We are glad to see you again!
We all need friends, both in life and in trading! Today, we will talk about a Trend Trading strategy, and we have all heard that trend is our friend when it comes to trading!
What is Trend Trading?
Trend Trading is a strategy that focused on markets that have strong momentum and a clear direction. Traders are looking to identify & make profits by taking positions in line with a trend. The main idea behind Trend Trading is simple. Traders will go long (buy) when the market is trending up or will short (sell) when the market is trending down based on the assumption that the price will continue moving in the same direction as the trend. It is not uncommon for trends to continue for days, weeks or even months (depending on the market conditions and timeframe used to find the trend). However, traders have to be very strict with their risk management and always use appropriate Stop Loss levels in case the trend stops and reversal occurs.
How to spot a trend?
The best trends are those that you can identify with price action by simply looking at the chart! A trend will form a series of swing high or low points! The bullish uptrend is defined by higher highs and higher lows. The bearish downtrend is defined by lower lows and lower highs.
When analysing the trend you can use all the help that you can get, including technical analysis, trading indicators, price patterns and other various tools you may be familiar with!
What about Timeframes?
The good news is that you can find trends in any timeframe! However, always remember that you may see different trends depending on the timeframe you analyse! You should also always consider the strength of the trend you want to trade: generally speaking, trends on a higher timeframe tend to be much stronger and longer when compared to the trends you can see on a smaller timeframe. Analysis of Price Action, Correction & Consolidation and use of Technical Indicators can also help you determine the strength of the trend you identified.
It should not come as a surprise to find ‘trends within trends’! Depending on the timeframe used we can identify Long Term Trends, Mid Term Trends & Short Term Trends.
Long Term Trends are usually found on the highest timeframes (such as weekly or monthly) and trading this kind of trend would require traders to have a large capital, large-stop losses and a lot of patience! These are a type of trades that could take months (and even years) to reach your Take Profit levels!
Mid Term Trends can occur within the Long Term Trends! These are usually looked at on a Daily timeframe. Positions are held no longer than a couple of weeks or months.
Lastly, Short Term Trends can be found in the Mid Term Trends by looking at lower timeframes (such as the 1H or 4H). These are the trends that will only last few weeks at most! They are heavily affected by all factors, including political or economical news releases, changes in volume or market sentiment, and more!
What are the stages of the Trend?
Let’s break it up a little bit! We can identify four main stages when looking at a trend:
The Beginning - the early stage of the formation of a new trend that takes place after the previous reversal. You can expect large price fluctuations at the start as traders are unsure about the direction of the trend (and whether the reversal has finished). This is the stage with one of the highest risk factors as the price will re-test various levels before it moves (or not) to the second stage.
The Momentum - the second stage is where the new trend has already been established. More and more traders are entering their positions generating momentum that will drive the price movement in the direction of the new trend. At this stage, the likelihood of a successful trade is the biggest.
The Distribution - the third stage is characterised by the momentum slowing down, formation of certain chart patterns (such as double tops or bottoms) and the general consolidation of the price around key levels. The market may start trading in range before it reaches the final stage.
The End (of Trend) - the last stage of a Trend cycle is the end of the trend. This is when most traders will close their positions leading to a reversal and Traders anticipation of a new Beginning!
When to enter?
As already discussed, the second stage of the trend is one with the highest likelihood of profitable trade, as such most traders will look to enter their positions when the trend has already developed itself and is showing strong momentum. But the question about entry-level remains!
How do we know when to enter?
It is important to remember that all trends will always have pullbacks or dips. These are generally the best times to enter a new position and increase a likelihood of a successful trade with a healthy Risk to Reward Ratio. Always stick to risk management and only enter a position with appropriate Stop Loss levels in place. These Stop Loss levels should allow your trade some breathing space to cater for all the noise on the chart as you expect the price to bounce back and move with the trend. The most common approach to set relevant Stop Loss levels is to place the Stop Loss above the moving average or high of the recent peak (in a bearish trend) or below the moving average or low of the recent trough (in a bullish market). You should also identify key support/resistance levels as some traders use them as Stop Loss levels (with the size of your position accordingly adjusted).
What can I use to identify a trend?
As already discussed, the best trends are visible on the charts when you look at them. However, various tools can also help you trade with the trend! These include:
Trend Line - a straight line on the chart that connects the pivot highs/lows of the price showing the direction of the trend. The strongest trend lines will connect with at least 3 points on the chart.
Support/Resistance Levels - lines on the chart that represent some major price levels where the price failed to break through at least twice in the past. It is important to check various timeframes and be aware of major support/resistance levels to ensure you enter a high probability trade and not one that is about to hit a major support/resistance level that may slow down or consolidate the trend.
Moving Average (MA or EMA) - the average closing price over a specific period is used by traders to determine the direction of the trend. Most common are 50MA or 200MA (or EMA when traders want to give more importance to the most recent values).
Relative Strenght Index (RSI) - another indicator that indicates whether the asset is overbought (over 70) or oversold (under 30), providing some insights when to sell or buy or how likely the retracement is going to be.
The Average Directional Index (ADX) - an oscillator used to determine the strength of a trend. If the value is below 20 the trend is considered to be weak, while values over 50 indicate a strong trend.
You’ve made it to the end of today's lesson! Make sure to join us next week as we are going to introduce another trading strategy!