Welcome to our comprehensive guide on the Trend Following Strategy in trading. This strategy, used by many successful traders, is all about capitalizing on the market’s momentum. In this blog, we’ll start with the basics of trend following, helping you understand what it is and how it works. We’ll then delve into the key components of a successful trend following strategy, including identifying trends, setting stop loss and take profit levels, and more.
We’ll also discuss the benefits and risks associated with this strategy, providing you with a balanced view. Then, we’ll explore how to implement a trend following strategy across different markets, including forex, stocks, and cryptocurrency. Finally, we’ll touch on some advanced techniques in trend following strategy, helping you take your trading to the next level.
Whether you’re a beginner just starting out or an experienced trader looking to refine your strategies, this blog is for you. So, let’s get started on this exciting journey into the world of trend following strategy in trading!
What are the Basics of Trend-Following?
In this section, we’ll explore the basics of trend-following, a popular trading strategy used by many successful traders.
Trend-following is a strategy that aims to capitalize on momentum in the market. Traders using this strategy believe that both up and down trends in the market can be exploited for profit. The key is to identify when a trend is happening and then follow it, hence the name ‘trend-following’.
We’ll start by defining what a trend following strategy is and how it works. We’ll discuss the importance of trading with the trend and why it’s a fundamental concept in many trading strategies.
Understanding these basics will provide a solid foundation for the rest of our discussion on trend following strategy.
What is Trend Following Strategy?
Trend Following Strategy is a trading strategy that seeks to capture gains by analyzing the momentum of a particular asset, be it stocks, currencies, commodities, or indices. The strategy is based on the idea that prices that have been rising steadily will continue to rise, and vice versa for falling prices.
Traders using this strategy do not aim to forecast or predict specific price levels; they simply jump on the trend and ride it. This strategy is typically employed using technical analysis tools which help traders to identify market trends and make trading decisions.
The key components of a trend following strategy include identifying the trend, deciding entry points, and setting stop loss and take profit levels. Risk management is also a crucial aspect of this strategy.
How do Trend Following Strategies Work?
Trend following strategies operate on the principle of recognizing and capitalizing on market trends. These strategies are rooted in a rules-based approach, with the belief that profits from trending markets will compensate for losses in non-trending markets.
The core of a trend following strategy is to leverage technical indicators to discern and follow market momentum. Rather than attempting to predict specific price levels or reversals, the goal is to identify a trend and stay with it until it shifts. This approach can be applied across different markets and time frames.
Common indicators used in trend following include moving averages, the relative strength index (RSI), and the moving average convergence divergence (MACD). The aim of these strategies is to capture the entire movement of a trend. While it may not always pinpoint the highest peak, it ensures that you’re part of the entire trend journey.
Risk management is also a crucial aspect of trend following strategies. A common practice is to limit capital loss to a maximum of 2% per trade if the price hits the stop loss. The initial stop loss is often set at 1 ATR below the lows of the Flag pattern, while the take profit method often involves a 20-period moving average trailing stop loss.
See below example of a MACD and RSI indicator in XAUUSD.
Why is it Important to Trade with the Trend?
Trading with the trend is a crucial aspect of successful trading because it can help identify opportunities for buying or selling securities, minimize risk, improve decision-making, and enhance portfolio performance. Understanding the direction of an underlying trend is one of the most basic ways to increase the probability of making a successful trade because it ensures that the general market forces are working in your favor.
Trend trading, also known as “trend following,” is a method of making money in the trading industry by strictly adhering to trend directions. Instead of guessing which way the market is going to move, you wait for it to establish a direction. After that’s clear, you simply jump onboard and follow the trend that has already begun.
The rationale behind trend trading is that if the market is already moving up, it’s given at least some evidence of its bullish bias so it makes sense to follow that. This approach simplifies trading and can also be highly profitable. To evaluate the effectiveness of your trading, measure the win/loss ratio (the number of your winning trades divided by the number of your losing trades) and the risk/reward ratio (the amount of money you initially risk on a trade versus the amount of money you make on a trade). The goal is to make more money on your winning trades than the amount you lose on your failed trades.
Trading with the trend is important because it aligns your trading with the direction where the market is most likely to move. It allows you to capitalize on market momentum, reduces the likelihood of trading against the market forces, and can lead to increased profitability over time.
Key Components of a Trend Following Strategy
The key components of a trend following strategy can be broadly categorized into the following areas:
- Identifying Trends: The first step in a trend following strategy is to identify the direction of the market trend. This could be an uptrend (consecutive higher highs and higher lows) or a downtrend (consecutive lower highs and lower lows). Anything else is considered a range.
- Technical Indicators: Trend following strategies often use technical indicators to help identify and confirm trends. Some of the most common indicators include moving averages, the relative strength index (RSI), and the moving average convergence divergence (MACD).
- Risk Management: This involves setting strict position sizing rules to manage risk. A common practice is to limit capital loss to a maximum of 2% per trade if the price hits the stop loss.
- Entry and Exit Points: Determining when to enter and exit a trade is crucial. The two most straightforward options are taking a long position for an uptrend and placing a short position for a downtrend.
- Timeframe Selection: Trend following strategies can be applied to short-term, intermediate-term, and long-term trading strategies. The choice of timeframe can significantly impact the effectiveness of the strategy.
- Market Screening: This involves selecting the right markets to apply the trend following strategy. Not all markets trend well, so it’s important to choose markets that exhibit strong trending behavior.
- Trade Execution Skills: Finally, the ability to execute trades effectively and efficiently is a key component of a successful trend following strategy. This includes the ability to place trades promptly when the entry signals occur and to exit trades when the exit signals are triggered.
These components work together to create a comprehensive trend following strategy that can help traders capitalize on market trends and potentially generate profits.
How to Identify Trends?
Identifying trends in trading is a crucial part of a trend following strategy. Here are some ways to identify trends:
- Drawing Triangles on Major Swings: This involves connecting the highs and lows of price swings to form triangles. The direction of the triangle can give an indication of the market trend.
- Using Moving Averages: Moving averages smooth out price data to form a trend following indicator. They do not predict the direction of price movement but rather define the current direction with a lag.
- Using Trend Lines and Channels: Trend lines are drawn below price in an uptrend and above price in a downtrend and act as support and resistance. Channels are two parallel trend lines with price moving between them.
- Following the Series of Highs and Lows: In an uptrend, price makes higher highs and higher lows. In a downtrend, price makes lower highs and lower lows.
- Marking the Trend Line: This involves drawing a line that connects at least two highest highs or lowest lows of the price to check the trend.
Remember, the type of trend you’ll look to trade will depend on your chosen strategy. Long-term investors, such as position traders, look for primary trends. Medium-term traders, such as swing traders, may seek to capture secondary trends lasting from days to weeks. Day traders and scalpers, on the other hand, will only pay attention to minor trends.
What are Trend Following Entry Signals?
Trend following entry signals are indicators that traders use to determine when to enter a trade in line with the prevailing trend. Here are some of the most commonly used trend following entry signals:
- Price Breakouts: This method involves observing the highest high and lowest low of price over a certain period. For example, a trader who uses a 100-day breakout window will open a long position when the price makes a fresh 100-day high.
- Price Momentum: Also known as absolute momentum or time series momentum, this method compares the most recent price to the price a certain number of periods ago. The rule is to be long if the current price is higher than the price a certain number of periods ago, and to be short otherwise.
- Pattern Recognition: This involves identifying specific price patterns that indicate a potential trend. These patterns can be as simple as a series of higher highs and higher lows in an uptrend, or more complex patterns like head and shoulders, double tops and bottoms, and so on.
- Volatility Breakouts: This method involves identifying periods of low volatility, often followed by a price breakout. Traders enter the trade when the price breaks out of the volatility range.
- Moving Averages: This is a lagging indicator that smooths out price data to form a trend following indicator. Traders often use two moving averages and enter the trade when the shorter moving average crosses above the longer moving average (bullish signal) or below it (bearish signal).
- Bollinger Bands: This is a volatility indicator that consists of a middle band (simple moving average) and two outer bands (standard deviations of the middle band). Traders enter the trade when the price touches one of the outer bands and then reverses towards the middle band.
- Price Regression Lines: This involves drawing a line through a series of price points. When the price breaks through the regression line, it can signal a potential entry point.
Remember, the effectiveness of these signals can vary depending on the market conditions and the specific parameters used. Therefore, it’s important to backtest these signals on historical data before using them in live trading.
How to Set Stop Loss and Take Profit Levels in Trend Following Strategy?
Setting stop loss and take profit levels in a trend following strategy is a critical aspect of trading. Here’s how you can do it:
- Identify the Trading Strategy: The characteristics of your trading strategy will influence how you set your stop loss and take profit levels. For instance, a mean reversion strategy will behave quite differently from a trend following strategy, requiring a different approach.
- Determine Stop Loss Level: A stop loss level is the predetermined price of an asset, set below the current price, at which the position gets closed to limit an investor’s loss on this position. This could be a fixed percentage below your entry price or a level determined by technical indicators or market sentiment.
- Set Take Profit Level: A take profit level is a preset price at which traders close a profitable position. This could be a fixed percentage above your entry price or a level determined by technical indicators or market sentiment.
- Use Technical Indicators: Technical indicators can help you set appropriate stop loss and take profit levels. For example, you might set your stop loss at a level below a long-term moving average or use support and resistance levels to set your take profit targets.
- Consider Market Volatility: Market volatility can impact your stop loss and take profit levels. In more volatile markets, you might want to set wider stop loss and take profit levels to avoid getting stopped out prematurely.
- Automate Your Exit Strategy: Many trading platforms allow you to set automatic stop loss and take profit orders. This means that once you’ve set these levels, your trade will automatically close when these price levels are reached.
Remember, setting appropriate stop loss and take profit levels is a key part of risk management in trading. It can help protect your capital and lock in profits when the price moves in your favor.
Recommended Brokers for Trend Following Strategy
Trend following is a trading strategy that attempts to capture gains through the analysis of an asset’s momentum in a particular direction. Here are some brokers that are recommended for implementing a trend following strategy:
Why Choose BlackBull Markets for Trend Following?
BlackBull Markets is a reputable broker that offers a variety of features beneficial for trend following. They provide comprehensive market analysis tools that can help identify and follow trends. Additionally, they offer educational resources to help understand trend following strategies better.
Advantages of Using EightCap in Trend Following Strategy
EightCap is another broker that is well-suited for trend following. They offer competitive spreads and access to a wide range of markets. Their platform includes advanced charting tools that can be used to identify trends. Furthermore, they offer a user-friendly interface which makes it easy for traders to navigate and place trades.
How TD365 Enhances Your Trend Following Experience
TD365 is a broker that offers a unique blend of features that can enhance your trend following experience. They offer tight spreads and low-cost trading. Their platform is designed for speed and efficiency which is crucial for trend following where timely execution is key. They also provide resources for education and market analysis. Highly recommended by Trader Tom.
Remember, while these brokers offer tools and resources to aid in trend following, the success of your trades will depend on your understanding of the market and the trend following strategy. Always do your own research and consider your risk tolerance when trading.
Benefits and Risks of Using a Trend Following Strategy
Trend following is a popular trading strategy used by traders worldwide. It involves identifying and following the market’s trend, which could be upwards, downwards, or sideways. While this strategy can offer significant profits, it’s not without its risks. Understanding these benefits and risks is crucial for any trader considering a trend following strategy. In the following sections, we’ll delve into the benefits of trend trading, the risks of trend following, and some risk management strategies in trading. Let’s explore.
What are the Benefits of Trend Trading?
Trend trading, also known as trend following, is a strategy that attempts to capture gains through the analysis of an asset’s momentum in a particular direction. Here are some benefits:
- Simplicity: Trend trading strategies are simple to understand and implement. They often involve buying assets when their prices are rising and selling when they’re falling.
- Profitability in Various Markets: This strategy can be profitable in both rising and falling markets, as it allows traders to take advantage of both upswings and downswings.
- Risk Management: Trend trading can help manage risk by allowing traders to identify stop-loss points and exit positions if the trend reverses.
What are the Risks of Trend Following?
While trend following has its advantages, it also comes with risks:
- False Signals: Trend following relies on technical analysis, which can sometimes give false signals. A trader might think a trend is forming when it’s not, leading to potential losses.
- Late Entry or Exit: Trends don’t last forever, and sometimes traders might enter or exit a trend too late, missing out on profits or incurring losses.
- Market Volatility: Sudden market volatility can reverse trends, leading to potential losses for trend traders.
What are Risk Management Strategies in Trading?
Risk management is crucial in trading to protect your investment. Here are some strategies:
- Setting Stop-Loss Orders: This allows traders to limit their losses by setting a point at which a trade will be automatically closed if the price moves against them.
- Diversification: Spreading investments across a variety of assets can reduce risk, as losses in one area could potentially be offset by gains in another.
- Position Sizing: This involves limiting the size of a trade to a certain percentage of the total trading capital, thus limiting potential losses.
- Regular Monitoring: Keeping a close eye on market trends and adjusting strategies accordingly can help manage risk effectively.
How do You Implement a Trend Following Strategy?
Trend following is a strategy that can be applied across different markets, from forex and stocks to cryptocurrencies. This strategy involves identifying the market’s trend and making trades based on the direction of this trend. In the following sections, we’ll discuss how trend following works in forex trading, stocks, and cryptocurrencies.
What is Trend Following in Forex Trading?
In forex trading, trend following involves analyzing currency pairs to identify their market trends. Traders use various indicators such as moving averages, relative strength index (RSI), and MACD to determine whether a currency pair is in an uptrend, downtrend, or sideways trend. Once the trend is identified, traders will open positions that align with the trend and close positions when the trend reverses.
Does Trend Following Work on Stocks?
Yes, trend following can be an effective strategy for stock trading. It involves analyzing the price movements of stocks to identify trends. Traders can use technical analysis tools like moving averages to determine the direction of the trend. When a stock is in an uptrend, traders might consider buying. Conversely, if a stock is in a downtrend, traders might consider selling or shorting the stock.
Does Trend Following Work for Cryptocurrency?
Trend following can also be applied to cryptocurrency trading. Given the high volatility of cryptocurrencies, identifying trends can be beneficial for traders. Similar to forex and stock trading, traders use technical analysis indicators to identify trends in cryptocurrency prices. They then make trades based on these trends, buying when the trend is upward and selling when the trend is downward.
Advanced Techniques in Trend Following Strategy
Trend following is a trading strategy that seeks to capture gains by analyzing the momentum of an asset in a particular direction. In this section, we’ll discuss some advanced techniques in trend following strategy, including the use of indicators, trend analysis in fundamental analysis, and the best trend trading strategy.
Which Indicator Follows Trend?
There are several indicators that traders use to follow trends. Some of the most common ones include:
Moving Averages (MA): This indicator smooths out price data to help traders identify the market trend over a certain period.
See below example of a moving average highlighted in blue on the DAX40. We see the DAX40 is falling.
Relative Strength Index (RSI): RSI measures the speed and change of price movements and is often used to identify overbought or oversold conditions in a trend.
In the figure below, there is a noticeable spike in the price of XAUUSD. This increase is accompanied by a rise in the RSI indicator at the bottom, suggesting that XAUUSD is overbought. Subsequently, we observe a decline in the price of XAUUSD.
Moving Average Convergence Divergence (MACD): This is a trend-following momentum indicator that shows the relationship between two moving averages of a security’s price.
Unlike the RSI and other oscillator studies, the MACD lines do not have definitive overbought/oversold levels. Instead, they operate on a relative basis. This means that an investor or trader should pay attention to the level and direction of the MACD/signal lines in relation to previous price movements of the specific security, as illustrated below.
What is Trend Analysis in Fundamental Analysis?
Trend analysis in fundamental analysis involves evaluating the financial statements of a company over time to identify any patterns or trends. For example, a company with steadily increasing revenues over several years may be considered to be in an upward trend. This type of analysis can help investors make informed decisions about whether to buy or sell a particular security.
What is the Best Trend Trading Strategy?
The best trend trading strategy can vary depending on the trader’s individual goals, risk tolerance, and trading style. However, some popular strategies include:
- Breakout Trading: This strategy involves entering the market as early as possible in a trend, often when a security’s price moves above resistance or below support.
- Pullback Trading: This strategy involves waiting for the price to pull back during a trend before entering a trade, in the hope that the trend will continue.
- Moving Average Crossover: This strategy involves entering and exiting trades based on the crossover of short-term and long-term moving averages.
Remember, while these strategies can be effective, they also come with risks, and it’s important to use risk management techniques to protect your investment.
In conclusion, the trend following strategy in trading is a powerful tool that can help traders capture significant gains. It involves identifying and following the market’s trend, which could be upwards, downwards, or sideways. While this strategy can offer substantial profits, it’s not without its risks. Therefore, understanding these benefits and risks is crucial for any trader considering a trend following strategy.
Moreover, the application of trend following can vary across different markets, from forex and stocks to cryptocurrencies. Advanced techniques in trend following strategy, including the use of indicators and trend analysis in fundamental analysis, can further enhance a trader’s ability to navigate the market.
However, it’s important to remember that while these strategies can be effective, they also come with risks. Therefore, employing risk management techniques to protect your investment is equally important. As with any trading strategy, it’s essential to do your research, understand the market, and make informed decisions. Happy trading!
Conclusion: Understanding Trend Following Strategy in Trading
In conclusion, the trend following strategy in trading is a powerful tool that can help traders capture significant gains. It involves identifying and following the market’s trend, which could be upwards, downwards, or sideways. While this strategy can offer substantial profits, it’s not without its risks. Therefore, understanding these benefits and risks is crucial for any trader considering a trend following strategy.
Moreover, the application of trend following can vary across different markets, from forex and stocks to cryptocurrencies. Advanced techniques in trend following strategy, including the use of indicators and trend analysis in fundamental analysis, can further enhance a trader’s ability to navigate the market.
However, it’s important to remember that while these strategies can be effective, they also come with risks. Therefore, employing risk management techniques to protect your investment is equally important. As with any trading strategy, it’s essential to do your research, understand the market, and make informed decisions. Happy trading!