Technical analysis
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Trading the trend
‘The trend is your friend’. You’ll often hear it said by traders – and for very good reason. Here, we take a look at how trends work in technical analysis, how to identify them and more.
What is a trend?
A trend is the term for when a given market is moving in one direction overall. There are three directions in which a market can move: upwards (a bull run), downwards (a bear run) and sideways (rangebound).
Whatever your chosen style, learning how to identify and classify trends as they form can go a long way to trading successfully.
Trends come in three main types:
1. Major (primary) trends
A major (or primary) trend describes the dominant direction of a market’s movement over a long period, from several months to several years
2. Intermediate (secondary) trends
Intermediate (or secondary) trends occur within major ones when a market moves in a certain direction over a shorter time
3. Minor trends
A minor trend will appear over a very short period – often less than one day
For example, a market that has rallied significantly over the past 18 months is in a major uptrend. However, within that bull run, the market may become rangebound for several weeks or months, before resuming the rally. This would create an intermediate trend.
And on any given day, a minor bull or bear run may form.
How to trade with trends
The type of trend you’ll look to trade will depend on your chosen strategy.
Long-term investors, such as position traders, look for primary trends. That way, they can capture larger moves to earn the large profits required by their plan. Medium-term traders, such as swing traders, may seek to capture secondary trends lasting from days to weeks. Day traders and scalpers, on the other hand, will only pay attention to minor trends.
Taking a contrarian view
You don’t always have to trade with a prevailing trend – indeed, lots of investors do the exact opposite. Instead of going with the general direction of the market, these contrarians take an opposing view, hoping to profit from an impending reversal.
Whatever your approach to the markets, the difference between success and failure will often depend on how well you can time your trends. If you can open positions as they form – then close before they reverse – then you’ll soon see your profit margins grow.
Tools for trend trading
Technical analysts have lots of tools at their disposal for identifying and classifying trends.
Trend lines
Trend lines are one of the simplest methods of determining bull and bear runs. You apply them to charts, using them to identify the strength and direction of trends.
Trend lines help to smooth out the oscillations within a market’s price action, enabling you to plot the rough course of any movement. They cut through the noise to show whether there is an underlying bull or bear run.
You can spot an uptrend when there are higher highs and lows as time passes.
To apply a trend line on a chart that you believe is on a bull run, simply plot a line between three or more of the market’s low points – when it has dropped to a low price and reversed. If the line points up, then you have confirmed the uptrend. The steeper the line, the stronger the move.
Downtrends, meanwhile, are identified by ever lower highs and lows. To find a downtrend, you draw a line between three high points. If it points down, then the market is on a bear run.
While you can draw a trend with two points, it isn’t confirmed unless there are three.
Did you know? A trend is always easier to see once it is established, so aiming to capture a move in its entirety is often unrealistic. Most traders aim to capture the majority of a trend rather than its exact top or bottom.
If the lines are horizontal, then the market is rangebound.
When a market is sticking to its trend line, then you can use them as areas in which to open new positions, maximizing your profit within a trend.
Channels
You can also use trend lines to identify channels. Channels are comprised of two parallel lines, with a market’s price action bouncing between them. To find a channel, draw two trend lines – one between two high points on a chart, and one between two low points.
If the market’s price action remains between these two lines, then you can trade the channel by selling at the top and buying at the bottom.
Patterns
Lots of traders will also use chart patterns to spot trends.
When a market is in a trend, then its chart will typically show an ascending or descending staircase pattern. This is when each high or low outpaces the last.
However, there are also lots of patterns that technical traders believe can predict whether a trend is about to form or reverse. These can include triangles, flags and wedges. We cover them in more detail in our Candlestick and chart patterns course lesson.
Volume
One useful tool when looking for trends is volume. Volume tells you how much a security has been traded in any given session, and can offer insight into how strong a move is. If a market is on the up, but barely anyone is buying it, the move may not have enough momentum to continue for much longer.
Indicators
Using indicators can also assist a trader in trading with the trend.
A popular indicator used by traders is the moving average. This gives you an average of a market’s price movements over a given period and can tell you when it is about to enter a new trend. The Relative Strength Index (RSI), on the other hand, is often used to measure the strength of ongoing moves.
Indicators and patterns can both be useful when looking for trading opportunities, but they aren’t foolproof. Correct money management and risk control, as always, is imperative.
Test your knowledge
To draw a trend line on this market, which price levels would you use?
- A 120, 140 and 160
- B 100, 130 and 160
- C 95, 130 and 175
To draw a trend line on this market, which price levels would you use?
- A 1300, 1175 and 1050
- B 1350, 1225 and 1100
- C 1000, 950 and 900