Trends are incredibly important to anyone that makes an attempt at earning money in the market. Just like in any other sense of the word, in the finance market the word trend is used to describe the overall direction in which a financial asset is headed. While there are several different ways that finance professionals may break down trends, there are really only a few different classifications for them.
- Short Term Trends – A short term trend is any market trend that only stays active for a short period of time. For example, if the trend is only active for a couple of days, it would be considered a short term trend.
- Long Term Trends – Long term trends just what they sound like. Any trend that lasts for a long period of time would be considered a long term trend.
- Uptrends – Any time the price of an asset is moving up overall, it is considered an uptrend.
- Downtrends – When the price of an asset is moving down overall, it is considered a downtrend.
- Sideways Trends – When the price of an asset stays relatively the same with little to no movement, it would be considered a sideways trend.
It's also important to mention that the market is a volatile place. With that being said, while tracking uptrends, you may notice short term periods of time where the value of the asset will drop. These are essentially blips on the screen as it's important to track the overall direction.
Why Traders Track Trends
History tells us that when a trend becomes apparent in the stock market, it's incredibly likely that the trend will continue; rather than change directions. So, by tracking obtaining and understanding of trends, and taking the time to identify and track them, traders are able to make more probable predictions when making trades.
How To Spot Trends
While there are several different ways to go about spotting trends, the most popular way to do so is by tracking moving averages. A moving average is essential the average price of an asset over a rolling period of time. For example, on a 20 day moving average, the price over the last 20 days would be taken into account when calculating the average. Every day moving forward, the value of the stock on the last day in the moving average is dropped out of the equation and the new value for the new day is added in.
In the world of moving averages, there are two different types. Those include…
- Simple Moving Average – The simple moving average or SMA is a hard calculation of the value of the stock over a specific period of time. Each day in the average is calculated with the same weight.
- Exponential Moving Average – The exponential moving average or EMA is calculated a bit differently. When calculating the EMA of an asset, more weight is given to more recent asset prices.
Trade the Trend as if it were your Friend
One of the classic lines in technical analysis, well known to long-time traders and beginners alike, is “the trend is your friend.” While the statement itself is simple enough, practical application of trend trading strategies can be a little more complex in actuality and do require good timing. The key to unlocking the potential of trend trading strategies falls chiefly on first identifying the trend and then applying the most basic tenants of technical analysis, namely waiting for a pullback in momentum before the trend continues. The second part is bit more tricky than it sounds, but some basic rules can help simplify the process.
Technical analysis, which forms the basis for reading asset charts, forms an important foundation for trend trading. The basic idea behind technical analysis is using historical price-action patterns as a means to predict future price behavior. While the practice does have its flaws, namely that past performance is not always a good predictor of future price behavior, it is nevertheless a good indicator. When it comes to unlocking the value of trend trading itself, the first important aspect is identifying the trend in an asset. Is a trading instrument trending higher, lower, or sideways? After identifying the trend during a time period, it is important to also change the chart time horizon to ensure that the prevailing trend during the time period you are measuring is a strong trend.
Once a trend has been identifying, the next important aspect is to attach a trend line to the trend itself. In the case of an upward trend, a trend line would be fitted to the bottom of the valleys of the higher trending peaks and valleys. In the case of a downward trend, a trend line would be fitted to the top of the peak of the downward trending peaks and valleys. Finally, in the event of a horizontal trend, a trend line would be replaced by two horizontal levels, considered in this case support and resistance. While slightly different in application, a horizontal or sideways trend also has good trend trading strategy potential.
Once a trend has been identified and fitted with a proper trend line, the next part of the strategy involves the actual timing of a trade. Although seemingly simple, timing the perfect trade takes patience and a strong understanding of how to set risk and reward. When it comes to trading trend, positions are ideally established near or at the trend line itself in the direction of the trend. The idea behind waiting for the trend to take a pause, or correct, is strongly rooted in the idea that an instrument trending will experience periodic pullbacks. These pullbacks to directional momentum can be anywhere from 30-60% of the initial move higher or lower. However, any correction that exceeds 70% or dips below the trend line is a good sign that a reversal is occurring and the trend is no longer intact.
In the event of an upward trend, a bullish position would ideally be established during a pullback that touches trend line. Conversely, in the case of a downward trend, a bearish position should conceivably be initiated during an upward correction that touches the trend line. For horizontal trends, the key is just to trade the range by establishing bullish positions at support and bearish positions at resistance. However, if the trend line or horizontal levels are broken for any reason, this is a strong indication to avoid trading that particular trend. If a trade has already been established and the trend line or horizontal level is broken, it is a sign to exit the trade and evaluate new charts for potential opportunities.
When it comes to trading trends, it is always best to get involved at the troughs and peaks of upward and downward trends respectively. Bad timing leads to buying tops and selling bottoms, putting an investor in the worst possible position to capitalize on trends. Additionally, it is important to understand when a correction has turned from a pullback into a reversal. The two situations can appear identical, so it is important to differentiate based on the 30-60% correction rules for traditional technical analysis.
Finally, even though trend trading is based on technical analysis, fundamentals such as company events, earnings, economic announcements, or geopolitical activities should not be ignored. If trading a currency pair, it is important to be aware of any upcoming data that could impact the directional momentum. In the case of commodities like oil, being aware of inventory and production figures is also relevant, because these announcements can lead to very swift trend reversals in certain cases.