Trading 101: Trends and a Basic Trend Following Strategy
“The Trend is Your Friend”
Being one of the oldest, and probably overused, trading axiom, this is all too often overlooked by new traders. Still, if you are using technical analysis – whatever asset you are interested in – the first thing that you should be looking for is the prevailing trend. Why? Because the trend is the single most reliable predictor of a position’s success. Trading in the direction of the trend, also called trend-following, significantly increases the success rate of your positions, although it doesn’t guarantee that you will be profitable in itself.
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Trading against a trend on a given time frame is like running into a strong headwind, while trading in the direction of the trend is like enjoying a pleasant tailwind. Without a doubt, trend-reversal strategies can be very lucrative, but they are more for the experienced trader, as the success rate of those plays is low.
How can a strategy be lucrative with a low success rate, you might ask. It’s simple; several small losing trades and one huge winner that can turn into a long-term position might make those strategies attractive. But that’s exactly why they are for more seasoned players—for a beginner, it’s hard enough to make profits with a high success rate strategy, let alone endure the frustration of numerous losing positions.
So, for now, we will take study the simplest trend-following strategies and look at real-world examples of how to use them. Let’s start with job number one, identifying the trend.
The Three Types of Trends
For some, speaking about three distinct types of trends might be a surprise. But rising and falling trends don’t cover the whole picture. The third type, neutral trend, is as important as the two obvious market phases. In fact, on average, neutral trends account for as much as 60-70% of the price action of a financial asset. Understanding that will help you make sense of the day-to-day movements of your preferred assets, as well as the changing profitability of certain strategies over time.
The trends are different in many characteristics too; volatility, liquidity, the suitable strategies, the ease of trading… all of those change when the underlying trend changes. On an interesting note, there are “fake” rising and falling trends, as some assets move inversely compared to the market. Without getting into details now, some ETFs, currency pairs, and even commodities (mainly gold) tend to gain when stock markets fall and negative sentiment is dominant. This will lead to rising trends with bearish characteristics and falling trends with bullish characteristics. First, we will take a look at a generic advancing trend.
Swing-lows and swing highs inside an uptrend in the S&P 500, 4-Hour Chart
As you can see on the chart above asset prices move in rising and falling “waves”. When a rising wave ends, we talk about a local (or swing) high or top. Conversely, when a falling wave ends, it’s called a local (or swing) low or bottom. These highs and lows are very important in trend analysis. Simply put, a rising trend on a given time-frame means that the asset reaches higher highs and higher lows with wave after wave.
Of course, real life trends are more complicated than that, but this simple analysis method is remarkably effective when judging the state of a market, even if irregular swings mess things up sometime. On another note, there is undoubtedly a subjective factor in defining highs and lows that could lead to somewhat different interpretations of the same price action.
With time, all traders develop a “feel” for swings that helps them in making quick and effective decisions. As you will see, identifying swing lows and swing highs is also essential for other analysis tools like trend-lines, divergences, support/resistance levels and so on… This means that every trader will have a slightly different analysis of the same asset even if they follow the same principles. Trend analysis (and technical analysis in general) is sometimes more an art than an exact science. That said, the strategies and the underlying logic remain the same for everyone, and in the long run, these small differences don’t matter that much— a trader’s success depends more on discipline and consistency.
The Characteristics of Rising Trends
A rising, or bullish, trend is generally a steady period. Volatility is low, trading volumes are also relatively low, and the steady rising waves are interrupted by short and usually shallow counter-trend moves. An increase in volatility or unusually high volumes might be interpreted as warning signs that the trend is about to end.
Trading in bullish trends is probably the easiest, but the least “exciting” for traders. Psychologically it can also be challenging to enter these trends, because of the shallow nature of the counter-trend moves, as you have to jump into the trend when ”it’s already up so much…”. As another old adage says,
“bulls markets won’t let you in and bear markets won’t let you out”.
Don’t worry we will help you in fighting those difficulties with our coming posts.
A basic swing trading strategy
Our first strategy will be a very simple one with lots of room for refinement, but the basic logic is the foundation of a vast number of profitable strategies.
- Enter the trend when the price closes above a new high (surpasses the prior swing high)
- Set the stop-loss at (or below) the prior swing low.
- Move up the stop loss on every new swing low
Let’s take a look at our previous example for entry and exit points according to this strategy:
Entry and exit points of a basic swing trading strategy S&P 500, 4-Hour Chart
As you can see the strategy gives two clear entry- and exit-signals that capture a healthy chunk of the bullish moves, without any refinement. That said, the exits are far from being optimal, and position-management techniques could boost the returns of the strategy as well.
This strategy is designed to benefit from strong trending moves on any time-frame and sometimes it is also used as an “overlay strategy”, meaning that being on a “bullish or bearish swing” is used as a condition to boost the success rate for certain other shorter-term strategies.
The Characteristics of Falling Trends
Now that we introduced swing lows and swing highs, identifying falling, or bearish, trends will be easy. As you guessed, a series of lower lows and lower highs defines a bearish trend. Apart from the same structure, falling trends are fundamentally different than bullish trends. Volatility is usually high, price action is vicious, and the counter-trend moves are also wild. In general, bearish trends are much harder to trade, even if the larger moves make them look attractive for the novice trader. In reality, even experienced players can struggle to make consistent profits in falling markets.
Let’s take a look at the chart below to see the differences in practice (method used is shorting):
Entry and exit points of the basic swing trading strategy, USO, Daily Chart
The structure of the bearish trend is similar to our bullish example (with two distinct trending moves and consolidation periods), but especially the counter-trend moves are strikingly different. Volatility is high, and highs and lows follow each other in quick succession. Although our basic strategy remains profitable, actually trading upon these entry and exit points is much harder. Why? Well, in real time, the wild moves and the relatively large change in your profits make things that much more difficult. Also, notice the false entry point towards the end of the period—those are much more common in the volatile environment of falling trends.
Of course, with adequate position sizing techniques, more refined strategies, and risk management, bearish trends can be traded successfully, but beginners should focus their attention on rising trends. You might have noticed the trend-lines that we drew on our example charts. Being the next logical step in trend analysis, we chose to put them on the charts to help you recognize the power of them.
Trend-lines can give you early warning signs for changes in the trend; they can help you in refining your entry- and exit-points, and much more. So in our next post, we will take a close look at trend-lines, and how to utilize them. We will also dedicate a whole post on neutral trends, as they need a bit different approach compared to bullish and bearish trends.
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