Trend following (or trend trading) is one of the most popular day trading strategies in the market. As the name suggests, it involves identifying a trend that has already formed and then following it. It is a relatively different strategy from the reversal strategy that hopes to identify points where reversals take place.
In this article, we will look at some of the best strategies you can use in day trading to follow a trend.
Contents
What is trend following?
For starters, a trend is a situation where the price of an asset is moving upwards or downwards for a certain amount of time. For example, if a stock moves from $10 in January to $15 in February and to $18 in March, it can be said to be in a bullish trend. Similarly, if it moves from $10 to $8 to $5 in this period, the stock is in a bearish trend.
On the other hand, if the price hovers in a certain range, this is not a trend but a consolidation phase.
Therefore, trend following is the basic strategy of identifying an asset whose price is moving either upwards or downwards and following the trend. Traders follow this trend until a time when they sense that the trend is ending. If a bullish trend ends and a bearish one starts, they will short it and make a profit as it slides.
Trend Trading can be a highly profitable trade when used well. However, it also poses some risks, especially to new traders, like We will explain below.
Using trend indicators in trend following
The most basic approach to follow a trend is to use trend indicators like moving averages, Bollinger Bands, and the Average Directional Index (ADX).
Trend Trading with Moving Averages
The most popular of these is moving averages. For example, if you spot an upward trend, a trader will apply a moving average of a duration of their choice. As such, in their view, the upward trend will remain as long as the price is above this moving average. If it comes close to the moving average, it will be a signal that the trend is about to end.
A good example of this is in the EUR/USD chart below. As you can see, we have added a 25-day moving average on the currency pair’s four-hour chart. Therefore, if a trend-follower was trading this pair, he would have continued to hold it so long as it was above the moving average.
In this example, we have used the 25-day exponential moving average. But some traders have found a lot of success using other types of moving averages, which include the simple moving average (SMA), smoothed moving average (SMMA), weighted moving average (WMA), and Hull moving average (HMA), among others.
Also, in this case, we have used the 25-day EMA. However, depending on your trading strategy, you can experiment with moving averages of other periods.
Using Bollinger Bands
Bollinger Bands are other popular trend indicators used today. The indicator is made up of three bands; the middle one is a moving average and is then surrounded by its standard deviation. In most cases, the standard deviation that is used is the 0.02.
Bollinger Bands are used in two main trading approaches. Nonetheless, they are perfect in trend following. There are several angles to look about it.
First, during an upward trend, in most cases, the price usually oscillates between the middle and upper side of the Bollinger Bands. Therefore, if the price manages to move below the middle line, it can be said to be the start of the end of the trend.
Second, during a descending trend, the price will typically remain between the lower and middle band. As such, if it manages to move above the middle band, it will be said to be the end of the bearish trend.
In the chart below, we see that the price remained in a bullish trend so long as it was between the upper and middle Bollinger Bands.
Using Donchian Channels to follow the trend
The Donchian Channels is an indicator that resembles the Bollinger Bands. It has three lines, with one in the middle and two others surrounding it. The only difference between the two is their calculation. In the Donchian Channels, you simply identify a period and identify the highest and lowest points. These will form the outer bands of the channel. The middle line will be the average of the two.
Like in the Bollinger Bands, the price will always remain in a bullish trend as long as it is between the middle and upper lines of the bands. If it moves below the middle line, it is said to be the start of the end of the bullish trend.
Similarly, in a bearish trend, the price will keep dropping so long as it is between the lower and middle lines of the channel, as shown in the chart below.
There are other indicators that are popular in trend following. For example, many day traders use oscillators like the moving average convergence and divergence (MACD) and the Relative Strength Index (RSI) using this strategy. In addition, many of them use tools like pitchfork, pivot points, and Fibonacci retracement to find potential levels.
Trend following works in stocks?
The strategy of trend trading can be used in all asset classes, including exchange-traded funds, stocks, and currencies. You simply need to identify an asset, see its trend, and then use technical indicators like the ones we have mentioned above.
Summary
Trend following is a strategy that is also known as momentum trading. Momentum traders hope to identify a trend and then follow it to the end. In this article, we have looked at some of the most commonly-used trend following strategies and how to use them well.
To succeed, you will need to practice it for a while in a demo account. Which of these strategies do you appreciate the most?
External Useful Resources
- Why does trend following trading work? – Turtle Trader