In the financial markets, there is an expression: ‘The trend is your friend’; and while this phrase might make logical sense, in practice it is as opaque as it can get. But what is a trend and how do we define it as well as trade with it?
- Trend Definition – What is a Trend?
- Identifying a Trend
- Using Price Action to Identify a Trend
- Moving Averages
- Bill Williams Fractals Indicator
- ADX Indicator
- What Creates and Sustains Trends?
- Effective Trend Trading
- Final Words
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Trend Definition – What is a Trend?
By definition, a trend is the general direction in which market values or the price of an asset evolve. 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’.
An uptrend is identified when an asset’s price is consistently making higher highs and 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).
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.
But not every trader loves their trading charts ‘raw’. There are other ‘sophisticated’ ways traders use to determine and trade trends in the market. Here are some of the major technical analysis tools used in order to qualify trends:
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. The computation of moving averages allows them to smooth out price action enabling one to easily determine the trend direction.
When prices sustain above a moving average, it simply implies a confirmed uptrend is in place. Traders may infer a trend’s momentum by observing the slope of the moving average. That is, a steeper slope implies a more momentous trend, and vice versa.
To perform even further analysis, traders combine multiple moving averages. In this way, they can definitively confirm prevailing trends as well as spot potential trend reversals early enough.
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. Trend reversals are foreseen when a moving average crossover occurs. For instance, if prices are trending higher, and the shorter period (faster) moving average crosses the longer period (slower) one downwards; this signals that the uptrend may soon reverse.
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.
A swing fractal will show the extreme price in the middle of 5 periodic price bars. Thus, an up fractal has the middle candlestick with the highest high between two lower highs. Similarly, a down fractal will have the middle candlestick with the lowest low between two lower highs.
The indicator is designed to give trade entry signals: Buy signals are triggered when the price closes above a previous up fractal, whereas Sell signals are triggered when the price closes below a previous down 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 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.
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 in 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.
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 indicators, 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!
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