Trend trading has been the best trading strategy for the past 30 years.
The price of an asset will always trend, and these trends can be traded up or down for profit.
The market can trend either upwards, downwards, or sideways.
Trend following has worked well in the past, works well today, and it will excel in the future.
The world will always change constantly and it’s hard for anyone to predict the start and the end of a trend until it becomes a record.
However, with a sound strategy, you can take advantage of the changes that happen in the market to make money by capturing the bulk of the trend.
Trend following is all about good business principles.
So, your goal should be to come up with business principles that adapt and the ever changing world will not hurt you materially.
The adapting nature of trend following makes it easy to pull in profits from the marketplace.
So, trend traders benefit when the market is trending.
Trend following is simple to implement and easy to follow.
Due to this, it is a common trading technique among retailers.
In this article, I will help you know more about trend trading and acknowledge that it works.
What is Trend Trading?
Trend trading is a great way to benefit from large market moves in the marketplace without having to spend much time in front of the computer.
Trend traders look for trends and identify low risk entry points from which they hold their positions until the trend makes a reversal.
This trading style is applicable to most asset classes and it can be very profitable when given adequate diversification, strong risk management, and the discipline to stick to the system.
A trend is a sustained price move in one direction.
Trends can be formed in any financial instrument, including forex pairs.
Trends can also be formed in different timeframes, but the longer the timeframe, the larger and the more rewarding a trend is.
When trading using this trading strategy, traders use technical indicators to determine the direction of the market momentum.
Other traders rely on the price action alone to know the direction of the market.
Of course, such traders check the market swings to know whether the price is in an uptrend or in a downtrend.
The price forms different swings when it’s in an uptrend from when it’s in a downtrend.
Trend following works based on the idea that markets have an element of predictability.
So, after analyzing historical trends and price movements, you can predict what will happen in the future.
Trend following is common among traders who prefer using a position trading or a swing trading style.
Position traders hold a trade for the entire period of a prevailing trend, ignoring the day-to-day fluctuations, while swing traders identify a trade and ride it from start to finish.
Trend traders enter long positions when the market is in an uptrend.
An uptrend normally shows higher swing lows and higher swing highs.
During the uptrend, the bulls are said to be controlling the market.
Due to the buying activities of the bulls, the price of the forex pair keeps on rising.
The consolidations that happen as a result of profit taking activities of the buyers lead to the formation of the higher lows.
Trend traders enter short positions when the market is in a downtrend.
A downtrend normally shows lower swing lows and lower swing highs.
Trend traders assume that the trend will keep on moving in the same direction that it is currently moving.
They use take-profit or stop-loss as the mechanism to help them lock-in profits and avoid incurring huge losses in case the trend makes a reversal.
Trend following is used by short, intermediate, and long-term traders.
To determine the direction of the trend and know when it may reverse, the traders use both price action and other technical tools.
When the market is trending upwards, trend traders want to see the move above the recent highs, and once the price falls, it should stay above prior swing highs.
This acts as a signal that although the price is oscillating up and down, its overall trajectory is up.
They also use a similar concept when the market is trending downwards.
They watch the market to see whether the price will create lower lows and lower highs.
When this stops to happen, the downtrend will be over or questionable, hence, the trend trader will no longer have interest to continue holding the short position.
The Search for Magic Bullet
Most traders love volatility because being on the right side of a moving market can help one make money.
If the market is stagnant, it means that there is no opportunity for traders to make money.
Most traders are looking for the magic bullet to help them make it as trend traders.
However, there are no secrets to trend following, but only hard work.
Here are some of the wrong views about the market that some traders hold…
- My trading style tells me when the market will be able to follow through.
- The markets have changed.
- Profit targets are wise.
- Trend following has changed.
- Short-term technical analysis that predicts direction works well.
Here is how trend followers should respond…
- It’s impossible to predict a follow-through of a market trend.
- Neither the market nor the trend has changed.
- If one trend trader fails, it has to do with the trader’s greed or fear, not trend following.
- All trend followers trade in a similar fashion.
- Profit targets are a prediction. Setting trends will make you miss out on making profits because you will exit the trend when it’s too early.
- There exists no trading technique that can help traders to predict the market direction.
Always see big trends as epidemics.
An epidemic begins with a small number of people and spreads to a large population by multiplying again and again.
So, the epidemic trends.
Extreme market trends can start from out of nowhere and move either up or down.
The trends normally feed upon themselves and they can quickly progress geometrically and give traders who trade the trend to make huge profits.
However, this can give traders a really hard time because just like an epidemic, the end result will seem out of proportion to the cause.
They seem to ride the trend to understand it rather than to make profit out of it.
Instead of gearing towards winning, they are geared towards being right.
If you want to appreciate why trends or market progressions can be very rewarding, don’t expect proportionality.
You must know and accept the fact that in some cases, big market changes follow small events, and in some cases, that change can happen so quickly.
The trend following strategy has been designed to identify and exploit such market trends long before arriving on the radar screen of the masses.
Impatience vs. Wisdom
You know that the price of a forex pair will always move up and down.
The price will always make such movements.
The most important thing for you to note is that there is an irresistible force behind these movements.
However, avoid being too curious about the reasons behind the price movements.
If you do, you will be risking clouding your mind with unnecessary stuff.
This is an enemy to all forex traders and an avenue to making losses.
Just know that there is a movement and take advantage of it to steer your speculative ship along with the tide.
Don’t try to argue with the condition or combat it.
Zero Sum Trading
The winning traders can only win to the extent that other traders are willing to lose.
Traders develop the willingness to loss once they obtain external benefits from trading.
The most important external benefits are the expected returns from holding risky securities that represent a deferred consumption.
Gambling and hedging provide other external benefits.
There cannot be markets without utilitarian traders.
Their losses will fund the winning traders who make the prices efficient and provide liquidity.
In the long run, the winners will profit because they have consistent advantages that allow them to win slightly more often and far larger profits than losers.
Trend following will provide these consistent advantages.
In the zero-sum game, one can only win if another person loses.
In any particular market transaction, you may have equal chances of winning or losing, but in the long run, you will only profit because you have persistent advantage that allows you to win more slightly than you lose.
If you have ever studied edges in gambling or played poker, the words ring true.
To make profit in the long run, you have to know your edge, know when it exits, and exploit it when you can.
If you don’t have an edge, and you are trading for other reasons, you can’t win.
The market players who lose in the long run are the commercial hedgers.
The reason is that hedgers use the market for risk insurance, and insurance premiums are costly.
Of course, there will be bad speculators in the market and these will also provide winners with their gains too.
Although it sounds counterintuitive, if you buy higher highs and sell short lower lows, then you use solid money management to manage and exit trades, you will be able to find a mathematical edge in the long run.
It will hold up with time robustly.
The forex market is brutal, so forget about being loved.
If you have to win, someone else will have to lose through their hedging or bad strategy.
If survival for the fittest seems uneasy for you, stay out of the zero-sum game.
If you need to become a successful trend trader, you should first know how to determine whether the market is trending or range-bound.
However, trend following doesn’t apply in range-bound conditions because there is no real trend in price direction, so, you don’t have to expect the market to bounce back after the pullback.
Although there are many philosophies and indicators that surround trend identification, it is a very simple process.
For an uptrend, a trend is simply a series of higher highs and higher lows.
For a downtrend, a trend is a series of lower lows and lower highs.
Many consecutive higher highs and higher lows in an uptrend are an indication of a strong trend.
Many consecutive lower lows and highs in a downtrend are an indication of a strong trend.
Furthermore, if these points are more defined, it’s a sign of a strong trend.
In most cases, trend identification is a qualitative act.
Ample experience reading charts may be needed.
Consider the chart give below…
The above chart shows a time during which the price of a forex pair is in an uptrend.
The uptrend has been shown by the green arrow running upwards on the chart.
The uptrend is made up of higher highs and higher lows.
The chart also shows that during the uptrend, each consecutive high is higher than the previous high.
Also, each higher low is above its previous higher low.
Until the cycle breaks, the market is considered to be in an uptrend.
Other than the above simple approach, you can use technical indicators to identify trends.
Examples of such indicators include the moving averages, relative strength index (RSI), average directional index (ADX), On-Balance Volume (OBV), and many others.
Let’s discuss some of these and know how to use them for trend identification…
#1: Moving Averages
This is a technical indicator that helps traders to determine the average price of an asset over a particular timeframe.
It creates a smoothing effect on the price data, generating a single line that traders can use to identify trends.
There are different choices for the moving average indicator, and the choice depends on the trader.
Moving averages are lagging indicators, and they move slower than the market price.
This means that the moving averages cannot help you to predict what will happen in the market in the future, but they instead tell you what has happened in the market in the past.
Moving averages can be very helpful to traders because their direction can tell trend traders of the direction of the market.
When using a single moving average on a price chart, you should focus on whether the price is above or below the moving average.
If the price is above the moving average, it’s a signal that there is an uptrend in the market while if the price is below the moving average, it’s an indication that there is a downtrend in the market.
However, the best way to use the moving average is by looking for crossovers between two moving averages since this can act as a signal of a change in the market direction.
In most cases, these will be two exponential moving averages (EMAs), one faster EMA and another slow EMA.
Consider the chart given below…
The above chart shows two exponential moving averages added on the price chart of a forex pair.
One EMA is faster than the other EMA.
The faster exponential moving average has been set to 10-day period while the slow moving average has been set to 15-day period.
The trader should enter a long position when the faster EMA crosses the slow EMA from below.
This is because it acts as a signal that there is a bullish trend in the market, hence, you can make profit from the rising price of the forex pair.
When the faster EMA crosses the slow EMA from above, it acts as a signal that there is a bearish move in the market.
This creates a good time for the trader to enter a short position.
If you were in a long position, you can exit immediately and enter a short position.
Alternatively, you can watch the market for when the price crosses above a moving average to send a signal of a long position, or when the price crosses below the moving average to send a signal of a short position.
Mostly, traders combine moving averages with other technical analysis tools so as to filter out signals.
For example, a trader can look at the price to identify the trend because moving averages don’t give good signals when the market is not in a trend.
During such times, the price only whipsaws back and forth across the moving average.
Moving averages are also used for analysis.
When the price is above the moving average, it signals the presence of an uptrend in the market.
When the price is below the moving average, it signals the presence of a downtrend in the market.
#2: ADX (Average Directional Index) Indicator
The ADX indicator helps traders to determine the strength of a trend, whether it’s up or down.
Its values range between zero and 100, with values between 25 and 100 signaling a strong trend, and the strength increases as the numbers get higher.
The indicator values below 25 are a signal of a weak trend in the market, and the trend gets weaker as the values get lower.
The ADX line is usually plotted on the same window as the DMI (Directional Movement Index).
The DMI comes with two other lines, the negative direction indicator (-DI) and the positive directional indicator (+DI).
Traders use the ADX line to determine the strength of the market trend, but the +DI and –DI lines help the trader to determine the direction of the trend.
If the +DI line crosses the –DI line while the ADX line is below 25, it’s an indication of an impending uptrend in the market.
This means that the traders can consider entering long positions.
When the –DI line crosses above the +DI line at a time when the DMI line is above 25, it is an indication of an imminent downtrend in the market.
This means that it’s a good time for traders to take short positions.
If they were in long positions, they can exit immediately.
Consider the chart given below…
The above chart shows the DMI indicator added on the price chart of a forex pair.
The lines of the indicator have also been marked accordingly.
When the +DI line crosses the –DI line and starts to trend above it, there is an uptrend in the market.
If the DMI line is below 25 at the same time, it’s an indication that the market is in a very strong uptrend.
So, it’s a good time for traders to exit short positions and enter long positions.
When the –DI line crosses the +DI line and starts to trend above it, it’s a signal that there is a downtrend in the market.
At the same time, if the DMI line is above 25, it’s an indication that the downtrend is very strong.
Traders should then exit their long positions and enter short positions.
#3: RSI (Relative Strength Index) Indicator
The RSI indicator is used by traders to determine the momentum in prices.
Traders also use it to identify the overbought and oversold levels in the market.
The indicator looks at the average gains and losses over a given number of periods, mostly 14 periods, and then ascertains whether more price movements were positive or negative.
The RSI indicator is represented using percentages, and its values range between zero and 100.
Indicator levels above 70 are an indication that the market is overbought, while indicator levels below 30 are an indication that the market is oversold.
Traders use these levels as signals that the trend may be reaching a level of maturity.
Traders should note that the market may remain in an oversold level for a long period of time.
Also, it’s worth noting that the RSI indicator does not signal an immediate change in trend.
The reason is that even though the RSI values range between zero and 100, the market price can range over a much larger set of values.
A trend trader in a long position will use an overbought signal as the price point at which to lock in their profit and exit their trade.
On the other hand, a trader looking to enter a short position will use an overbought signal as the entry point.
The vice versa is true for trend traders who use the oversold signal, they will use oversold signals as the point at which they should exit short positions and enter long positions.
#4: On-Balance Volume (OBV) Indicator
Volume is a very important indicator to forex traders.
The OBV indicator takes a significant amount of volume information and compiles it into a single one-line indicator.
The indicator measures the cumulative buying and selling pressure by summing the volume on “up” days and then subtracting volume on “down” days.
The volume should confirm price trends.
If the price is in an uptrend, the OBV should also be in an uptrend, and if the volume is in a downtrend, the OBV should also be in a downtrend.
If a disparity between these two occurs, it could be sending another signal.
Consider the following chart…
The chart given above shows the OBV indicator added on the price chart of a forex pair.
The OBV has been added on a separate window at the bottom part of the chart.
From the chart, it’s clear that the price of the forex pair is trending higher with the OBV indicator.
The green line added on the indicator window shows the trend line for the OBV indicator.
The OBV never managed to drop below its trend line, hence, the price will continue trending higher even after the pullbacks.
If the OBV shows that it is rising but the price is not, it acts as a signal that the price will most likely follow the OBV in the future and begin to rise.
If the price of the forex pair is rising at a time when the OBV is falling or flat-lining, the price could be nearing a top.
If the price of the forex pair is falling at a time when the OBV is falling or flat-lining, the price could be nearing a bottom.
Consider the chart given below…
The chart given above shows instances at which the behaviors of the price action and the OBV indicator match.
The black line added on the indicator window shows a time at which the indicator is falling or flat-lining.
At the same time, the price action shows that it has reached the peak.
The black line added on the price chart clearly depicts this.
The green line added on the indicator window shows that the indicator is rising.
At the same time, the price action is also rising.
So, traders can use the OBV indicator to tell the direction in which the price is moving.
If the price is rising and the OBV is flattening, it’s a signal that the price has reached a peak.
If the price is falling and the OBV is flattening, it’s a signal that the price has reached a bottom.
Risk management is very important in trend trading.
The forex market is too volatile today because of the diverse set of market participants.
Due to this, there will be times when the market will move in directions that you didn’t expect.
A stop loss is the best way to ensure that you are protected against unexpected market moves.
A stop loss is triggered when the price begins to move against you, helping you to exit the trade early enough to avoid incurring a loss.
Although you may incur a loss, it will be very minimal.
The use of a trailing stop loss is one of the greatest stop loss techniques.
It is a special type of stop loss that helps traders to make more profit.
It works by shifting its position once the market moves in a direction that favors you.
Each time that the trailing stop loss shifts its position, it locks in the profits that the trader has accrued in his account so far.
This process continues to recur as long as the market moves in a direction that favors the trader.
It means that if the market makes a reversal, the trailing stop loss will be triggered a bit earlier and you won’t incur much loss.
Other traders prefer using an ordinary stop loss.
The problem with the ordinary type of stop loss is that you may exit the market only for the price action to resume its previous move.
This means that you will watch the market moving in a direction that favors you as you are out of trade.
When using this type of stop loss, avoid placing it too close to the price action.
The reason is that price consolidations normally occur in the market, mostly due to the profit taking activities of the traders.
If the stop loss is placed too close to the price action, it will be triggered by such market consolidations and you will exit the market when it’s too early.
This may make you miss on making potential profits.
In trend trading, a tight stop should be considered to be less than two ATR (Average True Range) and a wider stop loss should be between two and four ATRs.
When buying trending instruments, there are high chances that your position can reverse and hit its stop loss before it turns into a major trend.
So, a typical trend following system will give a win rate of 30-50%.
This means that you must be prepared to handle many losses.
In trend following systems, the goal of risk management is to keep your risk on each trade as small as possible so that you can be able to tolerate a long string of losses without a large drawdown.
You must also keep small positions so that you can hold a highly diversified portfolio of instruments.
With a greater diversification, there are high chances of you catching a large trend in one of your positions.
However, it has a flipside in that in case you diversify too broadly, your positions will be too small such that when you catch a large trend, you will not be able to make large profit.
You can backtest your trend following system and optimize the risk per trade and the maximum exposure on every trade will help you find a sweet spot for your position size.
Remember that trend following gives you clear answers like when to take profits for a winning position or when to exit a losing position.
One of the major components of trend following is identifying your position size after making an entry into the market, meaning that you should have a specific rule that helps you determine how much you can buy or sell depending on the amount of money that you have.
Leverage and Margins in Trend Trading
Just like with other trading strategies, trend traders can use leverage.
Through leverage, you can combine a small portion of your money with a more substantial amount of borrowed money.
With leverage, you can trade even when you don’t have enough capital.
Due to this, leverage is expressed as ratios to show the amount of money that you can trade based on the amount of money that you have.
If you choose a leverage of 100:1, it means that you can increase your trade size by up to 100 times.
So, if your trading account has approximately $1,000, it is possible for you to trade as much as $100,000.
However, for you to be allowed to trade, you will be required to have a minimum amount of cash, which is normally referred to as the margin.
The margin is normally expressed as a percentage stating how much your brokerage firm needs from you in order to open or maintain a position in the trending market.
From the example we have given above, you can trade on a $100,000 contract provided you meet the 1% margin requirement of your broker.
The margin can help you know the maximum leverage that you can get in a particular trade.
Leverage can help you trade more than you could have done if trading cash alone, but you have to do it correctly.
However, it is worth noting that leverage is a double edged sword.
It can help traders to increase their exposure and grow their profits a bit quickly.
On the other hand, if you are leveraged and the market moves against you, your losses will increase quickly.
So, choosing the right leverage is good for you as a trader.
Forex traders should consider leverage levels of between 5:1 and 10:1.
Your broker can choose to give you more, but that does not make it a good idea.
Always remember that your risk of blowing up your trading account increases exponentially with an increase in your leverage.
Also, consider limiting the risk per trade to between 0.5% and 1% of your trading account depending on the system.
Impact of Trend Trading on Trader’s Emotions
The psychological difficulty that most traders face is that trend trading requires you to be wrong most of the times.
However, the fact that most people require to be subconsciously right makes this emotionally challenging.
Newbie traders normally need to be reassured that they are doing well, and this reassurance should come from winning trades.
However, that is not how trend following works.
Instead of focusing on winning trades or on being right, focus on your total profitability.
This is what you’ve learned in this article…
- The trend trading strategy involves determining the direction of the market momentum and trading based on that.
- Trend following is a mid to long-term trading strategy, but theoretically, it can cover any timeframe depending on the period for which the trend lasts.
- It is a good way for traders to exit the market early enough to avoid making losses.
- The price action is enough for a trader to identify market trends.
- When the price action is in an uptrend, it is characterized by higher highs and higher lows.
- When the price action is in a downtrend, it is characterized by lower lows and lower highs.
- You can also use technical indicators to identify market trends.
- Examples of such technical indicators include the Relative Strength Index (RSI) indicator, Average Direction Index (ADX) indicator, and the On-Balance Volume indicator.
- Trend followers take advantage of the volatility of the forex market to make profit.
- When the market is in a range or making a sideways movement, it does not provide trading opportunities for trend traders.
- The reason is that the traders cannot know whether the market will make an uptrend or a downtrend after the range.
- When trading using this trading strategy, you will record a win rate of 30-50%.
- This means that you should come up with a proper risk management strategy to prevent you from incurring huge losses.
- The best approach to this is the use of the stop loss strategy.
- It will help you exit your position immediately the market begins to move against you, preventing you from incurring a loss.
- A trailing stop loss will shift its position each time the market moves in a direction that favors you.
- This way, you will exit the trade at the right time and increase your chances of making more profit.
- Through leverage, you can combine a small portion of your money with a more substantial amount of borrowed money.
- This means that it can help you trade even when you don’t have enough capital.
- However, you will be required to have a minimum amount of cash, which is normally referred to as the
- However, consider using low leverage levels when trading forex.
- The reason is that the risk of blowing up your trading account increases exponentially with an increase in your leverage level.