What is trend trading?

Trend trading is a popular trading strategy that involves identifying the prevailing direction of price movement in a financial market, and then using that information to determine the direction of the trade.

In this lesson, we look at what a trading strategy is, why you need one, and why trend trading is one of the most popular strategies among traders.

What is a trading strategy and why do I need one?

A trading strategy is a plan or set of rules that you use as a trader to guide your decisions in buying or selling financial instruments in the markets.

The idea is to develop this strategy as a set of parameters you will use before you start trading and stick to it when it comes to identifying opportunities and taking decisions while trading. This includes your entry and exit points on a trade and how you manage your risk.

A solid trading strategy is one of the most important elements you’ll need to reach your trading goals. Here are a few ways it can benefit you:

• Ensuring consistency: A trading strategy gives you a consistent framework for making decisions. This can help you avoid common trading pitfalls, such as impulsive or emotional decisions that can result in losses. It protects you from the temptation to trade solely on gut feeling, which can be unreliable

• Managing risk: A good trading strategy incorporates risk management techniques, such as setting stop-loss orders and limits

• Improving objectivity: Following a trading strategy helps you remain objective and stick to your plan even when there’s market volatility or uncertainty

• Managing performance: A trading strategy helps you to set clear and specific goals and targets, and to define your personal risk tolerance, profit objectives, and overall trading style. It also allows you to measure your performance over time. By tracking your trades and outcomes, you can identify the strengths and weaknesses of your approach and make improvements by adapting your trading strategy. For example, you might review your trading strategy (after executing trades consistently according to it) on a periodic basis and alter it to improve it. You could do this at specific times (every three months or once a year) or after a certain number of trades (every ten or 100 trades)

• Reducing anxiety: Trading can be stressful. Having a well-defined plan reduces uncertainty and helps you to approach the markets with greater confidence

What is trend trading?

When the price of an asset is moving in one overall direction in a financial market, whether up or down (or even sideways), it’s known as a trend.

Trend trading is a trading strategy that involves identifying these trends and ‘riding’ them with the goal of following the trend to the end. It’s based on the idea that markets have an element of predictability. By analysing historical trends and price movements, you’ll be able to forecast what could happen in the future. Trend trading strategies aim to help you identify trends as early as possible and exit the market before they reverse.

Uptrends are seen when there are higher highs and higher lows, while downtrends will have lower highs and lower lows.

For example, if ACME Company’s share price increases by 100p, then declines by 50p, then rises by 110p and falls by 40p, it would be said to be in an uptrend as it is making higher highs and higher lows. If, however, the company’s share price decreases in price by 200p, then increases by 100p, falls again by 300p and rises by 50p, it would be in a downtrend because it is falling to lower lows and lower highs.

When developing a trend trading strategy, traders will use various technical indicators to identify the direction of market momentum. These include moving averages, the relative strength index (RSI) and the average directional index (ADX). We will look at these in more detail later in this course.

Generally, trend trading entails buying (going long) when the market is in an upwards trend, and selling (going short) when the market is in a downwards trend. When a market price is neither reaching higher price points or lower ones, it is said to be in a sideways trend. This is known as a bounded movement and is not generally considered an attractive trading environment for trend traders.

Trend trading works best in markets that are not prone to frequent reversals or erratic price movements. It’s usually considered a mid- to long-term trading strategy, but it can cover any timeframe, depending on how long the trend lasts. Trend trading is a strategy often used in stocks, bonds, currencies, metals, and commodities.

Importantly, trend trading (like any form of trading) carries risk and is more likely to be a successful strategy for you if you have done proper research and fundamental analysis, and put good risk management controls in place.

One other key point to consider is that good trends don’t come along very often. However, when strong trends do appear, they are known for lasting much longer than most people estimate. A common trading mistake is not having a good strategy to identify a trend reversal, which means traders may exit a trade too soon.