What is trend following? How does it work?

“The trend is your friend until the end when it bends.” – Ed Seykota

Trend following is a trading strategy that seeks to identify a trend (which is a general price direction of a market or security) and then follow that trend to take a favorable position. Trend following or trend trading is a commonly used intraday trading strategy.

How does trend trading work?

As mentioned earlier, a trend is an upward or downward movement in the price of a security for a certain period.

The key is to identify the trend right.

For instance, a stock that was INR 100 on 19th June, INR 117 on 25th June, and INR 125 on July 1 is said to be in an upward or bullish trend.

However, if the price moves in both directions within a range, it is not in a trending phase, but in a consolidation phase. Traders follow trends and hold on to positions until they believe the trend has ended.

The rule is simple:

For an uptrend and long position, one needs to place the stop loss below a swing low that has occurred before entry or below another support level.

For a downtrend and short position, one needs to place the stop loss above a prior swing high or above another resistance level.

Example of higher highs showing an uptrend
Example of higher highs showing an uptrend (Source: PHI 1)
Example of lower lows showing a downtrend
Example of lower lows showing a downtrend (Source: PHI 1)

A few things to keep in mind when trend following:

  • Buy high, sell higher makes sense, although avoid overbought stocks that are ripe for a reversal.
  • Follow the price objectively – look for higher highs and lower lows.
  • Expose yourself to multiple markets and get used to identifying trends first.

Commonly used indicators for trend trading

Traders use a variety of indicators in isolation or combination to identify price trends and reversals.

For instance, some may use breakouts to figure out the start of a trend and use moving averages as criteria to enter the trade.

Momentum indicators, like Relative Strength Index (RSI), Average Directional Indicator (ADX), Moving Averages or MA (specially crossovers), and MACD are commonly used indicators for trend following/trend trading.

Trend lines and chart patterns are widely used to determine the pullback likelihood and confirm market trends or stock trends. Flags and triangles are also widely employed for evaluating the continuation of a trend. But more on this later!

Let us move on to an example.

Trend trading – An illustration using Moving Averages

Both simple (SMA) and exponential moving averages (EMA) as well as crossovers are used extensively in trend trading strategies.

How to identify trends:

An angled-up moving average shows an uptrend, and an angled-down MA shows a downtrend.

Observe in the image below that the price has stayed well above the 50-day simple moving average (50-SMA).

As the price crossed the SMA, it entered ranges in most cases. You can use mid-term MAs like these as a filter using the daily timeframe and aim to trade toward the MA in smaller time frames.

Moving Average to identify trends
Moving Average to identify trends (Source: PHI 1)

How to trade trends:

In simple terms, when the price crosses above the MA, it can be taken as a buy signal, and when the price crosses below the MA, it can be considered as a sell signal.

Trading using crossovers:

In the image below, we have plotted the longer-term 50-SMA and the short-term 10-SMA on a chart of TATA POWER.

A buy signal occurs when the 10-SMA crosses above the 50-SMA. A sell signal occurs when the 10-day crosses below the 10-day.

MA crossover used for trend trading
MA crossover used for trend trading (Source: PHI 1)

However, you must bear a few things in mind when using MA for trend trading. As the price of a stock is more volatile than its MA, this strategy may likely give more false signals.

Further, a fast MA may give false and early signals as it reacts too much to price movements and even make you exit early in case of a trend change. A slow MA may give you late signals.

If you’re willing to explore trend following, consider trying it on PHI 1. As shown above, PHI 1 is super easy to use even for a complete beginner and offers a plethora of advanced options for the expert trader.

Also, you can screen securities, create buckets, create charts and save them, and even experiment with strategies. Once you test your strategies, you can deploy them on the same all-in-one tool with the broker of your choice.

Let us carry the burden of mundane tasks while you focus on trading opportunities.

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