Stock markets move like waves with peaks and troughs or in trend trading terms – highs and lows.
It is the direction of those highs and lows that constitutes a market trend.
Successful trend traders depend a lot on riding on market trends to make returns that investors would have to wait for months or even years to make.
How do we know how to read market trends?
In this article, I’ll share with you the 4 most common (and important) technical indicators in trend trading, and how to leverage them to make decent profits.
But before that, here’s a bit of background on trend trading just so we’re all on the same page…
If you’re more advanced, you can jump straight into the technical indicators portion.
Trend Trading 101
In the stock market, a trend is simply a sustained directional move over hours, days, weeks, or even months.
Trend trading capitalizes on this phenomenon and is an excellent way to profit from the market.
The idea behind trend trading is to
- identify a trend
- find an opportunistic entry, and
- hold onto the position until the trend reverses
This style works in most asset classes, including stocks, futures and forex.
With sufficient diversification, strong risk control and the discipline to stick to the system, it can be highly profitable.
Uptrends & Downtrends
An uptrend is a series of higher highs and higher lows, while a downtrend is a series of lower highs and lower lows over a period of time.
A series of horizontal highs and lows would identify a sideways price trend.
By far, the majority of technical analysis focuses on trend analysis because trading with trends is a safer and more profitable proposition.
In order to take advantage of a trend, a trader would have to ascertain firstly the mode of market action is trending, its direction and duration.
We can use a variety of technical analysis indicators (eg. trend line, moving average, MACD, etc.) that allow us to quantify the component parts of the trend.
Let’s jump right into the 4 technical indicators in trend trading.
1. Trend Line
Trend line is a very simple tool, yet its importance cannot be underestimated.
Trend line works on the premise that past events tend to repeat themselves.
Market patterns in the form of trends will rise and fall with a period of regularity.
If you plot the rise and fall of these price patterns, you will establish a line of direction and these lines of direction are called trend lines.
Drawing a trend line on a chart helps us to understand the direction of trends and allows us to identify key points in future price actions.
Plotting a trend line
Draw a trend line by connecting the lows of an uptrend or the highs of the downtrend.
The longer the trend line is and the more times price touches it without being penetrated, the stronger and more reliable the trend line becomes when the next time the market heads to test it.
One only needs two points to draw a line but in market analysis, the more points that confirm the line, the stronger and more significant the trend line becomes.
Trend lines tell us the market behaviour
In addition, the slope of a trend line can also give information regarding market behaviour.
A steep trend line represents a surge in market activity and will probably be accompanied by a surge in volume.
A steep trend line is rarely sustainable for long periods of time.
A shallower slope is more sustainable and trade-able.
2. Moving Average
Moving Average (MA) is an indicator that shows the average value of a security’s price over a period of time.
It smoothes out price data for easy analysis.
While it is possible to plot MA from the Open, High and Low data points, most MAs are created using the closing price.
For example, a 10-day simple moving average (SMA) is calculated by adding the closing prices for the last 10 days and dividing the total by 10.
The “10-day” in the above example is referred to as the “look back” period.
The period to use is determined by the time horizon of the trade, be it short, medium or long.
Trend identification using MAs
MA is very effective in identifying trends.
By monitoring MA, we can make the trend our friend.
It is a lagging indicator, which means that it does not predict new trends, but rather confirm trends that have already been established.
Fig 1 – Identifying Uptrend
For an uptrend to be identified, the prices should be above MA, and MA should be sloping upward (Figure 1).
Important: You should never sell short a stock during an uptrend.
Fig 2 – Identifying Downtrend
Conversely, for downtrends, prices should be below a downward sloping MA (Figure 2).
Important: You should never buy stock during a downtrend.
MA Crossover strategy
You might have heard of the MA crossover strategy.
That’s because crossovers are another great way to utilize moving averages.
By plotting a shorter (eg. 50-day) and a longer moving average (eg. 200-day) on a chart, a buy signal occurs when the shorter moving averages crosses above the longer moving average (Figure 3).
Fig 3 – Crossover strategy for BUY
A sell signal occurs when the shorter moving average drops below the longer moving average. The time frames can be altered to suit your individual trading time frame (Figure 4).
Fig. 4 – Crossover strategy for SELL
3. Moving Average Convergence Divergence (MACD)
MACD consists of 2 lines – the MACD line and the signal line.
2 moving averages give us the MACD line.
It is the difference between 12 and 26 EMA.
The 2 moving averages are continually converging and diverging. This is how the indicator got its name.
The signal line is the 9 EMA (exponential moving average) of the MACD line.
Fig. 5 MACD & Signal Line
A buy signal is given when the MACD crosses above the Signal Line; and a sell signal is given when the MACD crosses below the Signal Line.
Zero line represents those periods when the 2 EMAs are identical. MACD line fluctuates above and below a zero line.
Fig. 6 – MACD Buy & Sell Signals
Crossings above and below the zero line are also buy and sell signals respectively. It is useful as a confirmation of MACD crossover.
Example, a bullish crossover of the MACD lines that takes place below the zero line would be confirmed with the subsequent cross above the zero line by both lines (Figure 7).
Fig. 7 – Zero Line Crossover – Bullish
Conversely, a bearish crossover of the MACD lines that takes place above the zero line would be confirmed with the subsequent cross below the zero line by both lines (Figure 8).
Fig. 8 – Zero Line Crossover – Bearish
4. Average Direction Index (ADX)
ADX identifies trends and shows how strong a prevailing trend is to make it worthwhile following it.
If the trend is strong, it gives greater conviction in our trading.
ADX gives an objective measurement of the strength of the trend.
The higher the value, the stronger the trend.
ADX compares how much higher or lower the ranges of subsequent days are.
As the strength of a trend increases, the daily ranges will get large and so the ADX will report larger results.
If the range is small and the prevailing trend is weak, then the ADX will drop off.
As the ADX rises, the trend is getting stronger and is more likely to continue in the direction of the prevailing price move.
When the ADX line begins to weaken it can be a sure sign that the trend may be ending.
ADX is itself is derived from 2 other indicators, namely the Positive Directional Movement Indicator (+DI) and Negative Directional Movement Indicator (-DI).
It is the DI that determine trend direction.
Therefore, the best time to go long is when both +DI and ADX are above -DI and ADX rises.
This shows that the uptrend is getting stronger.
Conversely, the best time to be short is when both -DI and ADX are above +DI, and ADX rises. This shows that the downtrend is getting stronger (Figure 9).
Fig. 9 – Rising ADX indicates strong trend
When ADX falls below both DIs, it identifies a flat and listless market. In those cases, trend trading will not yield much result (Figure 10).
Fig. 10 – Falling ADX indicates a flat and listless market.
Final thoughts on trend trading indicators
It is important not to mix and match too many indicators into your trading system.
More importantly, you should understand the characteristics of the trending indicators you are using and appreciate its strengths and weaknesses.
In trading, LESS is often MORE.
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