Understanding trends
A trend is the direction that prices are moving in. Understand why they form to make the most effective trend trading decisions.
Trends form for a number of reasons, ranging from imbalances in supply and demand, to fundamental economic factors, news, market sentiment, institutional action, and traders following the crowd, among other things. Understanding why and what to look out for will inform your trend trading decisions.
Why do trends form?
- There might be an imbalance in supply and demand. For example, if buyers are more aggressive than sellers, prices tend to rise, forming an uptrend. Conversely, if sellers dominate, prices decline, leading to a downtrend
- Fundamental economic factors can also play a role, such as economic events, corporate earnings, interest rates, and geopolitical events that influence market sentiment and drive trends. Positive economic data can encourage buying, while negative data can lead to selling
- Often, a trend arises from market sentiment. For example, positive news and optimism can lead to uptrends, while negative news and pessimism can result in downtrends
- Related to this is what’s known as herding behaviour, where a market starts to move in one direction and more and more traders begin to notice the trend and follow it (or the crowd already following it). In the beginning of a trend, the theme isn’t visible to many, but as it matures it becomes apparent to an increasingly less sophisticated crowd of traders until the trend eventually reaches a point of exhaustion and changes course
- Institutional activity – such as trading decisions made by large hedge funds – can drive trends as other market participants react
Trends are not always linear or persistent. Markets can experience periods of consolidation, reversals, or erratic movements, even within an overall trending environment. The price may go against the trend every now and then (a pullback is the term used to describe a pause or moderate drop in pricing chart from recent peaks that occur within a continuing uptrend). But if you look at the longer time frames, the trend continues in a specific direction. So, what makes for a trending market is that the theme strengthens and becomes sustainable
In other words, a good trend won’t be derailed by individual fundamental events and data releases, as these act only as short-lived setbacks with market participants’ attention quickly turning back towards the broader underlying theme.
Did you know?
Trends develop on all time frames. In other words, what is an uptrend on a short-term timeframe can be nothing more than a counter trend on a longer-term time frame. Your focus when trend trading should be on the time frame that most closely matches your objectives. For example, if you’re a short-term swing trader with intentions of holding positions for several days to weeks, you’ll probably focus mainly on the daily and 4-hr charts. By contrast, if you’re a day trader, you’ll mostly focus on intra-day time frames.
How do trend-trading strategies compare with other trading strategies?
To assess the performance of your trading strategy, you’ll likely look at certain key metrics, which might include risk-reward ratios, win-loss percentages, and total return, among others.
The risk-reward ratio involves comparing the amount you're risking to the potential gain. For example, if you're risking $100 AUD on a trade and the potential gain is $400 AUD, the risk-reward ratio is 1:4.
The profit-loss ratio is the average profit on your winning trades divided by the average loss on your losing trades over a specific period.
Trend-following strategies often aim for higher risk-reward ratios than strategies that involve shorter timeframes, such as day trading and scalping. This means that traders are willing to risk a certain amount of capital to potentially earn a larger reward. For example, you might set a stop-loss order that limits your potential loss while targeting a profit that is several times larger than your risk. Day trading or scalping strategies focus on capturing small price movements, and so if you choose these strategies over trend trading, you might risk a relatively small amount to target a modest profit.
It's worth noting that the performance of your trend-following strategy will be affected by how long you hold onto a winning or losing trade. The temptation to let losing trades run in the hope that the market turns can quickly wipe out any profits you may have made. This is something you can track in the IG Trade Analytics Tool, which allows you to analyse your trade history and provides mistake diagnosis and tips for improving future trading performance.
Did you know?
Both risk-reward and win-loss ratios interact with each other and will influence your overall strategy performance. A strategy with a lower win-loss ratio might still be profitable if your average winning trade is significantly larger than the average losing trade (due to a higher risk-reward ratio). Conversely, a strategy with a higher win-loss ratio might still be profitable if your strategy's risk-reward ratio is well-managed.
Ultimately, whichever trend trading strategy you opt for should consider your risk tolerance, time commitment, and trading style.
