Trend trading, in its simplest form, is the act of buying assets that are going up and selling short assets that are going down.
It takes many forms too.
Some take a long-term view, buying the best performing futures contracts and try to hold them for years, only winning about 25% of their trades (but the winners are way bigger than the losers). Others buy momentum stocks at the market open and hold them for 10 minutes.
While the average day looks very different for each of these traders, they’re taking advantage of the same phenomenon: trends.
What is a Trend?
A trend, in its simplest form, is a series of higher highs and lower highs.
If you’ve looked at a few stock charts in your life, you know that stocks don’t move in a straight line. While the general trend might be upwards, it oscillates up and down on it’s way up.
This is a crucial thing to have in mind. Let’s look at some charts of strong trending stocks to illustrate this.
Below is a chart of Wells Fargo (WFC), a very large bank that you’re probably familiar with. The stock is one of the best performers in the financial sector this year and it’s in a clear uptrend.
But it hasn’t moved up in a straight line. It’s zig-zagged a bit, having occasional dips where some traders and investors probably thought the trend was over.
How Do You Identify Stock Trends?
In this article, we’re talking about price trends in stock prices, not trends in people liking a company more, or a trend in a company’s profits.
The primary method traders use to identify trends in stocks is through chart analysis, better known as “technical analysis.”
Technical analysis is simply using market-generated information like stock prices and the volume of transactions to make trading decisions. Many traders also use “technical indicators,” which are essentially arithmetic formulas applied to price and volume data.
There are thousand methods traders use to identify market trends, but they all really converge on the same concept: find something that is going up that has a better than 50% chance of continuing to go up.
So how do traders do that?
Pure Price Action
Traders refer to “price action” a lot to explain the character of stock prices. When a trader says he sees “bullish price action,” he’s saying that, to him, the price is moving in such a way that makes him think the price will rise.
This is a really relative thing, that differs from trader to trader. But for the most part, they’re referring to a clean series of higher highs and higher lows, unencumbered by a level of “resistance,” where price doesn’t seem to want to tread above.
Traders might use trendlines to estimate the trajectory of the trend:
They might use the price action to tell a story about the price movement:
Moving Averages
Another simple way to quantify trends is simply by looking at the slope of a moving average. The steeper the slope, the stronger the trend.
Below is a chart of Allstate Insurance (ALL) with a 20-day simple moving average. As you can see, there’s a steep upward slope.
Indicators
There are indicators created to gauge the strength of the trend.
However it’s important to understand the calculation behind the indicator. You need to know what you’re looking for. A high reading on RSI is not the same as a high reading on the ADX.
Most of the time, you’re better off not analyzing these indicators too much. They’re essentially formulas on price, so you’re just looking at a lagging derivative of price.
One such indicator is the Average Directional Index (ADX).
You can read more about the calculation here, but it essentially compares highs to lows and spits out a value that signifies the strength of the trend. Keep in mind that ADX doesn’t indicate the direction of the trend, just the magnitude.
You should be able to see which direction the trend is.
Generally speaking, ADX readings above 30 are viewed as a very strong trend.
Some other indicators worth reading into are the MACD and different modified versions of it, Rate of Change, and the stock’s relative strength to its underlying index or sector ETF.
Common Sense
If you spend some time studying price action, identifying a strong trend is pretty obvious.
The hard part isn’t spotting trends, it’s trading them profitably. Anyone can create a screen on Finviz to look for strong trends; there’s nothing proprietary to it.
Formulating a trading strategy based on trends can be beneficial.
Trend Trading Setups
Traders have tons of unique ways of entering trades. But when it comes to trends, most of them can be boiled down to two setups: the flag and the breakout.
The Bull Flag/Bear Flag Setup
The bull flag pattern is a consolidation pattern that enters a trend on short-term weakness, assuming the trend will continue after the weakness subsides. This is also called a pullback, a consolidation pattern, or an “ABCD” pattern.
A being the low of the move, B being the high of the move, C being the pullback, and D being the upward move out of the pullback.
Roughly, here is the schematic of your typical bull flag setup:
Essentially, a market makes a significant momentum move in one direction, pulls back a bit, then continues in the same direction. It’s called a flag because the setup looks like a flag when you draw it out. The flagpole is the move upwards, and the flag is the pullback.
Here’s an example in Target (TGT):
Obviously the setup was cut short by the overall bearish price action in the broad market, but it’s a textbook flag setup. Apologies for the bad use of the drawing tools. They’re a bit wonky on TradingView.
But why does it work? If this was a better way to position for trends, why wouldn’t everyone just wait for a pullback and buy then? Well, the markets are a bit more complex than that sometimes. You see, not everyone is a short-term technical trader.
The minority of market participants are.
There’s many explanations for why these patterns work. Most large institutional orders are “worked” intraday via VWAP algorithms, meaning they try to match the volume-weighted average price over the life of the entire order.
This means that when a stock reaches a high price that isn’t supported by volume, the algos reduce their buying, forcing the stock to pullback a bit.
Another theory on why this pattern works is because stock purchases, unlike futures, need to be cash secured.
This means that you need to place all or most of the purchase price upfront with your broker. As stocks reach highs, investors sell a portion of their holdings to free up some of their cash and lock in profits.
There’s significant academic evidence that commodity and bond futures have much stronger tendencies to trend, which makes sense, because you only have to put up a small portion of the notional (usually between 2% and 12%) to buy or sell short futures contracts, so traders don’t need to free up capital as a trade moves in their favor.
This is only a theory, of course.
The Breakout
The breakout is a trade setup that looks for a stock to break out above (or below on the short side) of a significant level.
The violent moves that many breakouts create often occur as a result of a gap in liquidity. When the market is just touching below a significant level, many traders might not be paying attention.
When the market does breakout, many are positioned incorrectly, or are trying to hop aboard the train because they’re late.
I’ve likened the breakout setup to being in a Walmart before a big Black Friday sale where the manager has forgotten that Black Friday is coming. When Friday comes around, the store isn’t ready.
There’s no liquidity. People are running around and buying whichever products they can because the store wasn’t prepared for the influx of demand.
There are many patterns traders look for in a breakout trade, and explaining all of those are beyond the scope of this article. But we’ll touch on one here, which is a concentration of tight range bars right below (or above on the short side) a significant level.
First, we should establish what a “significant level” is.
These critical levels are referred to as support levels (a price which buyers step in to support the price), and resistance levels (a price where sellers step in, and the market resists rising further). Actually figuring out a real support or resistance level is important.
Most of the time, a recent high or low acts as a short-term significant level, where increased activity occurs. Stop loss orders get clustered around these levels, and if there’s enough conviction from one side of the market, a big move can occur.
Here’s an example of an active stock temporarily falling into a tight range concentrated near the high of the move, a very typical breakout setup.
Know What To Expect From Trend Trading
Win-Rate
Most trend trading strategies have win-rates south of 50%. This is by design. There’s no free lunch in financial markets and if you want to be on the right side of some large trends, you have to get stopped out of a lot of trades.
Some strategies have win-rates around 50%-55%, but the profit targets are usually much smaller, preventing the trader from catching large trends.
The catch here is that when done correctly, the winners in a trend trading strategy are far bigger than the losers. So you could afford to lose more than you win.
This is unlike mean reversion trading, where you typically have a much higher win-rate but suffer more infrequent large losses.
Holding Periods
Like we said in the intro to the article, there’s many ways to trade trends. Some traders aim to catch just one leg of the trend.
This is why it’s called swing trading; you’re capturing one ‘swing’ of the market, whether that’s intraday or inter-day.
Other traders look to hop aboard lots of trends, knowing they’ll be stopped out most of the time, but they catch the odd runaway trend that makes up for the many losses.
This comes down to temperament and time frame.
There aren’t a ton of runaway trends intraday in stocks, so it often makes sense to use an intraday swing strategy, looking to just capture one swing of the trend; buying at the higher low and selling near the previous higher high.
Day Type
If you’re a day trader, the ‘day’ type will have massive implications for the success of your strategies.
Typically, “inside days,” where today’s range is inside of the previous day’s range, are more apt for mean reversion or small trend swings, rather than large directional moves.
On the other hand, “trend days,” where the market breaks out of a range and moves in one direction virtually all day, calls for looking for a larger move, rather than just taking one swing out of the trend.
Whipsaws
There’s no perfect way to enter trends. If there were, there’d be trend trading trillionaires that always enter at the right time and compound their money daily. You will be stopped out, only to see the trend move in your desired direction thereafter.
The stock might be within a cent of your target, only to reverse and stop you out.
Execution Choices
It’s worth considering how you’ll enter your trades.
Will you provide liquidity by sitting on the bid on the way down, within the pullback, or will you wait to see the market move in your direction a bit before establishing a position?
Bottom Line
Generally, there are two categories of trading setups: mean reversion and trend trading.
Mean reversion traders look to buy things that have gone down a lot quickly, looking for a bounce. Trend traders do the exact opposite. If you look at the portfolios of a trend trader and a mean reversion trader, they might be in the same stocks, betting in opposite directions.
The funny thing is that both of them could make money, depending on how they manage their positions.
The problem with mean reversion trading is that it’s psychologically difficult. Because they’re taking a position against momentum, they’re usually in the red right away and have to endure some pain before the trade goes in their favor. Most don’t use stop losses because the further the stock goes down, the better a trade it is.
They often add to losing positions. If you’ve never traded this type of strategy before, it’s hard to understand that gnawing feeling in the back of your head saying “will this be the one that won’t bounce?”
Your brain will want to exit the trade as it goes against you, but another part of your brain will be saying “as soon as I close the trade, it’s going to reverse, I just know it.”
Trend trading, while probably more difficult to get right, is much easier on your emotions.
You usually have a relatively tight stop loss and have defined your risk on each trade. Further, because losses are small relative to winners, it’s not gut-wrenching to take a string of losses if you’ve mentally prepared for it.