What is trend trading? The beginner’s guide to help you analyze markets

No matter what asset you are going to trade, trend is always your friend. In this guide, you will learn to distinguish between uptrend and downtrend, explore the most popular financial instruments and observe common trading strategies.

What is a Trend?

In simple words, trend is a general movement of the market, which shows how the market price of an asset changes. For example, a trend can be bullish (when the asset cost keeps rising) or bearish (when the asset cost keeps falling). As a rule, trends are observed in the mid or long term (from a few days to a few weeks or months). The longer direction sustains, the more well-established trend becomes. Note that when the price line is horizontal, i.e. there are no subsequent highs and lows, we are talking about a flat market - this is not a trend.

What is Trend Trading?

A trend is a direction of market movement - this is a fundamental concept in the theory of technical analysis. All tools for technical analysis have one goal: to understand the current market trend. If we look at trading charts, we can see that no asset can follow a straight line: its trajectory is a series of wave-like lines with ups and downs (a top and a bottom).

Trend following is considered a classic trading strategy since it was one of the first approaches and is still widely practiced. The principles are simple:

1. If the trend is rising, we are seeing an ascending line (uptrend).
2. If the price is going down, we are seeing a descending line (downtrend).
3. If the price does not move either up or down, but rather horizontally, a sideways trend is observed, i.e. the market is flat.

The trend-following strategy can be applied to a wide variety of time frames, but the most accurate predictions and lower risks are in medium to long-term trading, where more powerful and lasting trends are observed. Trends are ideal for swing and position trading, i.e. for traders who see and predict the market sentiment in the future. However, scalpers and day traders also pick up trends, but much smaller and of very short duration, a kind of fluctuation within the main trend.

How to Identify a Trend?

Technical analysis tools used are usually simple and understandable, however experience and training are required. Each trader, depending on the characteristics of the asset in which he invests, his individual preferences and other factors, can choose a variety of indicators, lines, periods, etc.

For identifying a trend, traders usually analyze moving averages of different periods:

• Bollinger Bands
• Alligator indicator
• Ichimoku
• Keltner channels
• MACD and ADX

As indicators are inherently lagging, i.e. reflecting the influence of events and movements in the market that have already occurred, then to predict the development of a trend and determine potential entry points in a trending market, correctly place a stop loss, take profit, trailing stop, it is also important to use oscillators.

Visually, trend direction is represented as follows: the price rises from the lower left corner to the upper right corner - an uptrend; the price from the upper left corner falls to the lower right corner - downtrend; price moves flat and horizontal - sideways trend.
But it’s not enough to notice a trend - you should understand its direction.

According to the theory of supply and demand, the market has 4 main phases of development:

1. Accumulation (sideways movement, flat, consolidation).
2. Rise (uptrend).
3. Distribution (lateral movement, flat, consolidation).
4. Downtrend (bearish).

Take a look at the chart below: any trend can rise (phase 2), go down (phase 4) or remain relatively horizontal (phases 1 and 3). Let’s review each of the trend types.

Uptrend

An uptrend is a movement in asset price where the lows and highs are constantly increasing, i.e. each subsequent high/low is above the previous ones. Thus, an uptrend identifies a rise in price over a period of time. Most traders start buying actively at exactly the rise of the trendline, but they often open positions when the bullish movement reaches its peak and crosses into the so-called price corridor, or flat, when the price is moving horizontally and preparing for the final phase of the uptrend.

The major problem of beginning traders is that at the end of an uptrend, they hold their positions longer than necessary, hoping for a continuation of the trend. As a result, they often enter late and lose their investment. The most experienced traders manage to correctly determine the moment of the end of the 1st market phase, that is, just before the price rally and open long positions.

Short positions are opened either in the distribution phase or at the very beginning of the 4th phase when the trend reverses. The current uptrend can be determined by drawing the support lines at the lows: the price at the lows, as if breaking out of the support line, rebounds, thereby increasing the highs. If the support line on the chart is pointing up, the trend is up.

Downtrend

This is the movement of asset price when highs and lows are gradually decreasing, i.e. each subsequent high/low is below the previous high/low. A downtrend identifies a drop in price over a period of time. It goes through the same phases and in the same order as an uptrend: accumulation of positions, stabilization of the trend, distribution (consolidation).

However, while an uptrend involves opening buy orders, a downtrend is the time of active selling. In a downtrend, the trend line is drawn along the highs: the price, as if meeting resistance, pushes and tends to get lower. After having corrected slightly, it goes back towards the support line and rebounds. If the vector of the resistance line on the chart is pointing down, the trend is probably down.

Pro tip: Note that a clear trend in the market can only be observed 20-30% of the time. Most days, the market is relatively neutral and flat: the price is trading within a narrow range, pushing back resistance and support lines one after another.

Trend Trading Strategies & Indicators

There is a wide range of trend trading strategies - most of them are based on indicators and technical analysis. Whatever strategy you choose, don’t forget to use a stop loss - it will help you save your funds if you fail to identify a trend or the asset’s price suddenly goes in the wrong direction. As a rule, stop loss is placed below the swing low during an uptrend, and above the prior high during a downtrend.

For higher efficiency, you can use a combination of these strategies. You can wait for the moment when the price surpasses the resistance level but enter a trade only when the asset is traded above the moving average.

Moving Averages

There are several types of moving average indicators. Let’s observe the most popular ones:

• Moving Average (MA) indicator is shown as a line based on the moving average of closing prices during a particular timeline. For example, a 1-month moving average will show the average of all closing prices within the last 30 days. Analysts watch MAs for different periods to decide whether they should expect a price rise or fall.
• Exponential Moving Average (EMA) is also based on the value of closing price over a certain period but the emphasis is put on recent data points, so this indicator reacts to price changes faster. The number of points for EMA calculation is based on the number of indicators displayed on the screen.
• Moving Average Convergence Divergence (MACD) shows the difference between short-term and long-term MAs. This difference is then displayed against another line representing a 9-day EMA (it is called the ‘signal line’). Some analysts believe that when the MACD line crosses above the signal line, it’s time to buy, and vice versa.

How to use these trend indicators? Traders usually enter long positions when a short-term MA crosses above a long-term MA, and enter short positions when a short-term MA crosses below a long-term MA.

As a rule, moving averages are combined with other forms of technical analysis to check the signals. The simplest way to use them is to watch for an uptrend (when the price is above MA) or a downtrend (when the price is below MA).

Momentum Indicators

There are several momentum indicators, and the relative strength index (RSI) is the most commonly used one. RSI is a line that moves within the range from 0 to 100 and serves to indicate whether a stock is under- or overvalued based on the recent changes in its price.

The value below 30 is an oversold signal: it means that the stock may be undervalued. Above 70 indicates that the stock may be overvalued (overbought). RSI is also interconnected with MA, but there is another subtype: Wilder’s Relative Strength Indicator uses Exponential Moving Average to provide a modified smoothing algorithm.

The logic of the RSI-based strategy is simple: you can enter when the stock is undervalued and sell when it’s overbought.

Trendlines & Chart Patterns

Trendlines are drawn along swing lows during a bull market, or along swing highs during a bear market. It allows defining the zone within which there might be a price pullback in the future.

Seasoned traders also try to buy during an uptrend when the price pulls back and then wait for another rise in the trendline. It is called ‘buying the dip’. The same strategy can be applied during a downtrend: a trader can wait for the short moment of price rise.

Trend trading also relies on a multitude of patterns, such as flags and triangles. They help to confirm a trade or its continuation. For instance, when the price is rising sharply and forms a flag or triangle, traders watch for the cost to break out of the pattern, which signifies the continuation of the bull market.

Counter Trend Trading

This strategy revolves around trying to predict a trend reversal and trading against it. As a rule, it is practiced over a medium term (a few days). Counter-trend trading is also called ‘swing trading’ because it implies finding a trend ‘swing’.

Here’s how it works:

1. A trader finds a trend pattern.
2. An underlying asset is bought when it faces a bullish or bearish shift.
3. When the trend restores, the asset is sold.

Traders practicing this approach tend to recognize small gains and quickly learn to manage risks to prevent losses if trend predictions don’t actualize.

Trend Trading Tips

Here is what you should mind when trading by trends:

1. Always use technical indicators to identify and confirm a trend. Market momentum can be efficiently detected when you use a combination of tools. Besides, the latter helps traders enter the market before a trend reverses.
2. Trend trading is usually applied to mid- or long-term strategies. Theoretically, it can be used for any timeline depending on how long the trend lasts.
3. There are three states of the market: uptrend, downtrend and sideways trends.
4. Prevailing trend trading strategies are RSI, moving averages and average directional index (ADX).
5. Even if you are sure about the trend, always prepare for trades properly and manage risks. You should always have a Plan B for saving a part of your fund in case of sudden price movements.
6. The best way to learn trend trading is to try different strategies and see what works best for you. If you are a beginner, you can start with a demo account.
7. The market is flat about 70% of the time. If you do not have experience and a clear understanding of market behavior during the accumulation and distribution phases, don’t practice trading with intraday trends.
8. The more often the price touches the resistance/support line and, pushing back, maintains the movement vector, the stronger and more stable the trend.
9. If the price rises/falls sharply and sharply, the probability of a trend reversal is higher. If the line is flatter, there is a high probability that this is a long-term trend.

You can practice the following approaches for testing your strategies:

• Classic (entering the market at the intersection of two moving averages).
• Breakout (placing a pending order and entering the market after confirming the price intention to continue the trend).
• The rollback (entering the market not immediately on a trading signal, but later, when the price is at a more favorable level).

Breakout and classic techniques are similar in some elements. For example, in both cases, not taking profit and setting a stop loss would be a rational decision. Entering the falling market is riskier, as there is no guarantee that the trend will continue as expected. Entering the market in rollback is riskier, as there is no guarantee that the trend will continue as expected - it may easily reverse in the opposite price direction.

Conclusion

If you want to start trading, learning about trends is the primary thing you should do. Although they don’t last too long, trends indicate the change of supply and demand well and allow investment opportunities regardless of price movements - up or down.

Once you learn to identify price trends in the medium or long term, the efficiency of your trading decisions will get higher. However, even if you are sure about a trend, you should always use stop loss and other tools for risk management - that will help you save funds if something goes wrong.