Fundamentals of trend trading
Trend trading strategies
In the previous lesson, we started looking at ways to identify a trend, examining price and moving averages. In this lesson, we look at two more methods to identify and measure trends: relative strength index (RSI) and average directional index (ADX). Plus, we start to explore some trend trading strategies.
Before we get going, remember technical analysis is based on the premise that what happens in the past can be used to predict what might happen in the future. Remember, future performance can never be guaranteed no matter how well you do it. Technical analysis shouldn't be used in isolation to make trading decisions.
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.
Did you know?
RSI values above 70 suggest that an asset price may have risen too quickly, and a pullback or reversal could be imminent, while RSI values below 30 suggest that the asset price may have declined too rapidly, and a potential bounce or reversal might occur. If the price goes one way but RSI goes the opposite way (known as “divergence”), it could mean the trend is about to change.
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.
Did you know?
RSI is one of the technical indicators available in IG’s demo and live trading environments. To see RSI, click the ‘technical’ tab on the chart and scroll across to RSI.
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.
ADX Chart
Popular trend trading strategies
If you’re looking to enter a trend, there are several ways to do so, but two of the most popular are pullbacks and continuation patterns.
Pullback trading
Pullback trading is a strategy where you try to take advantage of temporary price reversals within an existing trend. In other words, when an asset is in an uptrend or downtrend, pullback traders look for moments when the price temporarily retraces or ‘pulls back’ from its recent movement in the opposite direction of the trend. The goal is to enter the market at a favourable price level and to follow the trend to its end.
Traders will often look for key support levels or resistance levels to determine when a pullback has run its course and price is ready to resume in the direction of the prevailing trend.
Support levels: A level in an uptrend at which an asset's price tends to stop falling and may even reverse direction, moving back upward. Support levels may form at the low points of previous price movements, where buyers have stepped in before. Traders may choose a support level as an entry point to buy into the market
Resistance levels: A level in a downtrend at which an asset's price tends to stop rising and may reverse direction, moving back downward. Resistance levels may form at the highs of previous price movements, where selling pressure has emerged before. Traders may choose a resistance level as a selling opportunity as they look to exit a market
Support and resistance levels can be affected by market sentiment, news events, or other factors, so it’s important to use them in conjunction with other forms of analysis and risk management strategies when trading.
It's important to note that major support and resistance levels are rarely exact figures. It's unusual for a market to hit exactly the same price time after time before reversing, so it's probably more useful to think of them as support or resistance zones.
Continuation patterns
Continuation patterns are technical chart patterns that indicate a temporary pause or consolidation within an existing trend before the trend resumes. They tend to suggest that a prevailing trend is likely to continue once the consolidation is complete. Traders use continuation patterns to try to predict the next potential price movement in the ongoing trend. There are many patterns, but some of the most common are triangles/wedges and bear/bull-flags.
1. Triangles/wedges: As the name suggests, this pattern looks like a triangle or wedge on the chart. There are different types, including an ascending triangle (which signifies the continuation of an uptrend), a descending triangle (the opposite of an ascending triangle, signifying the continuation of a downtrend), and a symmetrical triangle (sometimes indicating indecision in the market). Usually, the market will continue in the same direction as the overall trend once the pattern has formed
Ascending triangle continuation pattern
Descending triangle continuation pattern
Symmetrical triangle continuation pattern
2. Flag patterns: A flag pattern forms when there's a sharp price move (called a ‘flagpole’) followed by a parallel consolidation (the ‘flag’) that slants against the prevailing trend. Flag patterns are also called ‘pennant patterns’. They can be either bullish or bearish. Bullish flags are spotted during an uptrend when there's a strong upward move followed by a short sideways or slightly downward movement. Traders may consider this a good time to buy as they expect the uptrend to continue. Bearish flag patterns are the opposite – when the flagpole goes downwards, with a short sideways or slightly upward movement. Traders may consider this a good time to sell, anticipating that the downtrend will continue
Bullish flag pattern
Learn more about chart patterns and how to use them here.
Practise identifying patterns
In your demo trading account, choose a market that you’re interested in and start to look for common chart patterns by:
Studying historical charts: Identify instances where continuation patterns have formed in the past. Take note of how prices behaved before and after the pattern
Drawing the patterns: Use the drawing tools to manually mark and draw continuation patterns as you think you spot them. This will help you visualise patterns more effectively
Try different timeframes and assets: Try to spot patterns in different contexts
Check and document your analysis: After a pattern completes, compare the actual price movement with your analysis to see whether your predictions were accurate or not. Make a note in your trading diary about the patterns you’ve spotted and analysed, and how the trend behaved once the pattern had completed. This will help you to improve your ability to identify trends and refine your trend trading strategy
Remember, as you’re learning to identify patterns (which takes time and practice) it’s safer to use a demo account and virtual money to simulate trades, so you don’t put real capital at risk. Apply risk management techniques, such as implementing stops and limits, to mimic real trading conditions and practise good risk management.
Lesson summary
Relative Strength Index (RSI) is a technical analysis tool to assess the momentum of assets. It can help to indicate whether an asset is in overbought or oversold territory
Generally, RSI readings above 70 indicate overbought conditions and readings below 30 indicate oversold conditions
Average Directional Index (ADX) is a technical indicator traders use to determine the strength of a price trend in a financial market on a scale of 0 to 100. ADX does not show the direction of a trend, but only its strength or weakness
An ADX value of more than 25 is considered a strong trend
Two popular trend trading strategies are pullback trading and continuation patterns
With pullback trading, you will look for instances when an asset’s price temporarily retraces or ‘pulls back’ from its recent movement in the opposite direction of the trend, so that you can enter the market at a favourable price level and follow the trend to its end
With continuation patterns, you will look for specific technical chart patterns that may indicate a temporary pause or consolidation within an existing trend before it resumes. Your goal is to try to predict the next potential price movement in the ongoing trend
Common continuation patterns include triangle/wedges and flag/pennant patterns
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