Identifying trends in trading

Trends form in financial markets for a variety of reasons that can contribute to a sustained directional movement in the price of the asset. Let’s look at how to identify trends for the purpose of trend trading.

How do I identify a trend?

Aside from making a general observation by looking at a chart and seeing the direction in which a price is moving, there are other quantifiable ways to determine and measure trends. These include observing basic price action, moving averages, the relative strength index and the average directional index.

Observing price action

Identifying a trend through price action involves analysing the movement of an asset's prices on a chart without relying on technical indicators. One of the ways of doing this is by using trendlines.

A trendline is an illustrated line that provides a visual representation of the trend's direction and strength. You can think of them as lines that connect two or more high/low points that extend into the future. Find out more about trendlines and how to use them here.

Remember that trends can change over different timeframes, so you might want to analyse multiple timeframes to get a more granular view of how short-term movements affect the overall trend. Combining price action analysis with other technical and fundamental tools can provide a more comprehensive understanding of the market's dynamics.

Moving averages

The moving average (MA) is a technical indicator used by traders to spot emerging and common trends in markets. In a nutshell, a moving average helps you to find the average of various data points. It's especially useful for spotting trends and making sense of price movements by removing the random ups and downs, so we can see the bigger picture more clearly, revealing the main path the data is taking. It’s calculated by adding up the prices for a certain number of periods (such as days or hours) and then dividing by the number of periods. In stock market analysis, a 50-day or 200-day moving average is often used to see trends and indicate where stocks are headed.

There are different types of moving averages, but two common ones are the simple moving average (SMA) and the exponential moving average (EMA):

• SMA: This moving average calculates the average price over a specified number of periods equally. For example, a 20-day SMA would add up the closing prices of the last 20 days and then divide by 20
• EMA: The EMA gives more weight to recent prices, making it more responsive to recent price changes. As a result, EMAs tend to react faster to market price movements compared to SMAs. It can sometimes be referred to as the exponentially 'weighted' moving average

To use a moving average to identify a trend, you need to observe the interaction between the price and the moving average line on a price chart. If price is above a moving average, traders will generally take a long position. If the price action is below the moving average, they will take a short position.

Using two moving averages, such as the 50-day and 200-day moving averages, can help you identify an uptrend in a financial market.

For example, you could plot both the 50-day moving average (representing a shorter-term average) and the 200-day moving average (representing a longer-term average) on your price chart. Because you're looking for an uptrend, which is characterised by higher highs and lower lows, you want to see the price consistently trading above both the 50-day and 200-day moving averages.

One common way to identify an uptrend using moving averages is by looking for a ‘golden cross’, which is when the shorter-term moving average (50-day moving average) crosses above the longer-term moving average (200-day moving average).

If the price remains above both the 50-day and 200-day moving average and the moving averages themselves continue to show an upward slope, the uptrend is likely intact.

Remember, however, that moving averages are lagging indicators, so there can be false signals.

It’s important that your trading decisions involve a comprehensive analysis that includes other factors aside from moving averages, such as fundamental data, market sentiment, and risk management.

Learn more about using MAs and MA crossovers here.

Try it yourself

• In a demo trading environment, select a chart you might one day like to trade. For example, the most traded forex currency pairing in your region
• Find the moving averages indicator and apply it to the chart
• Play around with the moving averages timelines
• When you look at this chart with the moving averages, see if you can spot times when the short-term price crossed over the long-term price
• What happened to the price after that? How many times did it result in a trend?

What is relative strength index and how do I use it to identify a trend?

Relative strength index (RSI) is a key tool used in technical analysis that assesses the momentum of assets to gauge whether they are in overbought or oversold territory. It shows traders how quickly prices are moving in one direction and gives a number between 0 and 100. Generally, readings above 70 indicate overbought conditions and readings below 30 indicate oversold conditions.

Overbought means an asset’s price has risen significantly and quickly, possibly to unsustainable levels, while oversold means the opposite – an asset’s price has fallen significantly and rapidly, possibly to levels that are undervalued. Traders might view overbought conditions as a signal to consider selling or taking profits because the price might be about to decline. They might view oversold conditions as a signal to buy because the price might be ready to recover.

Calculating RSI

To calculate RSI, the following equation is used:

RSI = 100 – 100/(1 + [average up closes/average down closes])

For example, let's say you want to calculate the 14-day RSI for ACME stock using its daily closing prices. You will add up all the gains and losses over the 14-day period to calculate both the average gain and the average loss and divide the gains by the losses. Let’s say ACME has finished up an average of five points and down an average of 10. Using the RSI formula, you will do the following sum:

RSI = 100 – 100/(1 + (5/10)

In this example, the 14-day RSI of ACME is 33.34.

Remember, RSI is just one part of your analysis, and should be considered together with other indicators and tools.

What is average directional index and how can I use it for trading trends?

Average directional index (ADX) is a technical indicator used to determine the strength of a price trend in a financial market on a scale of 0 to 100. Unlike other indicators that indicate the direction of a trend, the ADX provides insights into the trend's strength or weakness. A value of more than 25 is considered a strong trend.

So, to recap, RSI is a number between 0 and 100 that indicates how quickly prices are moving, while ADX is a number between 0 and 100 that indicates how strong a trend is.

ADX is normally based on a moving average of the price range over 14 days, depending on the frequency that traders prefer. It’s important to understand that ADX never shows how a price trend might develop – it simply indicates the strength of the trend. In fact, ADX can rise when a price is falling, which signals a strong downward trend. For example, the chart below shows a stock index over a period of six months from the end of one year to May in the next. The price falls sharply in January and February, and the rising ADX indicates that this is a strong downwards trend.

The most important thing to remember when using technical indicators is that they are not foolproof, nor a guarantee that a market will move in that predicted direction. Use indicators together with your trading plan, and robust risk management practices.