Trend Trading Explained

By  //  June 27, 2023

Trend trading is a strategy used by traders to leverage the momentum of a market trend in a particular direction.

It is usually a mid- to long-term strategy as investors will seek to ride out small changes in a trend’s direction, but it can also be a profitable way to take advantage of industry knowledge in a short-term strategy. 

While the traditional idea of traders making money on assets that are gaining in value, trend trading strategies allows investors to make money by being able to predict when an asset’s momentum is shifting. Trend traders use their knowledge of their chosen markets to identify trends that they believe are likely to continue. 

A trend trader will go for a long position when an asset’s price is on an upward trend and a short position when things are tending downwards. With so much data available online, assessing the trend of a particular security is easier than ever and many traders will leverage their knowledge of a particular industry or sector to identify which trends to follow. 

The tools to spot the trends

While it may seem obvious that an upwards trend would be characterised by climbing prices at the top end, it’s also important to look at the lowest prices. If short-term gains are countered by repeated drops back to the same level, it may not signify a trend.

Investors need to look at an asset’s lowest prices as well to identify whether they are showing steady increases as this is one of the signs of an ongoing trend. The same is true of assets that are dropping in value, but traders use a variety of other tools to confirm whether it’s likely to be profitable.

These include:

Moving averages – by plotting the average price of an asset, you can condense the data about its top and bottom prices to identify trends at a glance.

Relative strength index – this is another indicator of ongoing trends as, if the index gets too high, it can mean that an asset has been overbought and will therefore be more at risk of a correction. An asset with a low RSI may have been oversold and could therefore be due a recovery, so this can be a useful tool in spotting trends in time to maximise the benefits.

On balance volume – this is a measure of the buying and selling activity pertaining to an asset, allowing investors to determine the level of market interest. This should reconcile with the price if a trend is worth backing. 

Trend trading strategies

Investors have a range of tools available to take advantage of the trends they identify, and they will develop their own trend trading strategies to maximise their knowledge and skills. 

Even with the most obvious trends, it still makes sense to manage all positions using a stop loss to minimise risk in the event of a sudden and unexpected change in direction like the real estate crash in 2008. 

Most investors will choose a recent swing high or low point for their stop loss placement or another point of support (the lowest price for an asset) or resistance (the highest price for an asset).

How to identify a trend

Experts have identified several characteristics of trends that might be about to change, and the data available on the historical performance of an asset can be used to identify whether these ring true. 

For example, if the price of a stock begins to whipsaw repeatedly and the price is oscillating wildly, it can signal that a trend is levelling out. While this can mean that the price is going to plateau, it can also mean that the trend is reversing, so it’s the kind of data that investors monitor in order to get ahead of any impending downturn.

Whipsaws can also signal volatility in the market that can spell the end of a specific trend, but they can be symptomatic of general market upheaval, so understanding the context of the data is crucial. Day traders and short-term investors can maximise the benefits of a volatile market, but excessive price movement can make it hard to identify trends.

As with all trading, research is the key to a profitable trend trading strategy and success lies in spotting the very earliest signs that a trend is about to change. Trend traders rely on their understanding of the market, their dedication to keeping themselves informed, and their ability to move quickly and decisively when they can see all the markers of a trend emerging.