The Basics Of Trend Trading

Before beginning to trade in forex or other financial assets, it's important to be aware of some of the strategies you may choose in your trading activity. Traders customarily identify two strategies for analysing and taking positions in an asset: range trading and trend trading. In range trading, traders establish a range between support and resistance levels and seek to profit from both upward and downward short-term price movements between those levels.

Trend trading is a longer-term strategy where traders take positions along a cycle of price movements in a particular direction, either upward or downward. Traders can establish positions that are likely to see larger price movements over the long term while avoiding losses that can occur from price "breakouts" from a given range.

Trend Trading Requirements

Unlike range trading, where traders can limit their concerns to a particular price range, trend trading may require a greater level of patience from traders in addition to some confidence that the trend they have identified should continue. Further, traders need to be aware that trends can be suspended, or reversed, by actions like government interventions in markets or changes in market sentiments.

Successfully trading trends requires predefined risk management parameters. A few of the most common are stop loss orders, trailing stop losses and risk vs reward ratios (R/Rs).

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Stop Loss Orders

A stop loss order is an order that limits the capital lost on a given trade. Stops are placed at market to ensure that losses are manageable if a strong trend suddenly reverses course.

For a long position, a stop loss is placed below market entry and exists as a sell order. For short positions, stops are located above market entry and exist as a buy order. Stop losses can be used to mitigate the damage of a significant trend retracement.

Trailing Stop Losses

Trailing stops are frequently used by day traders and swing traders to maximise profitability in the live market. A trailing stop is located a set amount of pips from market entry. If price moves positively, the trailing stop moves in concert with price.

As an example, Trader A buys the EUR/USD at 1.1400 and uses a 10 pip trailing stop loss. Upon Trader A's order being filled at 1.1400, a trailing stop is placed at 1.1390. If rates move to 1.1401, the stop loss order moves to 1.1391. If the EUR/USD reverses course, the stop loss doesn't move backward—it holds firm.

Risk vs Reward Ratios

A risk vs reward ratio aligns a trade's assumed risk to its potential reward. In forex day trading, a position's risk/reward is key to its potential success or failure.

As an example, Trader A's EUR/USD trend trading strategies demand at least a 1:2 risk vs reward ratio. Trader A decides to risk 25 pips on a long EUR/USD trade. Accordingly, the reward must be 50 pips to satisfy the parameter.

Commonly implemented forex risk/reward ratios are 1:1, 1:2, 1:3, 1:4 and 1:5. Generally, the higher the assigned reward, the lower the probability of a trade being successful. However, when swing trading, trades with minimal risks and much higher rewards can be the most profitable over the long run.

Identifying A Trend

On technical charts, trends are usually marked by a succession of higher or lower trading ranges. An uptrend is understood as a market that makes a series of higher highs and higher lows, and a downtrend is understood as a market that makes a series of lower highs and lower lows. Trends may continue for a matter of days, weeks, or months, depending on the condition of the financial markets.

Many traders use trendlines to clearly identify trends. To do so, one simply draws a line connecting a series of periodic higher highs or lower lows. Some traders use multiple trend lines to spot trading opportunities in real-time.

Following Events

Traders will find it helpful to pay attention to real-world factors that could be driving long-term trends for certain currencies and assets. To examine this crossover, they will want to follow the latest news for interest rate policies, national trade and investment balances, inflation, national production factors or government policies that could be influencing these indicators.

The Trend Is Your Friend: Getting In On A Trend

It may not always be possible to identify the absolute beginning or end of a trend. However, traders can seek to get into a trade at least early enough to take a position ahead of the middle of the trend and ride it upward or downward towards its completion.

By far, one of the biggest challenges posed by trend following is entering the market. Many directional moves in price come with little warning and happen quickly. This phenomenon can discourage beginners and lead traders to "chase price."

Technical analysis offers traders many tools for trading trends. Among the most popular in forex trading are the MACD, Relative Strength Index (RSI) and chart patterns.

Price action trading is also useful as market entry decisions are made according to the pricing fluctuations themselves. In this way, trend traders can buy pullbacks in concert with the broad trend direction.

Stop Loss: Protecting Against A Reversal

Despite advances in forecasting tools and analysis, the future of a trend is never 100% certain and traders can stand to lose if a trend changes direction. One popular way to lock in profits and protect against losses from a trend reversal is to set stop-loss orders along the trend.

A stop-loss is a pre-set order to buy or sell a security in case its price moves below or above a certain predetermined level. While this functions as a sort of insurance against losses, the levels at which stop-losses are set should be carefully considered. The reason being the stop-loss could end up locking a trader out of further gains with the trend if the price reversal turns out to be only temporary. Some traders like to use a percentage level of price movement to determine where they are comfortable in setting stop-losses.

Reversals: Finding The Top Or Bottom

Calling the absolute top or bottom of a trend can be difficult. Some traders even suggest that it's easier to accept some small losses and assure gains than to try to always take a maximum profit by exiting a trade at a peak or trough of a long-term price movement. Still, it's important for traders to have an idea when a trend may be reversing. Among the popular techniques for determining the end of a trend include identifying what traders call "double tops," or "double bottoms," of chart trend lines.

These can be identified when a chart trend line reaches a short-term high or low point and then fails to surpass that resistance or support level on a subsequent second movement in that same direction. When this occurs, traders often take it as a signal that a trend reversal may have begun.

How To Trade A Trend: An Example

Let's say a trader is considering getting in on a trend in the Mexican peso. He has seen news reports that the level of inflation in Mexico is rising and that the country's central bank may be forced to consider raising interest rates. Global oil inventories are high and Mexico's oil exports have fallen.

The country is also reporting a trade deficit that will need to be covered by incoming investment. Analysts estimate Mexico could begin an interest-rate-tightening cycle that could last for 14 months or more. Checking more data, the trader finds that Mexico's currency has fallen to a five-year low against the dollar.

Under such conditions, the trader could expect that the peso could begin to rally for some time as investors pour money into the country seeking low-priced Mexican assets and rising returns from increasing local interest rates. Looking at the charts, he identifies the start of a trend of strengthening in the peso.

The trader then decides to take a long position in the peso at 15 per USD with the expectation of holding onto that position for a period of time as the currency makes a steady march stronger against the dollar. Considering some historical data and opinions from analysts in the market, the trader decides to try to maintain the position until the peso returns to at least a five-year high against the dollar.

In the interim, the currency level may vary upwards or downwards on an intraday or weekly basis, but the trader will nevertheless aim to hold on to the position while the longer-term trend continues. When the peso reaches 50% of the long-term price target, the trader decides to set a stop-loss to lock in the profit obtained so far in case there is an unexpected reversal of the trend. The stop-loss order may then be set at progressively higher levels as the currency moves toward a point where the trader expects it could see a long-term reversal.

Catching The Wave: Commonly Used Technical Indicators In Trend Trading

While catching a trend, like catching a wave in surfing, may require some special observation of market conditions, there are technical indicators found on some trading platforms that can help.

  • Moving Averages – One simple way to spot a trend is to use a moving average, which is measured by the closing price of 'n' periods summed up and divided by 'n.' One of the most common moving averages is the 200-day moving average, which represents about a year of price data.
  • Regression Channels – This is a type of price channel that uses multiple-time-frame analysis to show you where the price trend, or "trend bias," is going over time. The channel uses an algebraic formula to determine a median price line and upper and lower resistance and support levels that will likely accompany that line.
  • Ichimoku Cloud – This cloud indicator uses direction, momentum and volatility data to attempt to measure the strength of a price trend and give signals about whether it is stable or may be weakening.
  • Speculative Sentiment Index – The Speculative Sentiment Index (SSI) is an indicator unique to FXCM trading platforms that reveals how strongly market participants feel about the trend for a particular asset at a given time.

The index measures the number of long positions in a currency pair compared to the number of short positions in the same pair.

Summary

Although asset prices can sometimes remain "range-bound" within given highs and lows, trend trading can be a reliable strategy to use at times when markets are on a long-term trajectory in a particular direction. Traders will do well to incorporate both range trading and trend trading techniques into their skill sets to maximise their potential for gains in varying market conditions. This includes gathering useful tools and knowledge to identify currency trends, take positions, protect against possible market reversals and identify market tops and bottoms that signal appropriate points to exit a trade.

As always, risk is inherent to investment, so forex traders can benefit from conducting their due diligence and/or consulting independent financial advisors before participating in range trading or other strategies.

FXCM Research Team

FXCM Research Team consists of a number of FXCM's Market and Product Specialists.

Articles published by FXCM Research Team generally have numerous contributors and aim to provide general Educational and Informative content on Market News and Products.

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