Overview: Trend Trading and Trend Traders
A trend trader is someone who follows the price of a security, attempting to identify trends that predict when to buy and sell a security. Over time, these traders develop techniques and strategies to anticipate the price movements of a security. How do they do this? Price action and indicators.
Technical analysis assumes that the price of a security, such as a stock or bond, moves directionally – up, down or sideways. Market forces such as momentum carry a stock in a particular direction over time. This is termed the trend (see Dow theory for some interesting background information). Price action is an important component in trend trading and is the foundation for the technical analysis of securities. Briefly, price action is the movement of a stock’s price over a specific time, such as one day or one week. Trend traders identify future trends using the price action and a select combination of other technical indicators. More on the indicators below.
Trend traders come in many forms. Risk tolerance, available capital, trading frequency, and commitment level all determine the types of strategies a trend trader pursues.
Indicators for Trend Traders
Besides price, indicators are a critical part of trend trading. Indicators are created using market data and mathematical formulas (or general rules or guidelines). These are overlaid onto a stock chart and are used to help traders determine the future trend of a stock. While there are hundreds of indicators, many traders keep to the most popular. Below are three top technical indicators.
#1. Moving Average Convergence Divergence (MACD)
The MACD is used by traders to understand trend changes in a stock, such as the strength, momentum, direction, and duration of the trend. In the below picture, the MACD is shown under the price chart for Apple (AAPL). The two lines in the MACD represent two moving averages: a 12-day and 26-day. Traders look for when these lines cross (highlighted) to gauge when the trend is changing.
#2. Relative Strength Index (RSI)
RSI is a momentum indicator used to determine the strength or weakness of a trend. It shows how much a stock is overbought or oversold based on historical trading data. This can be useful for predicting when a trend may be transforming (highlighted).
#3. On Balance Volume (OBV)
The OBV indicator relates the price of a stock to the volume of a stock. This makes it a momentum indicator, good for determining the strength of a trend and whether or a trend is increasing or decreasing. Traders use this to confirm price moves, with the assumption that a stock is traded more heavily during a dominant trend. In the below chart, the dominant trend after the highlighted spike is decreasing, which keeps the OBV high.
Trend Trading Strategies
Using the AAPL chart from earlier, let’s analyze the chart pattern and trend.
Trend traders combine price action and technical indicators to create a strategy for approaching the market. This article won’t go into much detail, other than to say there are a few key parts to a trend trading strategy:
- Choice of security
- Choice of indicator(s)
- Entrance rules
- Exit rules
Good trend trading is dependent on a backtested strategy, a good understanding of market trends, and appropriate rules. Trend traders also need to consider where to place stop losses to manage risk.
We will leave you with this pearl of wisdom from Georg Soros, known as the man who broke the Bank of England.
“Markets are constantly in a state of uncertainty and flux and money is made by discounting the obvious and betting on the unexpected.”