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- Trend Definition – What is a Trend?
- Identifying a Trend
- Using Price Action to Identify a Trend
- Moving Averages
- Bill Williams Fractals Indicator
- ADX Indicator
- RSI Indicator
- What Creates and Sustains Trends?
- Effective Trend Trading
- Final Words
Trend Definition – What is a Trend?
By definition, a trend is the general direction in which market values or the price of an asset move. Trends can be upwards (bullish), downwards (bearish) or sideways (flat). There is no specific timeline for a direction to be considered a trend, but overall, the longer the direction is sustained, the more qualified the trend becomes.
Identifying a Trend
The easiest way to identify trends is by watching the raw price action of an asset. Price action (technical) traders believe that the information provided by candlesticks is sufficient to decipher the market. After all, they say ‘candles exhaust themselves to give light to men’. You can identify an uptrend when the asset’s price is consistently making higher highs and higher lows, while a downtrend occurs when the price is making lower lows and lower highs. The trend is sideways or horizontal when the price oscillates between fixed levels of support (the bottom-most border) and resistance (the upper). Different trends have different characteristics in terms of direction, speed, or momentum.
Trends of different nature can co-exist together, and do not have to contradict themselves. This means that it is possible to have trends within trends. There is no single correct trend of any underlying asset unless it is viewed in the context of a defined timescale. It is possible for a daily chart of an underlying asset to show that the trend is rising, but when you zoom in to smaller timeframes, such as hourly or 30-minute charts, the trend may be seen as falling.
Think of a trend like an ocean tide rising and falling. Every tide is made up of smaller waves and ripples. A tide that has been rising for the last one hour may be made up of waves and ripples that have been falling in the last few minutes. This is why rising tides eventually fall, and falling tides eventually rise. When trading, the timeframe context is very important when you seek to identify and take advantage of any trend. This is why traders perform multiple timeframe analysis. Obviously, trends on longer timeframe charts have had a long time to develop, and it will take a much more significant effort for them to change course than trends in shorter timeframe charts. Nonetheless, you can always trade the trend according to your timescale as well as price targets and risk appetite.
Using Price Action to Identify a Trend
Trending markets (uptrends and downtrends) are ideal for swing traders who can set wide price targets, whereas range-bound markets (sideways) are suitable for scalpers and day traders who seek quick profits by setting short price targets. To pick out optimal entry and exit points in a trend, price action traders use trendlines and channels. In an uptrend, a trendline is drawn from one particular swing low, connecting it to another successive but higher swing low, and projecting the line into the future. The line then acts as a dynamic support line, with optimal Buy position entry points identified when the price touches or comes close to the trendline. The reverse also applies on a downtrend, where a trendline is drawn from one particular swing high, connecting it to another successive but lower swing high, and projecting the line into the future. The trendline then acts as a dynamic resistance line, with optimal Sell position entry points identified when the price touches or comes close to the line.
In range-bound markets, the trendlines are drawn as horizontal lines along clearly defined areas of support and resistance. Traders will then seek to place Buy orders when the price is at or close to the support line and Sell orders when the price is at or near the resistance line. Trendlines serve as one of the best guides for structured price action trading. That said, the price never moves in a uniform manner, and it is important to always adjust trendlines so that they are able to deliver practical trading ideas or signals. As mentioned earlier, there are trends within trends, and this means that at any given time, there can be multiple trendlines at play.
An uptrend can be made up of multiple ‘uptrends’ or even some ‘downtrends’. When using trendlines, it is important to watch their gradient or slope. The steeper the slope, the more momentous the trend. However, steep trendlines are broken more easily than the less steep ones. In some cases, it is always advisable to draw ‘best fit’ trendlines, and not be overly bothered by tracking every swing low or swing high. In this way, price extremes or spikes can be overlooked so as to have a practical price guide in the market. Because trendlines act as a guide, it is important to always seek confluences with other price action signals. Some of the best price action signals that complement trendlines are candlestick and line chart patterns.
Chart patterns allow traders to decipher raw price action in the market. They literally help traders to track demand and supply forces in the market through price and time. Chart patterns show 3 primary signals: trend continuation, trend reversal, and trend neutrality.
- Continuation chart patterns form in trending markets, and they signal that the prevailing trend will likely continue. Some popular continuation patterns include directional wedges and flags.
- Reversal chart patterns form in trending markets as well, but they signal that the prevailing trend is losing momentum and a reversal is about to happen. Some popular reversal chart patterns include head and shoulders as well as double bottoms.
- Neutral chart patterns can form in any market to signal that a big price move is about to happen, but they do not provide any directional cue. A popular neutral pattern is a symmetrical triangle.
But not every trader loves their trading charts ‘raw’. There are other ‘sophisticated’ ways traders use to determine and trade trends in the market. Below are some of the major technical analysis tools used in order to qualify trends.
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Technical Analysis – Trend Following Indicators
Using technical analysis indicators is an important part of identifying, defining, and confirming trends in the market. These indicators are used to check past trends and to then anticipate future moves. Some examples of technical indicators include moving averages, the relative strength index (RSI), ADX indicator and stochastic oscillators. Trend trading strategies, which also include trade management rules as well as entry and exit points, often use one or more trend-following indicators to guide day-to-day trading decisions.
Moving averages are the oldest and undoubtedly the most popular technical analysis tool available. They not only help in establishing trend direction but also trend momentum and possible trend reversals. Moving averages are easy and practical to use in trend trading. An uptrend is in place if prices are above a moving average, whereas a downtrend is in place if the prices are below it. The steeper the slope of a moving average, the more momentous the trend, and vice versa. Multiple moving averages can also be combined to help traders confirm trends as well as qualify reversals. When the faster moving average is above the slower one, an uptrend is confirmed; and when the faster-moving average is below the slower one, a downtrend is confirmed. A moving average crossover can also signal a trend reversal. For instance, in an uptrend, a trend reversal crossover will happen when the faster moving average crosses the slower one downwards.
Bill Williams Fractals Indicator
They say that markets are fractal in nature, that amidst the chaos, there are repetitive patterns, which if deciphered keenly, can help one pick out lucrative opportunities. The Bill Williams Fractals indicator is a visual indicator that helps traders watch the cyclical movement of the market and pick out good entry points in trending markets, as well as spot potential trend reversals early enough. The indicator prints buy and sell fractals on a chart. A buy fractal is an arrow printed above the price. It acts as a resistance point, and traders will confirm an uptrend is in place when the price closes above the buy fractal. Similarly, a sell fractal is an arrow printed below the price. It acts as a support point, and traders will confirm a downtrend when the price closes below the sell fractal. While it is not definitive when giving trade signals, the Bill Williams Fractals indicator is more than effective for easily establishing trend direction. By simply observing the fractals, traders can determine whether the prevailing market condition is an uptrend, a downtrend, or even a sideways market.
The Average Directional Index (ADX) is a popular oscillator that helps to identify trend direction as well as trend’s momentum. It oscillates between the values 0 and 100. ADX also has the +DI (green line) and the –DI (red line). When the +DI is above the –DI, it signals an uptrend, and when the –DI is above the +DI, it signals a downtrend. When the lines are close to each other, it signals a range-bound market. It is also important to watch the centreline (value 50). When the ADX is above 50, it implies a strong trend; below that, it implies the prevailing trend is losing steam, which might be an early signal of possible trend reversal or the start of a ranging market.
RSI (relative strength index) is a popular leading momentum indicator used to determine trend strength. It is an oscillator that shows overbought and oversold conditions in the market, but it can be used to qualify the strength of trends as well. The RSI oscillates from 0 to 100, with the readings of 30 and 70 showing oversold and overbought conditions, respectively. In trend trading though, traders watch the centreline at 50. When prices are above 50, it implies that the underlying market is in a strong uptrend; whereas prices below 50 imply that the underlying market is in a strong downtrend.
What Creates and Sustains Trends?
It is important to be able to identify trends and trade with them, but it is also vital to understand what shapes and sustains them. The major influencers of trends are the fundamental factors behind the underlying financial asset and market sentiment. As an example of fundamental factors, a stock’s trend may be a reflection of a company’s economic strength. If it moves higher, it may be because of the company’s success in executing its business plan or a projection of future higher revenues and profit margins. In currencies, a currency may enjoy strength or experience weakness depending on the underlying country’s interest rates, employment, trade and other economic factors. A trend can also be created and sustained by technicians. The collective actions of technical traders may define areas of support and resistance.
For instance, if an uptrend price breaks above a defined resistance level, technicians will be inspired to join in on the move or add to their positions. This will then fuel demand, which will propel the uptrend further, even without any notable change in the underlying fundamentals. Human emotions can also sustain trends in the market. Fear, greed and confidence are the major emotions that influence trader activity, and collectively, they may determine the prevailing market sentiment. If market participants are collectively fearful, there will be negative market sentiment, and consequently, bearish pressure in the market. On the other hand, if they are collectively confident (or even greedy), there will be a positive market sentiment, and consequently, an uptrend.
Effective Trend Trading
Picking out good trade opportunities in a trend is not enough; ultimately, the success of any position will be determined by the exit point. When trading based on raw price action combined with trendlines, price targets would be ideal when using channels. Channels are essentially parallel trendlines drawn in a manner to ensure the price action is contained within the trendline borders. Channels are ideal for placing targets. For instance, in an uptrend, the upper line represents areas where the price may begin to retrace or decline, and this would be a good level to exit a Buy order. The Fibonacci tool is also vital for trend trading. The tool draws out two kinds of lines: Fibonacci Retracements and Fibonacci Extensions.
While Fibonacci retracements help traders pick out optimal trade entry points in trending markets, Fibonacci extension levels attempt to show how far the price can go. As such, Fibonacci extensions can be used to place definitive price targets points, or the exit price. Traders can also exit positions using raw price action signals, for example, reversal candlestick patterns, such as double bottom, in bullish trending markets. Exiting trade positions can be done manually or using stop loss and take profit orders. Take profit orders book a predetermined profit amount out of the market and are best applied using tools, such as channels and Fibonacci extensions as discussed above.
On the other hand, stop-losses are orders that close your position when prices move against you, so as to protect you from further losses. Stop-losses are an important risk management tool because they prevent catastrophic losses. The downsides of implementing a stop-loss strategy is that sometimes the orders can lock you out of a position that would otherwise have been profitable had it not been liquidated. This means that it is important to establish the best points to place stop-losses.
There are different types of stop-losses traders can use in the market, such as standard stop-losses and trailing stops. Standard stop-losses are best utilised in volatile markets that can turn chaotic such as during news releases. They will liquidate your position when the set price is achieved. Trailing stops, on the other hand, are moving stop-loss orders set below or above the market price. They are ideal for trading trending markets because they lock in profits as prices advance in your direction.
It is true that ‘the trend is your friend…. until it ends’. But the end of a trend need not catch you off-guard. With the proper application of price action techniques and the above useful indicator-based strategies, traders will ensure they trade with the flow, always following the cue of the market. If you are also a good friend, the trend will reward you!
What is a Trend? – main FAQs
Does trend trading work?
Trend trading has worked ever since there have been markets, it continues to work today, and it will work well into the future for one simple reason: trends exist, they can be identified, and once identified they can be traded for a profit, although of course risks exist too. Naturally there’s no way to tell when a trend will begin, or when it will end, but there are ways to identify it while it’s occurring, and once you are able to do that you are also able to capture some part of that trend on a fairly regular basis.
How long does a trend last?
The true answer to that is trends last for as long as they last. It isn’t our job to know how long a trend lasts. It is our job to identify the trends, to capture part of the trend for a profit, and to get out before the trend comes to an end and reverses. Note that trends come in a number of varieties. There are both uptrends and downtrends, and even sideways trends. There are trends that last for 5 years or longer, trends that last for a year or less, and even trends that occur over a single trading session. That’s how long a trend lasts.
How can you tell when a trend is reversing?
A market in an uptrend will continually make higher highs and higher lows. A market in a downtrend will continually make lower highs and lower lows. When you see these conditions end you know the trend is also coming to an end. So in an uptrend if price fails to make a new higher high or if it drops below the last low and makes a lower low you know the trend is coming to an end and that it will soon reverse.
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