Trend Trading Introduction

Trend Trading – What Is It?

One of the foundational principles of technical analysis is that asset prices move in trends. The intent of any technical trader is to enter early in the price’s trend and exit when it changes.

A chartist’s use of moving averages, trend lines and other indicators are an attempt to determine the direction of the price trend. Trend trading is, therefore, a systematic way of reading and trading the direction of the trend.

As you begin to develop a systematic way of trend trading, a common question that comes up is, “Which trend?” Trends can be intraday or can appear on daily, weekly or monthly charts.

One of the most important principles of technical analysis is that it is “fractal” in nature. That means you can technical analysis principles like trend, support and resistance to a daily chart. You can also apply to charts of various aggregation periods. This includes periods such as intraday, weekly or monthly.

In this Intro to Trend Trading, you’ll learn about the difference between trend and swing trading. You’ll also learn about trend timeframes and trending indicators. Finally, you’ll learn invaluable risk management methods you can use when trend trading.

Trend Trading Versus Swing Trading

It’s very common for traders to confuse the concept of swing and trend trading. Both strategies are, in fact, trading trends. However, the approach is quite different. For example, a swing trade captures the price movement as it “swings” from a cyclical low to a cyclical high or vice versa.

Trend trading intends to ride out the cyclical highs and lows as long as the “trend” is intact.

We determine trend based on the progression of cyclical highs and lows in the price. Therefore, the definition of an uptrend is a series of higher highs and higher lows. The definition of a downtrend is a series of lower highs and lower lows.

 The foundation for trend trading is formed by the trend in the cycle of highs and lows--which was popularized in the 1980’s. In the chart below, you’ll see an example using Adobe Inc. (ADBE) as it progressed through periods where it was trending up, down and sideways.

The red curves denote the cyclical highs and lows. The black arrows indicate the trend based on the progression of highs and lows.

In the chart, there were many opportunities for bullish swing trades while the price was in a neutral to bullish trend. In contrast, there was essentially one trend trade made an exit when the support broke at the beginning of January.

The swing trader is trying to capture more frequent smaller swings within the trend to generate a higher profit potential.

This is accomplished by selling at a higher price and buying back at a lower price. While the swing trader always has a greater potential for profit, it can be difficult to realize that potential. Trend trades will typically outperform when the trend experiences shallow pullbacks or upward gaps that the swing trader missed.

For more information on swing trading, check out my Introduction to Swing Trading.

Trend Trading - Trend Timeframes

A trend can be defined as intraday, short term, intermediate term and long term. In theory, a short-term trend is defined by the price movement for a period of a few days to a few weeks. The intermediate-term trend is defined by the price movement of a period of approximately six weeks to nine months. A long-term trend is defined by the price movement of a period of nine months or more.

These timeframes assume a four-week cycle for stock prices on a daily chart. A cycle is completed as the price moves from a cyclical low, to cyclical high and back to a cyclical low.

This understanding is essential when determining the period settings for indicators.

On a daily chart, the short-term trend is the movement from cyclical highs and lows. This is the trend that swing traders typically trade. The trend trader is usually trading the intermediate term trend.

On a weekly or monthly chart, the swing trader is playing the intermediate term trends between the cyclical highs and lows. The trend trader is playing the long-term trend in the price.

Trend Trading - Trending Indicators

Moving averages are a common indicator used when determining the trend of the price. While it’s possible to identify trend by the progression of its highs and lows, many traders prefer moving averages. This provides a way to simplify things or to make their system less discretionary.

Simple and exponential moving averages tend to be the most popular types of moving averages that most traders use.

A simple moving average places equal weight to each closing price over the look-back period selected. Exponential moving averages place greater weight to the most recent price movement.

Using the assumption of a four-week cycle, it allows us to understand how to determine the period settings for indicators. For example, short-term trends could be identified using indicators that are approximately half of the four-week cycle or less.

Therefore, periods ranging from two to fourteen days are common for short-term trending indicators. Intermediate-term trends can be identified using periods that encompass one to two complete cycles.

Therefore, periods ranging from 20 to 50 days is typical for intermediate-term trending indicators. Long-term trending indicators typically use 100 to 200-day periods for determining trend.

On the chart below, you’ll see three exponential moving averages representing the short-term, intermediate-term and long-term trends. These are presented on the chart by the 10-day (red), 30-day (blue) and 200-day (black) exponential moving averages for ADBE.

Because the 10-day and 30-day moving averages are declining and the price is trading below the average, ADBE is in short-term and intermediate-term downtrends. Since the price is trading above a rising 200-day moving average, the price is in a long-term uptrend.

Trend Trading - Risk Management

With any trading, controlling or defining risk in some way is imperative to your success as a trader. A common method of managing risk is the use of stop orders. A stop order is a preset order that will close your position at market if the stop price is triggered.

Stop limits can also be used but may fail to sell. This is because the stock or option price may fall too quickly or gaps below your limit price. The stop is triggered, but the limit order isn’t filled since the desired sale price is outside the market price. A mental stop could be employed but does require discipline to follow your system’s rules and manage the risk.

Trend Trading - Risk Management – Average True Range (ATR)

Average True Range (ATR) is a commonly used indicator for determining stop placement. The ATR value determines how far above or below the entry price your stop should be. The ATR calculation takes the average range between the high and low or the previous day’s close to the next day’s high or low, whichever’s greater.

A typical setting for the ATR is 14 periods, which equals one-half of the 4-week cycle for a daily chart. A stop set at 2-3 times the ATR is reasonable for trend trades, and it's a rule that can used for intraday, daily or weekly aggregation periods.

When trading or investing, it’s important to take similar amounts of risk per trade.

The process of determining how many shares to trade is called position size. Using the risk per share is a great way to calculate your position size for a trade. The first step in this process is determining how much portfolio risk you’re willing to take.

It’s typical for traders to risk up to one to two percent of their portfolio. The next step is to calculate your risk per share based on your stop and then divide that number into your portfolio risk. Voila! You now know how many shares to purchase.

Trend Trading - Putting it All Together

For a trend trading system to be complete, you need an entry and exit signal, and risk management rules. In October, I taught a class that was titled, “The Beginners Guide to Swing Trading Growth Stocks” that showed a trend trading system using the Keltner Channel. I covered the system during the last hour of the class.

Trend Trading – The Keltner Channel

The Keltner Channel is an indicator that incorporates an exponential moving average with volatility bands. The volatility bands are determined using the multiple of the ATR you set. Because the ATR will expand and contract with the price volatility, the upper and lower bands are considered “volatility bands.”

When applying the Keltner Channel indicator, the period length for the moving average has to be determined, whether the moving average is simple or exponential, the number of ATRs for the bands, and whether the ATR uses a simple or exponential average.

The indicators and settings are listed below. There is a shared link for TOS chart setup on the class page linked above:

  • 20-day exponential Keltner Channel with a 2 ATR simple average ATR
  • 200-day simple moving average
  • 20-day simple moving average applied to the volume

As you may have guessed, using the 20-day exponential defines the intermediate-term trend, and using the 200-day moving average represents the long-term trend. The lower band of the Keltner Channel, set to 2 ATR, is used for determining stop placement.

Trend Trading - Trading Rules

Entry Signal

  • A close above the 20-day EMA on 120% of average volume
  • The entry order would be placed just before the close or for the next morning
  • A stop would initially be set at the lower Keltner Channel or 2 ATR below the 20-day EMA

Exit Rules

  • Raise the stop to the lower Keltner Channel when the price closes below the 20-day EMA
  • Consider exiting on a large sell-off on high volume
  • Consider closing or hedging before an earnings announcement

Position Sizing

  • Based on the risk per share between the entry price and the lower Keltner Channel
  • Typically risk 0.5% to 2% of growth stock allocation, depending on the size of the account
  • # of shares are determined by taking the total risk (0.5% to 2%) and dividing it by the risk per share

Trend Trading - Example

The image below is of Ulta Beauty Inc. (ULTA). An entry signal was triggered when the price closed above the 20-day exponential moving average with over 120 percent of average volume. Upon entry, the stop is set using the lower Keltner Channel (blue line) value, which is 2 ATR below the exponential moving average.

Applying this methodology will typically have your stop set between 2-3 ATR below your entry price. The stop remained at the initial price until the price closed below the 20-day exponential moving average.  At that point, the stop increased to the lower Keltner Channel value on that day.

As the price continues to trend and the stop raised, eventually the price will break through the lower Keltner Channel and will trigger your stop. Being applied to a daily chart produces an intermediate-term trend trading system.

Trend Trading - Conclusion

For many traders, incorporating a trend trading system is important to utilize within some portion of their portfolio.

The allowance for more extended holding periods, compared to swing trades, allows some degree of patience for a trade to develop.

A trend trading approach can be applied to intraday holding periods up to long-term holding periods using weekly charts.

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