Trend Following Trading Explained

As the saying goes, the trend is your friend (until, of course, it isn’t). Trend following is a popular strategy in the world of trading and investing, one that involves analyzing the direction of price movements in the market and using that information to make trading decisions. Trend following strategies have been used by traders and investors for decades and have been shown to be effective in a wide range of markets. In recent years, trend trading has become even more popular as the use of quantitative methods and algorithmic trading has increased (be still our crypto trading hearts).

Trend following strategies are based on the idea that market trends tend to continue over time, rather than reversing abruptly. The goal of a trend trading strategy is to capture as much of a trend as possible, while minimizing losses in the event that the trend reverses. To accomplish this, traders use a variety of indicators and techniques to identify trends and determine when to enter and exit trades.

One of the key benefits of trend following strategies is that they can be applied to a wide range of markets, including stocks, bonds, commodities, and (crypto)currencies, making them a versatile tool for traders and investors who want to diversify their portfolios and take advantage of opportunities in different markets (or simply focus on one market in particular).

In the following article, we’ll explore the fundamentals of trend following strategies and examine some of the most commonly used indicators and techniques. We will also look at some real-world examples of trend trading in action, and provide tips for traders and investors who want to incorporate trend following into their own strategies.

What Is a Trend?

In the world of trading and investing, a "trend" refers to the general direction in which the price of a particular asset or market is moving over a given period of time. It represents the overall sentiment of the market towards that asset, and can be characterized by a series of higher highs and higher lows in an uptrend, or lower highs and lower lows in a downtrend (easy, right?).

Identifying a trend is a fundamental aspect of technical analysis, which involves analyzing charts and using various trend indicators to determine the direction of the market. Traders and investors use trend analysis to inform their buying and selling decisions, as well as to manage risk and identify potential opportunities for profit, as they do with many other approaches to trading.

Trends can be short-term, medium-term, or long-term, and can occur in any financial market, including stocks, bonds, currencies, commodities, and cryptocurrencies. A trend can be influenced by a variety of factors, such as economic data, political events, and global news, as well as supply and demand dynamics within the market itself. As the term implies, though, trends can change quickly and unexpectedly, as markets are subject to volatility and fluctuations (particularly the crypto market).

What Is a Trend Line in Trading?

Quite simply, a trend line is a straight line that connects two or more price points on a chart, representing the direction and strength of a trend. It is one of the simplest and most popular technical analysis tools used in trading to identify potential entry and exit points.

How to Identify a Trend

Traders and investors use a range of tools and techniques to identify trends in financial markets. Some common methods for identifying trends include the following:

Price charts and trends

The most common way to identify trends is to analyze price charts. Traders and investors often use candlestick or bar charts to look for patterns in the price movements of an asset over time. They may also use technical indicators like moving averages or trend lines to help identify trends.

Traders can use price charts to identify trends by looking for patterns of higher highs and higher lows in an uptrend or lower highs and lower lows in a downtrend. These patterns indicate that the price is moving in a particular direction and that a trend is developing.

Some traders also use moving averages in combination with price charts to confirm trends. For example, if the price is above the moving average, it may suggest an uptrend, while a price below the moving average may indicate a downtrend.

Additionally, traders can use chart patterns, such as head and shoulders, triangles, and flags, to identify trends and potential breakouts. These patterns can provide valuable information about market sentiment and potential price movements.

Moving averages and trends

Moving averages are technical indicators that help smooth out the price data by calculating the average price over a specified period. Traders and investors use different types of moving averages to identify trends in the price movements of an asset.

To use moving averages to identify trends, traders typically look for two key signals: price crossing above its moving average and the slope of the moving average.

In the case of the former, when the price of an asset crosses above its moving average, it can be a signal that the trend is turning bullish. Conversely, when the price crosses below the moving average, it can indicate that the trend is turning bearish. In the case of the latter, if the moving average is sloping upward, it can be a signal that the trend is bullish. Conversely, if the moving average is sloping downward, it can indicate that the trend is bearish.

Traders will often use a combination of moving averages of different time frames to confirm the trend and identify potential trade opportunities. For example, a trader might use a longer-term moving average, such as the 200-day moving average, to identify the overall trend and a shorter-term moving average, such as the 50-day moving average, to time their entry and exit points. By using multiple moving averages, traders can get a more comprehensive view of the trend and reduce the likelihood of false signals.

Trend lines

Trend lines are diagonal lines that are drawn on a price chart to help identify the direction of a trend. An uptrend is typically identified by connecting the low points on a chart, while a downtrend is identified by connecting the high points.

To use trend lines to identify trends, traders should first determine whether the market is trending up, down, or sideways. This can be done by looking at the chart and identifying a series of higher highs and higher lows in an uptrend, or lower lows and lower highs in a downtrend.

Once the trend has been identified, the next step is to draw the trend line, which involves connecting at least two significant price points in the trend using a straight line. After drawing the trend line, traders should look for additional confirmation that the trend is in place, which can be accomplished by looking for additional price action signals such as higher highs or lower lows that support the trend.

And, finally, once the trend line is in place, traders can use it as a signal for potential entry and exit points. For example, in an uptrend, traders may look to buy when the price touches the trend line, or wait for a pullback to the trend line before buying. In a downtrend, traders may look to sell when the price touches the trend line or wait for a bounce back to the trend line before selling.

Price patterns and trends

Price patterns are another tool that traders use to identify trends in the financial markets. These patterns are formed when the price of an asset moves in a particular way that is repeated over time, and they can provide valuable information about the underlying trend.

One of the most common price patterns used in trend following strategies is the "higher highs and higher lows" pattern. This pattern indicates an uptrend, where the price is consistently making higher highs and higher lows over a period of time. Traders can use this pattern to enter long positions and ride the trend.

Conversely, the "lower lows and lower highs" pattern indicates a downtrend, where the price is consistently making lower lows and lower highs over time. Traders can use this pattern to enter short positions and profit from the downward trend.

Other price patterns that traders use to identify trends include triangles, flags, and channels. These patterns can be used to confirm an existing trend or to identify a potential trend reversal.

Volume and trends

Volume is an essential tool for traders to identify trends. An increase in trading volume can be an early sign of a developing trend, providing traders with the opportunity to enter or exit a position before the trend is fully established.

The trend is confirmed when the trading volume increases. The trend is deemed more robust when there is a corresponding increase in trading volume. An increase in volume shows that market participants are taking positions and are committed to the trend. Conversely, a decrease in volume indicates that market participants are losing interest, and the trend may be weakening.

Volume spikes can indicate a potential shift in the trend direction. For example, if there is a sudden surge in volume during a downtrend, it may indicate that the trend is reversing, and an uptrend is emerging.

When the price is rising, and the trading volume is also increasing, it is a strong indication that the trend is bullish. On the other hand, when the price is declining, and the trading volume is also decreasing, it is a strong indication that the trend is bearish.

Traders should use volume analysis on multiple time frames to gain a broader understanding of the trend. For example, if the trading volume is increasing on both the daily and weekly charts, it is a strong indication that the trend is robust and has the potential to continue for some time.

How to Use Trend Lines in Trading

To use trend lines in trading (whether in day trading, copy trading, or another form of trading), traders first need to identify a trend in the market. This can be done by examining the price chart and looking for a series of higher highs and higher lows in an uptrend or lower highs and lower lows in a downtrend. Once a trend has been identified, traders can draw a trend line by connecting at least two swing points in the direction of the trend.

When using trend lines in trading, there are several things to consider. First, the more times a trend line has been tested and held, the more significant it becomes, indicating stronger support or resistance levels. Second, trend lines can be used to help identify potential breakouts or breakdowns in the market, where prices move beyond the trend line, indicating a potential reversal of the current trend. Finally, traders can use trend lines in conjunction with other technical indicators, such as moving averages or oscillators, to confirm potential trading signals and improve the accuracy of their trades.

What Is a Trend Following Strategy?

A trend-following strategy is a popular trading approach used by traders to identify and capitalize on market trends. This strategy involves analyzing the historical price data of an asset to identify the direction and strength of a trend. The goal of a trend-following strategy is to enter into a long or short position when a trend is identified and ride the trend until it shows signs of reversing.

The trend-following strategy assumes that trends in the market persist over time and that there is a higher probability of a trend continuing than reversing. The strategy is based on the idea that it is easier to make a profit by following the trend than trying to predict market movements.

Trend-trading strategies can be used in various financial markets such as stocks, currencies, commodities, and cryptocurrencies. Traders can use technical analysis tools such as moving averages, trend lines, and momentum indicators to identify trends in the market.

In a bullish trend, traders would look for buying opportunities, and in a bearish trend, they would look for selling opportunities. The strategy involves placing stop-loss orders to limit potential losses if the trend reverses, and profit targets to lock in profits if the trend continues.

Examples of Trend Following Strategies

Now that we know a bit more about trends, trend lines, and what a trend following strategy actually entails, let’s look at some practical strategy examples.

Moving Average Crossover strategy

We’ve mentioned it enough in this article, and it should come as no surprise that moving average crossover strategy is a popular one. This strategy involves using two or more moving averages with different periods to identify trends. When the shorter-term moving average crosses above the longer-term moving average, it's considered a bullish signal. Conversely, when the shorter-term moving average crosses below the longer-term moving average, it's considered a bearish signal.

This strategy works well in trending markets, where there is a clear and sustained uptrend or downtrend. In such markets, the moving averages act as dynamic support and resistance levels, helping traders to stay on the right side of the trend. The strategy helps traders to avoid making impulsive trades based on short-term fluctuations in the market and instead focuses on the bigger picture of the trend.

One of the main advantages of the MAC strategy is its simplicity and ease of use. Traders can easily identify buy and sell signals by observing the crossover of the moving averages on a price chart. The strategy is also adaptable to different time frames, making it suitable for traders with different trading styles and preferences.

Donchian Channel strategy

This strategy involves using the Donchian Channel, which is a channel indicator that plots the highest high and lowest low over a specified period. When the price breaks above the upper channel, it's considered a bullish signal, and when it breaks below the lower channel, it's considered a bearish signal.

It was developed by Richard Donchian, who is considered the father of trend following trading. It consists of two bands, an upper band, and a lower band, that are drawn based on the highest and lowest prices over a set period of time, typically 20 days. The upper band represents the highest price over the past 20 days, while the lower band represents the lowest price over the past 20 days. The area between the two bands is known as the "channel."

Traders using the Donchian Channel Strategy can buy when the price breaks above the upper band and sell when the price breaks below the lower band. This strategy assumes that a breakout from the channel indicates a strong trend in that direction, and traders can ride that trend until the price breaks below the lower band or above the upper band.

Parabolic SAR strategy

The Parabolic SAR (Stop and Reverse) is a trend following indicator developed by J. Welles Wilder. It's used by traders to identify potential reversals in the price direction of an asset and to set trailing stop-loss orders. The Parabolic SAR strategy is based on the idea that a strong trend is likely to continue until the price action and the Parabolic SAR indicator intersect.

In the Parabolic SAR strategy, dots are plotted above or below the price action, depending on whether the trend is up or down, respectively. When the dots are above the price, it indicates a downtrend, and when the dots are below the price, it indicates an uptrend. In other words, when the dots are below the price, it's considered a bullish signal, and when they are above the price, it's considered a bearish signal.

When the price crosses the dots from below, it's a signal to buy, and when the price crosses the dots from above, it's a signal to sell. Additionally, the Parabolic SAR can also be used to set stop-loss orders, as it tracks the trend and can adjust the stop-loss order as the trend develops.

Relative Strength Index (RSI) strategy

The Relative Strength Index (RSI) strategy is a popular trend following strategy that can also be applied to the crypto market. The RSI is a momentum oscillator that measures the speed and change of price movements. The indicator oscillates between 0 and 100 and is considered overbought when it is above 70 and oversold when it is below 30.

In the context of crypto trading, the RSI strategy can be used to identify potential trends by looking for oversold or overbought conditions. When the RSI is oversold, it may indicate that the asset is undervalued and due for a price increase, which could signal a potential buying opportunity. Conversely, when the RSI is overbought, it may suggest that the asset is overvalued and due for a price decrease, which could signal a potential selling opportunity.

Traders may also use the RSI to confirm a trend that has already been identified using other indicators or chart patterns. For example, if a trader identifies a bullish trend using a moving average crossover strategy, they could use the RSI to confirm that the asset is oversold and likely to continue the upward trend.

Ichimoku Kinko Hyo strategy

The Ichimoku Kinko Hyo strategy, also known as the Ichimoku Cloud strategy, is a popular technical analysis tool used by traders to identify trends in the crypto market. The strategy is based on a complex set of indicators and can be used for both short-term and long-term trading.

One reason why the Ichimoku Kinko Hyo strategy is considered a trend following strategy in crypto is because it is designed to provide a comprehensive view of the price action and market trends over multiple timeframes. The strategy uses several lines and a cloud that move in tandem with the price chart, which can help traders quickly identify trends and potential entry and exit points.

The first line in the Ichimoku Kinko Hyo system is the Tenkan-sen line, which is a moving average of the highest and lowest prices over a set period. This line is often used to identify short-term trends and is considered a signal line for trading.

The second line in the Ichimoku Kinko Hyo system is the Kijun-sen line, which is a longer-term moving average. This line is used to identify medium-term trends and is often considered a confirmation of the short-term trend.

The third line in the Ichimoku Kinko Hyo system is the Senkou Span A, which is calculated by averaging the Tenkan-sen and Kijun-sen lines and plotting the result ahead of the current price. This line forms the upper boundary of the cloud and can be used to identify resistance levels.

The fourth line in the Ichimoku Kinko Hyo system is the Senkou Span B, which is calculated in a similar way to Senkou Span A but uses a longer-term moving average. This line forms the lower boundary of the cloud and can be used to identify support levels.

The cloud between the Senkou Span A and Senkou Span B lines is shaded in green during an uptrend and red during a downtrend. Traders can use the position of the price relative to the cloud as a signal for entry and exit points.

When the price is above the cloud, it's considered a bullish signal, and when it's below the cloud, it's considered a bearish signal. The indicator also includes a lagging line, which can be used to confirm the trend.

Do Trend Following Strategies Work?

Trend-trading strategies have been used by traders for decades and have shown to be effective in certain market conditions. However, like any trading strategy, trend-following is not foolproof and does not guarantee success in all market conditions.

One of the advantages of trend-following strategies is that they can help traders avoid emotional decision-making. By following objective rules based on market trends, traders can avoid making impulsive decisions based on fear or greed. This can help reduce trading losses and increase the likelihood of profitable trades.

However, trend-following strategies can also have drawbacks. One of the biggest challenges is that markets are not always trending. There are periods of consolidation, ranging, and choppiness where trend-following strategies may not work as well. In addition, there can be false signals and whipsaws that can result in losses.

Another challenge with trend-following strategies is that they can be slow to respond to changes in market conditions. By their nature, trend-following strategies require a sustained trend to be profitable. If the market changes direction quickly, trend-following strategies may not be able to adapt quickly enough, resulting in losses.

Overall, trend-following strategies can be effective in the right market conditions, but they are not a guaranteed path to success. Traders should be aware of the limitations and risks associated with trend-following strategies and use them in conjunction with other analysis and risk management techniques.

Common Indicators Used in Trend Following Strategies

We’ve already alluded to some of the most popular ones in the sections above, but he’s a quick and handy guide to some of the most common trend indicators used in trend following strategies.

• Moving averages: A moving average is a commonly used technical indicator that shows the average price of a security over a specific period of time. Traders often use moving averages to determine the direction of a trend.
• Relative Strength Index (RSI): The RSI is a momentum indicator that compares the magnitude of recent gains to recent losses in an attempt to determine overbought and oversold conditions of an asset.
• Average Directional Index (ADX): The ADX is another momentum indicator used to determine the strength of a trend. It measures the strength of the trend on a scale of 0 to 100.
• Bollinger Bands: Bollinger Bands are a volatility indicator that consists of three lines. The middle line is a moving average, and the upper and lower bands are calculated by adding and subtracting a multiple of the standard deviation from the moving average.
• Ichimoku Cloud: The Ichimoku Cloud is a popular technical indicator used to identify support and resistance levels, trend direction, momentum, and trading signals. It consists of several lines, including a conversion line, a baseline, a leading span, and a lagging span.

Tips and Tricks When Using Trend Following Strategies

Trend following is a popular trading strategy that aims to identify and capture trends in the market. While there is no one-size-fits-all approach to trend following, there are some tips and tricks that traders can use to enhance their success with this strategy. Here are a few:

• Use multiple time frames: Looking at multiple time frames can give you a more complete picture of the trend and help you avoid getting caught up in short-term fluctuations. For example, if you're trading on a daily chart, you might also look at a weekly or monthly chart to get a longer-term view.
• Combine indicators: No single indicator is foolproof, so it's a good idea to combine multiple indicators to confirm a trend. For example, you might use a moving average crossover strategy in combination with the relative strength index (RSI) to identify buy and sell signals.
• Set realistic expectations: Trend following is not a get-rich-quick strategy, and it requires patience and discipline. It's important to set realistic goals and not expect to make huge profits overnight. It's also important to manage your risk and avoid taking on too much leverage.
• Keep emotions in check: Trading can be emotional, especially when you're dealing with losses. But letting emotions guide your trading decisions can lead to impulsive and irrational behavior. Stick to your strategy and avoid making emotional trades.
• Stay up-to-date with news and events: Trends can be influenced by a wide range of factors, including economic data, geopolitical events, and central bank policies, among many other things. Stay informed about the latest news and events that could impact the market and adjust your strategy accordingly.

Getting Started with Trend Following Trading

The easiest and safest way to get started with trend following trading is through Trality’s Bot Marketplace, a one-of-a-kind space that brings together crypto trading bot creators and investors for mutually beneficial purposes. Unlike other platforms with anonymous bot makers and unproven bots, Trality’s Marketplace is a carefully curated space with hand-picked creators and the best bots available.

Whether you’re interested in copy trading or different types of trading strategies, the Trality Marketplace enables investors to rent profitable bots tailored to specific risk tolerances (low, medium, and high) and individual investment goals. A full suite of metrics is available, allowing investors to decide on a bot based on clear, quantifiable data.

Receive updates in real time whenever changes are made to a bot. Should a bot underperform, investors have the ability to unfollow it at any time and select another bot. With just a few taps in the Marketplace’s mobile app, investors can easily leverage the expertise of professionals by renting the most trusted bots on the market.

Parting Words on Trend Following Strategies

Trend-following trading is a type of investment strategy that involves buying or selling assets based on the direction of the market trend. The basic premise of trend-following trading is that if a market is trending in a certain direction, it is more likely to continue in that direction than to reverse.

The win rate for trend-following trading can vary widely depending on the specific strategy and market conditions. In general, trend-following traders aim to capture the majority of the trend, which can result in a high win rate when the trend is strong. However, when the market is choppy or in a range, trend-following traders may experience more losses.

Whether trend following trading works or not depends on the specific strategy and market conditions. Like any investment strategy, trend trading has its pros and cons. One advantage of trend trading is that it can potentially capture large gains when the market is trending strongly. However, trend trading can also result in losses when the market is choppy or in a range.

All in all, many traders believe that trend following is the best strategy because it allows them to capture the majority of the trend and potentially make large profits. Trend trading is also relatively simple to understand and implement, making it accessible to both novice and experienced traders.