What is Trend And How to Identify It?
Trend: definition and types
A trend is a term that on financial markets defines the direction (upwards, downwards, or sideways) of the price movement on the chosen timeframe.
Ascending (bullish, uptrend) is a trend in which every next high is higher than the previous one and every next low is higher than the previous one. Quite often, a trend of one type changes into a trend of another type; in the example below, the uptrend did not continue: the highs and lows remained at the same horizontal level.
Descending (bearish, downtrend) is a trend in which every next high is lower than the previous one and every next low is lower than the previous one. As in the case above, one trend smoothly changes into another one and may even reverse into an opposite one. In the example below, the trend goes at an almost right angle, and such sharp impulses tend to smooth out.
Sideways (flat, channel, consolidation) is a type of price movement in a certain price range. As has been mentioned above, in such a case, on the chart we can see several extremes at the same horizontal level parallel to each other.
It is also important to mention that the first two trends may also look like channels — ascending and descending ones, correspondingly. See the examples of such market configurations below.
🔔 (Sign up for RoboForex Blog, to get lots of useful information on trading and keep abreast of the latest news from the world of finance and investments)
Phases of a trend
- Trend (impulse) phase
- Reversal (change) of the trend
You can never be sure whether a correction precedes a reversal or will change into an impulse. The strength of a trend is defined by the timeframe: an uptrend on a D1 will always be stronger than a downtrend on H1. The latter is usually a phase of a stronger trend.
Identifying the trend on the chart
In tech analysis, there are two main ways of identifying the type of trend: graphic and indicator. Initially, before mathematical methods appeared, trends were only identified by graphic means, such as drawing a trendline. To draw one, we need three fixed points on the chart (see an example below).
- The first point is the beginning of a new trend, where the previous one gets an inverted impulse. See such a configuration on the chart below when the trend changes at a very chart angle because of the extremely high concentration of trade volumes. Those who work in the old trend are taking the profit or closing losses, and those who have just come to the market are also opening positions, either by the trend or against it. Depending on the speed of this process, we get the other two points that facilitate drawing the trendline.
- Point two marks the end of the first impulse; at this point, a part of players or positions taken at the beginning of the trend start taking profits. This can be called the start of a correction or the second phase of the trend, no matter how peculiar this sounds. Even though such a pullback might be quite deep, we use this point as a landmark for subsequent renewals of the high and the low formed after the restoration of the impulse.
- The third point is the most important one because it is “responsible” for the slope of the trendline. At this point, growth resumes after the correction at the second point. Through points one and three, we can draw the trendline now. The market may correct it: as we see, there have been attempts of a breakaway on the chart; however, on the whole, the general direction does not change.
This algorithm is the simplest, perfect case. Sometimes it happens that after point two, the trend renews the high by a new impulse, in which case point three should be redrawn and the slope of the trendline should be changed. You should not be scared off by such situations because they simply reflect the struggle between sellers and buyers. If things were so primitive, the share of successful traders would have become over 95% long ago. This drawing demonstrates a false breakaway of the trendline. To decrease the number of false signals to minimum, try following these recommendations:
- points one and three must not be closer than 10 bars/candlesticks away from each other;
- a minor pullback between points one and two must neither be interpreted as a reversal of the trend. In such a case, early development of the reversal should better be skipped;
- do not draw trendlines on timeframes smaller than H1. Start with D1, at least, and descend to H1. If you crave for a precise entry, try searching for a breakaway on M30.
Trendlines can be used for:
1. Finding entry points at the places where the price pushes off the trendline. Such places form the buying area;
3. Finding precise and clear entry points with minimal Stop Losses in a flat. Breakaways of flats (channels) normally happen at least at its width. That is why you can also open an opposite position with precise parameters.
👉 If you want to know more about how to trade trendlines, please see this post.
Apart from the graphic approach to drawing trendlines, the mathematical one, i.e. the use of trend indicators, is now widely used.
The simplest and most popular indicators are the Moving Averages — lines that smooth out the trajectory of the price in a chosen timeframe. For D1, I recommend using two MA with periods 5 (fast) and 22 (slow). Thus we get information about the trend by the number of workdays in a week and month.
When the fast MA crosses the slow one from below, it is a signal to buy, vice versa — to sell. The disadvantages of this indicator are its proneness to false signals and the inability to work in a flat. Look at the signals in the example below: if you receive a signal to sell from a buy and vice versa, close the position you opened earlier. You can decrease the number of false signals by using a modernized version of the Simple Moving Average (SMA) — the Exponential Moving Average (EMA).
👉 Find more information about Moving Average indicator in this post.
It is based on the MAs with different periods.
If the bands get closer to each other, this means major players are accumulating positions. The trend is identified by the direction of breakaways. In a flat, the lower line gives signals to buy, while the lower one — to sell. Thus, the indicator becomes universal in certain cases; however, its main problem is large Stop Losses. Not any trader is ready to assume such risks, but if we decrease the working lot, the potential profit shrinks.
👉 Find more information about Bollinger Bands indicator in this post.
The indicator consists of two MAs and a histogram that reflects the difference in the values of the MAs. When the histogram starts to grow, and the MAs cross, this is a signal to buy. If vice versa — open a short selling position.
👉 Find MACD indicator description and settings in this post.
Trading the trend: pros and cons
Let us discuss the main advantages and drawbacks of trading the trend.
- You trade “in the crowd”, in mid-channel of the main movement;
- Arithmetically, the probability of a profitable trade is higher than when you trade against the trend;
- If you have identified the direction correctly, you can augment your position, “pouring in” money;
- This method is relatively simple and suits for beginners;
- There is a lot of information for studying this method by yourself.
- Frequent reversals, especially when trading intraday, will entail unacceptable losses;
- The signals of trend trading systems often lag, while graphic analysis is subjective to a certain extent;
- You risk falling prey to a “market maker”, for whom the behavior of such traders is predictable;
- Trading against the trend is more profitable.
Trading the trend is a popular strategy, which means there is plenty of information available. You can trade by graphic means or based on mathematical indicators. It is suitable for both beginners and experienced traders and allows them to “pour in” positions — in the case of a lengthy trend your profit will be higher than the market.
However, such tactics are obvious for market makers and make risks unpredictable. Moreover, the signal of trend trading systems always lag, so losses in intraday trading may be huge.
All in all, this trading method is suitable for beginners, but further development and augmentation of profits need you to master counter-trend strategies.
By Dmitriy Gurkovskiy, Chief Analyst at RoboForex