Key Points

• Trend trading aims to take advantage of an uptrend, in which prices tend to make new highs, or a downtrend, in which prices tend to make new lows.
• An uptrend is a series of higher swing highs and higher swing lows. A downtrend is a series of lower swing highs and lower swing lows.
• In addition to observing swing highs and lows, trend traders also utilize other tools such as trendlines, moving averages, and technical indicators to help identify trend direction and potentially provide trading signals.

Understand trend trading

Trend trading strategies assume that a security will continue to move in the direction of the current trend. Such strategies often include take-profit or stop-loss clauses to lock in profits or avoid significant losses if the trend reverses. Trend trading is suitable for short-term, medium-term and long-term traders.

Traders use price action and other technical tools to determine the direction of a trend and when it may change.

Price action traders focus on price movement on charts. For an uptrend, they want to see the price break above the recent high, and when the price falls, it should remain above the previous swing low. This shows that although prices are moving up and down, the overall trajectory is upward.

The same concept applies to a downtrend, with traders watching to see if price keeps making lower lows and lower highs. When this no longer happens, the downtrend is called into question and trend traders will no longer be interested in taking short positions.

Trend Trading Strategy

There are many different strategies for trend trading, each employing a variety of indicators and price action methods. All strategies should use stop losses to manage risk. In an uptrend, stops are placed below the swing low that occurred before the entry, or below other support levels. In downtrends and short positions, stops are often placed above previous swing highs or other resistance levels.

Traders often employ a combination of these strategies when looking for trend trading opportunities. Traders may look for a break above a resistance level to indicate a possible uptick, but only enter a trade when price is above a specific moving average.

These strategies involve entering a long position when the short-term moving average crosses the long-term moving average, or entering a short position when the short-term moving average crosses the long-term moving average. Alternatively, some traders may wait for price to break above the moving average to signal a long, or for price to fall below the moving average to signal a short.

Often, moving average strategies are used in conjunction with other forms of technical analysis to filter signals. This may include observing price action to determine a trend, as moving averages provide very poor signals when there is no trend; prices simply swing back and forth around the moving average.

Moving averages are also used in analysis. When the price is above the moving average, this helps indicate that an uptrend may be present. When the price is below the moving average, this helps indicate that a downtrend may be present.

There are many momentum indicators and strategies. In terms of trend trading, an example might be to look for an uptrend and then use the Relative Strength Index (RSI) to signal entry and exits.

For example, traders might wait for the RSI to fall below 30 before rising again. This could send a bullish signal, assuming the overall uptrend remains in effect. The indicator shows that prices have pulled back but are now starting to rise again, in line with the overall uptrend.

When the RSI exceeds 70 or 80 and then falls back to selected levels, traders may choose to close their positions.

A trendline is a line drawn along the swing lows of an uptrend or the swing highs of a downtrend. It shows areas where prices may pull back in the future.

Some traders in an uptrend will buy when the price pulls back and bounces off the uptrend line, which is a buy-the-dip strategy. Likewise, some traders in a downtrend will choose to go short when the price rises and falls back from the downtrend line.

Trend traders also look for graphic patterns, such as flags or triangles, that suggest a possible continuation of a trend. For example, if price forms a flag or triangle after a strong move up, trend traders will watch for price to break out of the pattern to signal a continuation of the uptrend.

Trend Trading Chart Example

Below is a chart from Alibaba Group that shows how to analyze trends, as well as some examples of potential trades using graphic patterns and trends.

The price started in a downtrend and then broke above the downtrend line and above the moving average. However, this does not mean that the trend has turned upward. Trend traders will typically wait for price to create higher swing highs and higher swing lows before considering an upward trend.

Prices continue to rise, confirming a new uptrend. It then pulls back and starts rising again, forming the first graphic pattern. Price breaks out of this graphic pattern, signaling potential long positions.

The uptrend continues strong, forming two additional graphic patterns on the way. Both patterns provide the opportunity to enter a long position or add to an existing position (called adding to a position).

Prices continued to rise, but then warning signs began to appear. Prices broke below the moving averages for the first time and created a lower swing low, breaking above the short-term uptrend line.

After this, the price made new highs but then fell below the moving average again. This performance is not consistent with a strong uptrend, and trend traders will generally avoid going long in this situation. They will also try to close any long positions they still have.

The chart shows that price continues to fluctuate around the moving averages, lacking a clear trend direction. Finally, the price slips into a downtrend. Trend traders will exit long positions, avoid new long positions, and may seek opportunities to enter short positions.

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