Action: Price movement on a chart. In an uptrend, traders want to see the price move above recent highs and stay above prior swing lows. For downtrends, traders watch for lower lows and lower highs. When these are no longer happening, the downtrend is questioned or over, and traders exit short positions.
Trend Trading Strategies
There are numerous trend trading strategies involving a variety of indicators and price action methods. All strategies should incorporate a stop loss to manage risk. For an uptrend, a stop loss is placed below a swing low before entry or below a support level. For a downtrend, a stop loss is placed just above a prior swing high or another resistance level.
Moving Averages
Moving Average strategies involve entering a long position when a short-term moving average crosses above a longer-term moving average or entering a short position when a short-term moving average crosses below a longer-term one. Alternatively, traders watch for the price crossing above or below a moving average.
Moving average strategies are often combined with other technical analysis to filter signals, because moving averages alone provide poor signals in non-trend markets, causing whipsaws.
Moving Averages Analysis: When the price is above a moving average, it typically indicates an uptrend. When below, it suggests a downtrend.
Momentum Indicators
Trend traders may use momentum indicators, such as the RSI, to signal entries and exits. For instance, in an uptrend, traders could wait for the RSI to drop below 30 and then rise above, signalling a long position. They may also exit when RSI rises above 70 or 80 and falls back below.
Trendlines
A trendline is drawn along swing lows in an uptrend or swing highs in a downtrend, indicating potential pullback areas. Some traders buy during an uptrend when the price bounces off a rising trendline or short during a downtrend when the price falls off a declining trendline.
Chart patterns, like flags or triangles, indicate potential trend continuation. For example, during an uptrend, a breakout from a flag or triangle signals a trend continuation.
Trend Trading Chart Example
The Alibaba Group chart illustrates how trends can be analyzed and highlight potential trades.
The price begins in a downtrend, then rises through a descending trendline, crossing above the moving average before making a higher swing high and swing low, confirming a new uptrend. Chart patterns along the way offer long position opportunities. The price then shows weakness, dropping below the moving average and breaking trendlines, signaling potential exit points. Finally, the price oscillates around the moving average, indicating no clear trend direction, before entering a downtrend again.
Related Terms: momentum, long position, short position, take-profit, stop-loss, price action, technical analysis.
