Trend Trading Overview
Trend trading is the practice of riding a security during a strong move up or down.[1] Now, what one person calls a trend can vary from trader to trader.
For example, a penny stock trader may expect a massive move higher of 20% or more intraday before considering a stock in an uptrend.
Conversely, a low volatility trader may need minor price expansion before declaring a new trend in play.
Whatever the time frame or strategy, the goal with trend trading is to identify the trend and find a way to jump on board with least amount of risk. To that end, in this post will discuss a few of these strategies and reveal how you can scan for trending stocks.
First, let’s talk about to discover the trend.
Trend Trading Indicators
When trading, the less subjectivity you have about the markets the better. Therefore, you can use technical indicators to gauge market trends.
Trend lines
Trend lines are a great way to clearly define the market trend. This can still prove to be somewhat subjective as you are required to identify the start and endpoints for the lines. But for all intents and purposes, with a little practice you should be able to identify the prevailing points of support and resistance for a clear trend.
For bullish trends, you want to connect the low points and high points to develop an up channel. [2] After all, an uptrend is only confirmed once you have a series of higher lows and higher highs.
As the stock is on its upward trajectory, the stock should not breach the prior low on its way up.
Likewise, for a bearish trend you’ll simply reverse your low and high points.
Notice that this is the exact same stock, just on the backside of the intraday trade. Trends can really help uncover which side of the trade you’re on. And the great thing about trend lines is that the more you draw with them, the more you train your eye to anticipate the direction of a stock.
This can help with setting targets and reversals as your trading develops.
Trend Channels
To take it a step further, you can use the trend channels drawing tool. These channels create a clean parallel line. However, these channels will not allow you to create wedge patterns or diamond formations.
Often, trend channels work best for more natural price action in larger cap stocks: bigger, more liquid companies.
Slope of the Line
The other point to note is that you need to identify a minimum slope of the line, which will trigger a trend for you.
A strong trend will usually have a slope north of 50 degrees to generate the level of an impulse move higher.
This is completely subjective. Nonetheless, if you are trend trading, the move should be strong enough for you to care.
Moving Averages
Moving averages are another great indicator you can use to measure the strength of a trend.
On the bigger time frame, you can take the simple approach of waiting to see if the stock is above or below its 200-day moving average. However, another approach is to look for a strong trend where the averages do not intersect on the way up. This spread of the averages shows you that the stock is trending hard for all periods (short and long).
To that point, we’ve created a scanning filter in the TradingSim application that, when checked, will eliminate stocks on a daily chart whose 20, 50, and 200 moving averages are stacked on top of each other. In other words, the 20 is above the 50, and the 50 is above the 200.
This tells us that the shorter time frames are above the longer time frames, revealing the uptrend. Of course, reverse this and you get a downtrend.
Here is what that scan filter looks like:
When one of these is checked, it will filter the results to only those stocks trending bullishly or bearishly.
You may be thinking, “why is this important?”
Well, the great thing about trending stocks is that they can offer short term traders great opportunities with pullback buys. If you’re not familiar with this strategy, be sure to check out our post on the 20 Moving Average Pullback.
Example of an Up-trending Stock
To illustrate the results from the scanning filter, here is just one stock that was populated from that list.
From the chart above, you can see that the purple 20 moving average is trending nicely above the red 50 moving average. And, down below, the 200 moving average is pointing upward as well.
All three are in alignment giving us the indication that the trend is strong.
Example of a Non-trending Stock
Now that you know what a strong uptrend looks like, notice the difference between GOOGL and this XNCR trend.
Plenty of chop, right?
The above chart has two moving averages the 10 and 20 EMA. You can see the level of backtesting the 10 has with the 20, which is a clear sign the stock is not trending hard.
Example of a Down-trending Stock
ABIO has a clear sell off after reaching climactic highs around $18. From there the stock never recovered.
The above chart is a clear example of when a stock is trending really hard. Notice how the averages do not cross at all. To add more validity to the trend, the averages are also far apart all the way down.
Just to level-set your expectations, these sort of trends are hard to find. You certainly don’t want to be on the wrong side of this trade. And, unfortunately, some selloffs never pullback for low risk entries.
Momentum Oscillators
Another indicator you can use to analyze the markets are momentum oscillators. These indicators have no upward or lower bound which allows the oscillator to run with the stock. [3]
The TRIX indicator is a momentum oscillator that moves above and below a zero line. In the next chart, we will cover a stock that is in a strong downtrend.
As this stock continue its downward momentum, notice that the TRIX is practically living below zero.
That being said, the TRIX does not react quickly because it smoothes out three exponential moving averages, so it’s a great indicator for measuring trends.
Notice how as the stock moved lower the TRIX respects the zero line. This does not mean there aren’t moments when the TRIX breaks zero by a hair or two.
Remember, in the market rarely does the price action fit nicely into a box dictated by technical analysis books.
More Trend Trading Examples
For our first example, we have a stock in a clear downtrend. You can see how the stock is making lower lows and lower highs.
Next up, we have a strong bullish uptrend with higher highs and higher lows.
Hopefully examples are helping you to see the difference. How about one more:
Can you see how the above chart lacks any trend? This is what we would call a choppy market or a security that lacks a clear trend. Most of these stocks are range bound.
Where Trend Trading Fails
Trend trading is like any other strategy in the markets. There will never be a 100% success rate. Often times a bullish trend will fail when a stock has reached a climax top, overthrows its channel, or supply becomes too heavy.
Conversely, a down trend will end when a stock has a climactic selloff, or demand comes in to support the stock.
The key is to study the trends to find consistencies in the volume and price action. [4]
Not Honoring Your Stops
When you are trading a stock that is trending, it feels great. You don’t have to do much and the money just flows into your account. However, if you jump into a trending stock at the time it reverses, you can find yourself in a pickle.
This is because being late to the party can lead to a nasty reversal as the stock could drop back down to its origination point.
So, you have to use your stops or the trending move will become your worst nightmare.
If you find yourself buying at a top of a strong trend, do not add to the position as it violates each swing low on the way back down. This is called averaging down, and it can be devastating.
In the above chart example, we’re pointing out what happens if you were to buy support in a channel of a strong uptrend that fails.
As you can see, if you did not place a stop below the low of the test, things got ugly fast and in a hurry.
Strategies to Join a Trend
Now that you know what not to do, let’s look at a few strategies to help you join the trend.
The Moving Average Pullback
Many times during a strong trend, stocks will pullback to an important moving average like the 20 or the 50 moving average. These pullbacks can provide a great opportunity to join the trend if it continues higher, all while keeping your risk low.
Because institutions love to buy at lower prices, often stocks will find support at this levels.
Let’s use our GOOGL example from above and see how buying at the 50 moving average would have been a great decision.
We were given three great opportunities to buy the pullback in GOOGL at the 50 moving average, noted by the arrows on the chart. Each one of these buys would have been a great opportunity to profit.
You could have placed a stop loss just below each consolidation if the trade didn’t work out for a small risk.
Mean Regression Trend Trading
If you don’t like using the moving averages, sometimes a channel works better. Taking the moving averages off the chart of GOOGL, we’ll add a channel this time.
Notice how the buys correspond with the channel lows, and the sells correspond with an overthrow of the channel highs.
This can be a great and easy way to manage short-term positions. Basically, you’re buying the dips at support, and selling the rips at the highs.
How Can Tradingsim Help with Trend Trading?
If you are looking to practice trading trending stocks, it will come down to your entries, stops and the method of choice. Whether it’s moving averages, channels or oscillators, you’ll need to master each method in order to develop an edge.
This is where you can use Tradingsim to practice with over 11,000 stocks and 1,000 ETFs. Be sure to drop us a line and let us know how your edge is developing!
External References
- Peterson, Nathan. The Trend Is Your Friend: A Guide to Trading Trends. schwab.com
- Perfect Stock Alert. (2011). Bull Price Channel Chart Pattern. YouTube.com
- Oscillators. Wikipedia.com
- Etiology Of Human Errors In Trading. (2016). seekingalpha.com