Many a saying has been coined about trading. One classic stock market pearl of wisdom is “the trend is your friend,” meaning an existing trend is likely to continue and worthy of your attention.
Attempting to predict market trends in advance can be tricky business, even for experienced traders. Existing trends, however, can be identified with relative ease. Experience shows that, while there are never guarantees, profit probability is generally greater if you take advantage of an existing stock market trend rather than attempt to predict a new one.
Trading with a trend can also allow traders to take day-to-day volatility in stride, not getting too caught up in short-term fluctuations. As we will see, tracking trends allows us to observe how the market is being driven as a whole, rather than as a series of individual events that are often unexpected and difficult to predict.
Traders who properly understand the principle of “the trend is your friend” can use it to their advantage. Let’s look at some of the ways one might identify a market trend.
What is a trend?
Anyone who follows the markets for even a short while can see that prices fluctuate constantly. Identifying trends requires us to widen the lens a bit – take a step back and see the bigger picture.
Over time, it is easier to see that the market does move in a certain general direction over a longer period. This direction might be up (called an uptrend), or it might be down (a downtrend). How long of a time period varies – but experience shows that, usually, the steeper a trend is, the shorter its duration. Using technical analysis of charts and price patterns, traders can make an educated guess about the future.
3 key indicators for identifying a trend
- The moving average. A frequently used aspect of the technical analysis is the moving average, as this determines the direction of the trend. Simply stated, this is the average rate over a certain period, calculated by adding all closing prices in this period and dividing by the number of days. The most used period is 50-day and 200-day, with candles on a daily basis. Sometimes more recent values are given greater weight in the calculations.
- The relative strength index. This indicator examines whether an investment product such as a share or a commodity has been bought too much or sold too much. The value of the RSI is between 0 and 100. If the value is 30 or lower, the share is ‘oversold’ and generally given a buy recommendation. If the value is 70 or higher, the share is ‘overbought’, and generally, the advice is to sell. However, when the RSI holds its position over a period without the expected rise or fall, this would indicate a trend is occurring.
- The average directional index. This indicator is used to assess the strength of a trend, regardless of whether it is ascending or descending. The ADX ranges between 0 and 100 but very rarely exceeds 70. The basic interpretation is that values above 20 indicate a trend, and the higher the value, the stronger the trend. A rising ADX indicates that the trend is growing stronger.
How to start trading trends
Once you have correctly identified a trend, the best time to enter is at a “dip” in the trend. Keep in mind, however, that with very strong trends, these dips will be minimal.
An advantage of trend trading is that you can trade a trend whether it is up or down. If an uptrend has been identified, you will want to be buying with the trend. If a downtrend has been identified, you will want to be short selling. For more information on short selling, see eToro’s guide here.
Integral to successful trend trading is having appropriate discipline during short-term fluctuations. Many a novice traders exited too quickly due to a temporary market correction. Jesse Livermore, one of the most famous traders in history who is given credit for saying “the trend is your friend,” also said, “It never was my thinking that made the big money for me. It always was my sitting.” On the other hand, just as important is the understanding that no trend lasts forever. Don’t ignore the numbers when analysis indicates that the trend has come to an end.
Always practice appropriate risk management with any trading strategy. You want your stop loss to be set to allow for normal movement within the trend, giving it room to breathe and bounce back, yet not too far. One common technique is to set stop loss to below the low of the most recent trough, or the moving average, whichever is lower, for an uptrend. In a downtrend move your stop loss to above the high of the most recent peak, or the moving average, whichever is higher.
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