July 2023 saw the Indian stock markets on a bullish run and Sensex also hit the milestone of 67,000 points on July 18th, 2023. However, this peak was short-lived and Sensex contracted back to the range of 65,000 points in mere days. This swing of ups and downs of the stock markets are market trends and there are many traders who closely follow these trends to simply do trend trading. Sounds interesting? Read on to know more about trend trading and how you can make a successful portfolio out of this simple yet highly exciting trading strategy.
Read More: Trend Analysis – All you need to know
What is the meaning of trend trading?
The simple meaning of trend trading is trading as per the prevailing market trends. Market trends are the direction in which the index or the stock markets as a whole are moving. Trend trading involves identifying such trends and making suitable trading decisions to have a profitable trading portfolio. Traders believe that assets tend to move in trends and such trends will continue for certain periods due to various factors such as market sentiment, economic indicators, and news events.
Did you know – What is trend reversal?
A trend reversal is a point at which the prevailing direction of an asset’s price movement changes, transitioning from an uptrend (rising prices) to a downtrend (falling prices) or vice versa, often signaling a shift in market sentiment.
What are the different market trends?
Market trends are like the weather of the financial world. They tell you which way the wind is blowing in terms of asset prices. There are three main types of trends which include uptrend, downtrend, and sideways trend.
Uptrend
Imagine you’re climbing a staircase that keeps going higher. An uptrend is like that – the prices of assets (like stocks, currencies, or commodities) going up over a period of time. This is a good time for traders who want to buy, hoping to sell later at an even higher price. It’s like buying a shirt when it’s on sale and selling it when everyone wants it and the price is higher.
Downtrend
Now think of walking down a hill. A downtrend is similar – the prices of assets are going down. In this scenario, traders might want to sell first, and if they’re right, they can buy back later at a lower price. It’s like selling a bicycle when everyone is tired of biking and the price drops, then buying it back when people start cycling again.
Sideways Trend
Imagine standing still and juggling a ball between your hands. A sideways trend is like that – the prices of assets aren’t moving much up or down. Traders might find it a bit tricky to make big profits during this time because the price isn’t changing much. They might wait for the market to make up its mind and start moving more clearly in one direction.
Did you know – What is the breakout trend?
A breakout trend occurs when an asset’s price surpasses a well-defined level of support or resistance, indicating a potential shift in market direction and the beginning of a new trend.
What are the trend trading strategies and trend indicators?
There are various trading strategies that are used in trend trading and indicators as well that help in identifying a trend. A few popular trend trading strategies and indicators are mentioned below.
Trend trading strategies
Discussed here are a few trend trading strategies that are used by traders.
Moving Averages
Moving averages are the way to smoothen the price fluctuations during the period of consideration. They help traders identify trends by filtering out the noise and showing the average price over a specific period. In trend trading, moving averages act as dynamic support and resistance levels. Simple Moving Averages (SMA) and Exponential Moving Averages (EMA) are the commonly used modes of understanding and analysing averages.
Traders use SMAs to identify the general trend direction. If the current price is consistently above the SMA, it might indicate an uptrend while if it is below the SMA, it may indicate a downtrend. EMA is similar to SMA, but it gives more weight to recent prices. This means it reacts faster to recent price changes, making it more responsive to shifts in the trend. Traders often use EMAs for quicker trend signals.
Did you know – Does trend trading have any limitations?
Yes, trend trading has a few limitations. It can be less effective in sideways (range-bound) markets where clear trends are absent, and there’s a risk of false signals during sudden market volatility.
Trendline trading
Picture a graph showing the prices of something over time, like a stock. To understand where the price is heading, you draw lines connecting the lowest points when the price rises (upward trendline) or the highest points when the price falls (downward trendline).
- Upward Trendline (Uptrend) – Connects low points as a supportive line. If the price bounces off this line and goes up again, it confirms the uptrend.
- Downward Trendline (Downtrend)- Connects high points as a resistance line. If the price touches this line and goes down again, it confirms the downtrend.
These lines help traders predict the price direction and possible changes in trends.
Support and Resistance
Imagine floors and ceilings in a building. Support is like a sturdy floor that prevents the price from falling further. Resistance is like a solid ceiling that stops the price from rising higher. When the price approaches a support level, traders expect it to bounce back up because buyers tend to step in at this point. When the price approaches a resistance level, traders expect it to reverse downward because sellers are likely to become more active. Support and resistance levels can help traders set entry and exit points and manage risk.
Breakout Trading
Breakout trading involves capitalizing on instances where an asset’s price breaks through established boundaries, such as trendlines or horizontal ranges. This can signify the start of a new trend. Traders focus on breakouts above resistance levels, suggesting potential uptrends, or breakouts below support levels, indicating possible downtrends. Confirming indicators like volume and momentum are commonly used to validate breakout signals.
Trend trading indicators
RSI Indicator
The Relative Strength Index (RSI) is a momentum oscillator that measures the speed and change of price movements. It oscillates between 0 and 100, with readings above 70 considered overbought and readings below 30 considered oversold. The RSI is calculated using the formula: RSI = 100 – (100 / (1 + RS)), where RS (Relative Strength) is the average of up closes divided by the average of down closes over a specified period (often 14 periods). When RSI is above 70, it suggests that the asset might be overvalued and a potential reversal or corrective move could occur. When RSI is below 30, it indicates the asset might be undervalued and a potential bounce or upward movement might be on the horizon.
ADX Indicator
The Average Directional Index (ADX) is used to determine the strength of a trend, rather than its direction. It measures the strength of both up and down trends. The ADX value typically ranges from 0 to 100, with readings above 25 indicating a strong trend and readings below 20 suggesting a weak or non-existent trend. A higher ADX value suggests a stronger trend, whether upward or downward, while a lower ADX value implies a lack of a strong trend.
Bollinger bands
Bollinger bands consist of three lines, namely, a simple moving average (SMA) in the middle, and an upper and lower band that are typically set at a certain number of standard deviations away from the SMA. These bands help traders identify volatility and potential price reversal points. When the price moves towards the upper band, it indicates higher volatility, while moving towards the lower band suggests lower volatility. If the price reaches or crosses the upper band, it might be an indication of an overbought condition and a potential reversal might occur. Similarly, if the price touches or crosses the lower band, it could suggest an oversold condition and a potential reversal might be in the works.
Is trend trading a good strategy?
Trend trading offers advantages like aligning with market direction, allowing traders to capitalize on the momentum and make informed decisions through clear entry and exit points. It’s a straightforward concept accessible to traders of various skill levels, offering time efficiency by not demanding constant market monitoring. However, traders must navigate considerations such as trend reversals, volatile market risks, and limitations during sideways trends, as well as understand the importance of risk management, including the use of stop-loss orders and adaptation to changing market conditions.
Did you know – What is the difference between swing trading and trend trading?
Swing traders aim to capture shorter-term price moves within a trend, typically holding positions for days to weeks, while trend traders focus on riding longer-term price trends, holding positions for weeks to months.
Conclusion
Trend trading can indeed be useful for traders, providing a structured approach to capturing profitable opportunities by following established price movements. However, like any trading strategy, it comes with its own set of considerations and challenges. Successful trend trading requires a combination of technical analysis skills, risk management, adaptability, and a deep understanding of the specific markets being traded. Traders who can effectively identify and capitalize on trends while managing risks have the potential to achieve consistent success in the dynamic world of trading.
