"The trend is your friend" is arguably one of the oldest and most often repeated adages in trading. Some would argue that it is one of the most useful. Many new traders start out attempting to "buy at the bottom and sell at the top". However, most soon realize that it is a difficult, if not impossible task. Fortunately, many traders eventually learn that riding existing trends—and acting decisively when the trend changes—can be a very effective trading strategy.
Using trend-trading tools as a catalyst to enter trades
It is one thing to use an indicator to merely identify the current trend for a given security as "bullish" or "bearish". It is another thing to actually enter into a trade based on this information. However, once a trader understands the strengths and limitations of trend trading indicators, they then have a tool to help them better identify trading opportunities.
The primary advantage of using trend-trading methods to trade is that trends can often take a long time to play out and can also run much farther and longer than traders expect. The primary limitation of trend trading indicators is simply that they do not come with a guarantee.
Bullish stocks don’t stay bullish forever. A stock or index that has been trending bullishly may not necessarily continue this trend in the future. And a trend trading strategy will generally not exit the position until after the share price has declined enough to be considered to have broken its trend. As a result, a trader who uses a trend trading strategy must accept the fact that the trend that they believe to be buying into will fail a certain percentage of the time.
The implications are that a trend trading trader must:
- Be vigilant in employing some sort of risk controls in order to limit losses on those trades where the trend fails to follow through.
- Be prepared psychologically to deal with the inevitable losing trades.
Trend trading catalyst example: moving averages
The moving average is probably the easiest to understand and most commonly used trend trading tool. A "simple" moving average merely calculates the average closing price for a given security over a specific number of trading days.
For example, a 50-day simple moving average represents the average closing price over the latest 50 trading days while a 200-day simple moving average represents the average closing price over the latest 200 trading days.
Many traders apply the 50-day and 200-day moving averages to major stock market indexes such as the Dow Jones Industrial Average and the S&P 500 index to identify the current trend of the overall market. In a nutshell when the 50-day moving average is above the 200-day moving average the overall market is deemed to be "bullish" and when the 50-day moving average is below the 200-day moving average then the overall market is deemed to be "bearish."
The moving averages employed, however, can give very different signals. The shorter the time frame the more sensitive to smaller price movement, the longer the time frame, the less sensitive to smaller price movement and smoother the line. For example, a chart that has 10-day and 30-day moving averages generates differing buy and sell signals than one that has a 50-day and 200-day moving averages.
Many moving averages exist and it is important to note that there is no "one best" moving average or combination of moving averages to use. Their usefulness and importance lies in how they complement your trading strategy and match your trading time frame.
Trend trading catalyst example: ADX (DI+ and DI-)
The Average Directional Index (ADX) uses the entire price action in a given period, from low to high, to measure the strength and persistency with which a security moves up or down. It is displayed on a scale from 0 to 100 and is designed to rise when a trend is strengthening and to decline when a trend is weakening. This holds true, regardless of the direction of the trend.
The Average Directional Index may appear differently across charting services, but is primarily made of four indicators. Among these is a pair of trend trading indicators known as DI+ and DI-. DI+ measures the percentage of positive price movement while DI- measures the percentage of negative price movement.
Traders look for DI+ and DI- "crossovers" for indications to the trend’s strength and potential changes in trend. There are two types of DI crossovers. When the DI+ line crosses above the DI- line it signals a potential change of trend to the upside. When the DI+ line crosses below the DI- line it signals a potential change of trend to the downside.
The default window for the ADX indicator is 14 days. However, for trend trading purposes traders will often look at longer day windows in order to identify the longer-term trends. Some traders will look at the overall market first before looking at individual stocks.
For example, the trend is considered to be bullish when DI+ is greater than DI- and bearish when DI+ is below DI-. If DI+ for a market index such as the S&P 500 is greater than DI- then some traders will consider this to be a bullish sign for the overall market and will focus on buying individual stocks. If DI+ for a market index like the S&P 500 is below DI- then some traders consider this to be a bearish sign for the overall market and will either stand aside or consider trading the market from the short side.
Traders might also consider applying this method to individual securities. For example, when DI+ is greater than DI- on the chart for XYZ, the trend is deemed to be bullish and when DI+ is less than DI- then the trend is deemed to be bearish.
Combining trend trading indicators
Rather than relying on one indicator, some traders will combine two or more trend trading indicators in hopes of identifying strong trends more clearly. For example, a trader might combine DI+ / DI- with a moving average, another trend trading indicator, and only act when the two are in agreement.
For example, when $SPX’s price is above the 200-day moving average and the DI+ value is greater than the DI- value then the trend is deemed to be bullish. A bullish trader might consider a strategy of looking for bullish opportunities only when both of these trend trading indicators are bullish.
Traders might also consider applying this method to individual securities. For example, when XYZ’s price is above the 200-day moving average and the DI+ value is greater than the DI- value the trend is deemed to be bullish. When price is below the 200-day moving average and the DI+ value is less than the DI- value the trend is deemed to be bearish. Traders might consider buying shares when the trend is bullish and selling shares when the trend is bearish.
Trend trading is one of the most time-tested and potentially useful approaches to trading where traders try to "swim with the tide" rather than try to fight against it. By using a trend trading method—and/or by combining more than one trend trading method—a trader can often identify the major trend for a given security.
Traders who rely on trend trading should remember that not every newly emerging trend will play out as a big price move. Frequent short-term reversals will inevitably occur at times and can be frustrating. Also, by definition, a trend trading method can never buy at the bottom nor sell at the top. Still, traders typically find that trading in the direction of the major trend offers many advantages in the long run.