As a forex trader, you must know how to trade using the trend following strategy.
The market will always trend, either upwards, downwards, or sideways.
Taking advantage of these trends is one of the ways through which you can trade forex.
The general idea behind this trading strategy is that once in a while the financial market will produce a strong bias.
The cause of the trend is the fundamental reason causing the price of the security to move either upwards or downwards.
The good thing with this kind of trading strategy is that you don’t need to be an expert in forex since the price of the forex pair in question will create the trend.
However, you must understand the market psychology and know when to enter as well as when to exit the market while ensuring that you have made profit.
You should understand the market fundamentals very well such as the key industry players.
This is what is called smart money.
When such traders are entering the market with large positions, large footprints will be left on the charts.
More smart money investors will then buy, followed by early trend followers, and finally, the masses pick up the trend and get involved.
At some point, the market will have risen or fallen to extremes which will cause the smart money to get involved again.
Basically, it will be good for a trader to catch a trend as early as possible to maximize his returns, but it will not be good for a trader to enter the trade early since it’s easy to get involved in false trend charts.
Since this trading strategy is easy and simple to implement, it has become very popular among retail traders.
In this article, I will help you understand the trend following strategy in depth.
What is Trend Following Strategy?
This is a trading strategy that allows traders to identify and take advantage of the market momentum.
When trading using this trading strategy, you must use technical indicators to determine the direction of the market momentum.
It works based on the idea that markets have an element of predictability.
So, when you analyze historical trends and price movements, you can be in a position to predict what will happen in the future.
It is considered to be a mid to long-term trading strategy, but theoretically it can cover any timeframe, depending on the period taken by the trend.
It is mostly used by traders who prefer using a position trading or a swing trading style.
Position traders are those that 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.
A trend is said to have been formed in the market when the price is moving in one overall direction, either up or down.
Trend traders normally enter long positions when the market is trending upwards.
An uptrend is normally characterized by higher swing lows and higher swing highs.
The trend traders normally enter short positions when the market is trending downwards.
A downtrend is normally characterized by lower swing lows and lower swing highs.
The trend traders assume that the trend will keep on moving in the same direction that it is currently moving.
The strategies normally have a take-profit or stop-loss provision to help them lock-in a profit or avoid big losses in case a trend reversal occurs.
This trading strategy is used by short, intermediate, and long-term traders.
To identify the direction of the trend and determine when it may be reversing, the traders use both price action and other technical tools.
When the market is in an uptrend, they want to see the move above the recent highs, and once the price falls, it should stay above prior swing highs.
This is a signal that even though the price is oscillating up and down, its overall trajectory is up.
A similar concept is applied to the downtrends.
The traders 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 in question, and the trend trader will no longer be interested in holding the short position.
How to Identify a Trend
As we stated earlier, trend trading strategies are designed to help traders identify trends as early as possible and exit the market before the price makes a reversal.
The opening and the closing price, as well as the trading range of every individual candle provides traders with useful information that they can use to identify the flow of the trend.
There are three types of trends that can be formed in the market namely uptrends, downtrends, and sideways movements.
An uptrend is formed when the market price is increasing in value.
If you need to take advantage of this, you can enter a long position when the market is reaching increasingly high price levels.
You will then make profit from the increase in the price of the forex pair.
A downtrend is formed when the market price is decreasing in value.
In such a case, a trend trader should enter a short position because the market is falling to lower price points.
Consider the chart given below…
The above chart shows an instance at which the price action was in a downtrend and another instance at which the price action was in an uptrend.
The point at which the market is in an uptrend has been shown by a black arrow running upwards and marked as Uptrend.
This is a good time for the trend traders to enter long positions and buy the forex pair.
They will make profit from the bullish move.
The point at which the price action is in a downtrend has been shown by a red arrow running downwards and marked as Downtrend.
This is a good opportunity for traders to enter short positions and benefit from the bearish move in the market.
The market is said to be in a sideways movement when it is neither reaching higher price points nor lower ones.
Consider the chart given below…
The above chart shows an instance at which the price of a forex pair is in a sideways movement.
This has been shown by the two black lines running horizontally on the price chart.
The price seems to be moving in between these two lines, hence, they can be seen as the support and resistance lines.
The support is the black line shown at the bottom while the resistance is the black line shown at the top.
When the price hits the support line, it bounces off it upwards.
When the price hits the resistance line, it bounces off it downwards.
Majority of trend traders will not notice the presence of these trends in the market, but range traders or scalpers who need to take advantage of the extremely short-term movements in the market will put effort to identify these bounded movements.
Trend Following Strategy Indicators
Forex traders try to isolate and gain profit from trends.
The trend trading method tries to capture gains by analyzing the momentum of the market in a particular direction.
There are many ways through which you can do this.
You must note that there is no single technical indicator that will help you become a successful trend trader.
Other than technical analysis, you should be good at risk management and trading psychology.
Let’s discuss the various tools that are popular among traders who use the trend following strategy…
This is a technical analysis tool that finds the average price of an asset over a particular timeframe.
This way, it creates a smoothing effect on the price data, creating 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 an indication 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.
The faster exponential moving average has been set to 9-day period while the slow moving average has been set to 14-day period.
The trader should enter a long position when the faster EMA crosses the slow EMA from below.
The reason is that this is a signal that there is a bullish trend in the market, hence, the trader can make profit from the increase in the price of the forex pair.
Whenever the faster EMA crosses the slow EMA from above, it’s a signal that there is a bearish move in the market.
This means that it’s a good time for the trader to enter a short position.
If the trader was in a long position, he can exit immediately and enter a short position.
Alternatively, a trader can watch for when the price crosses above a moving average to signal a long position, or when the price crosses below the moving average to signal a short position.
In most cases, traders combine moving averages with other technical analysis tools to filter out the signals.
For example, a trader may look at the price action to determine the trend because moving averages don’t give good signals when there is no trend in the market.
In such cases, the price just whipsaws back and forth cross the moving average.
Moving averages are also good tools for analysis.
When the price is trending above the moving average, it’s an indication of an uptrend.
When the price is moving below the moving average, it’s an indication that there may be a downtrend.
#2: RSI (Relative Strength Index) Trend Indicator
This trend indicator helps traders to determine the momentum in prices as well as the overbought and oversold levels.
It achieves this by looking at the average gains and losses over a given number of periods, mostly 14 periods, and then ascertaining whether more price movements were positive or negative.
The RSI is normally represented in the form of a percentage, and its values range between 0 and 100.
When the indicator moves above the 70 level, the market is said to be overbought, and when the indicator moves below 30, the market is said to be oversold.
Traders use these levels as signals that the trend may be reaching a level of maturity.
As a trader, you must note that the market can remain in an oversold level for a very long period of time.
It’s also worth noting that the RSI does not signal an immediate change in trend because even though the RSI values range between 0 and 100, the market price can range over a much larger set of values.
Usually, a trend trader in a long position will use the 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 open a short position will use the overbought signal as the entry point.
Trend traders who use the oversold signal will do the vice versa, they will use the oversold signal as the point at which they should exit short trades and enter long trades.
#3: ADX (Average Directional Index) Trend Indicator
The ADX indicator is used by traders to determine the strength of a trend, whether it’s up or down.
The values of the ADX indicator range between zero and 100, with values between 25 and 100 signaling a strong trend, and the strength increases as the numbers get higher.
ADX values below 25 are an indication of a weak trend, and the trend gets weaker as the values get lower.
The ADX is usually plotted on the same window as the DMI (Directional Movement Index), which comes with two other lines, the negative direction indicator (-DI) and the positive directional indicator (+DI).
The ADX line helps traders 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 acts as a signal that an uptrend is about to start.
This means that the traders can consider entering long positions.
If the –DI line crosses above the +DI line at a time when the DMI line is above 25, it acts as a signal that there is an imminent downtrend.
Traders can then take short positions.
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.
Whenever the +DI line crosses the –DI line and begins to move above it, there is an uptrend in the market.
If at the same time the DMI line is below 25, it’s an indication that there is a very strong uptrend in the market.
This is an ideal time for traders to exit short positions and enter long positions.
Whenever the –DI line crosses the +DI line and begins to move above it, there is a downtrend in the market.
If the DMI line is above 25, it’s an indication that the downtrend is very strong.
This is the right time for the traders to exit long positions and enter short positions.
#4: On-Balance Volume (OBV) trend indicator
Volume is a very valuable indicator, and the OBV indicator works by taking a significant amount of volume information and compiling it into a single one-line indicator.
It measures the cumulative buying and selling pressure by adding the volume on “up” days and then subtracting volume on “down” days.
Generally, the volume should confirm trends.
If the price is rising, the OBV should also be rising, and if the volume is falling, the OBV should also be falling.
Consider the chart given below…
The above chart shows the OBV indicator added on the price chart of a forex pair.
The OBV has been added on the bottom part of the chart.
The chart shows that the price of the forex pair is trending higher with the OBV indicator.
The green line drawn on the indicator section shows the trend line for the OBV indicator.
The OBV never dropped below its trend line, hence, this acts as an indication that 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 is rising and the OBV is falling or flat-lining, the price could be nearing a top.
If the price is falling and the OBV is falling or flat-lining, the price could be nearing a bottom.
Consider the chart given below…
The above chart shows instances at which the price action and the behavior of the OBV indicator match.
The black line on the OBV indicator shows a time at which the indicator is falling or flat-lining.
A closer look at the price action during the same time shows that it has reached the peak.
This has been shown by the black line drawn on the price chart.
The green line drawn on the OBV indicator shows the indicator rising.
A closer look at the price action at the same time shows that it is also rising.
So, you can use the OBV to tell the direction in which the price is moving.
Whenever you see the price rising and the OBV flattening, it’s a signal that the price has reached a peak.
And whenever you see the price falling and the OBV is flattening, it’s a signal that the price has reached a bottom.
How to Start Trading using the Trend Following Strategy
Here are two major steps that you should take before you can start trading using the trend following strategy…
#1: Create a plan
Before you can open a position, you need to come up with a plan.
This involves knowing what you want to trade in terms of forex pairs.
Some traders who use the trend following strategy choose to focus on a particular forex pair, but it will be good for you to diversify the opportunities in order to gain exposure to more trends.
Diversifying your opportunities will also give you an opportunity to spread your risks.
Always remember that forex is a very dynamic market and anything can occur.
After choosing what to trade, you should keep up to date with the latest developments that can impact the prices of currencies.
This means that you keep on following breaking news, political events, and central bank policy announcements.
#2: Implement a risk management strategy
There are different ways to protect yourself from losses, but most traders prefer using stops and limits.
Limit close orders normally exit a position at a more favorable market price.
This way, they allow the trader to lock in some profits.
Stop losses on the other hand will close a position after the market has moved against the trader by a predetermined amount.
When entering a trade, a trader is advised to set a stop loss order.
The reason is that the forex market is very dynamic and the market can begin to move against you unexpectedly.
However, if this happens, your stop loss will be triggered and you will automatically exit the trade.
This will protect you from incurring a loss.
One of the greatest stop loss techniques is to use a trailing stop loss.
It is a special type of stop loss that can help you make more profit.
It shifts its position the moment the market moves in a direction that favors you.
Each time that the trailing stop loss shifts, it locks in the profits that you have made so far.
This process keeps on recurring as long as the market moves in a direction that favors you.
This means that in case the price makes a reversal, the trailing stop loss will be triggered a bit earlier and you won’t incur much loss.
However, when using an ordinary stop loss, don’t place it too close to the price action.
The reason is that price consolidation usually occur in the market, mostly as a result of 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.
This is what you’ve learned in this article:
- The trend following strategy involves using technical indicators to determine the direction of market momentum.
- It is normally considered to be a mid to long-term trading strategy, but it can theoretically cover any timeframe, and this will depend on the period for which the trend lasts.
- With the trend trading strategies, you can identify trends when it’s early and exit your positions before the market makes a reversal.
- The market can be in any of the three types of trends at any particular time, uptrend, downtrend or sideways trend.
- Most trend following strategies use technical indicators such as moving averages, average directional index (ADX), and the relative strength index (RSI).
- Before you enter the market, it is good for you to have a proper plan and know how you will be managing your risks. No trading strategy can work well without these.
- Try different trend indicators to know the ones that seem to work well for you. You can then implement them in your trading strategy.
- The two common types of risk management strategies used by trend traders are limit and stop orders.
- The limit order helps a trader to exit the market at a more favorable price point.
- Stop orders help traders to exit the market once the price begins to move against them.