Trend following is the foundation of trading or investing in the financial market. This is because the goal of any trader is to buy a financial security that is reasonably priced and then riding the upward trend. Similarly, the trader could sell a security and wait for its price to drop. The trend is a consecutive diagonal movement of a financial asset. To follow the trend, traders may either get in as the trend continues or may get in when it is starting. The difficult part in trend following is in predicting when the trend will happen and when it reverses. This article will explore a few strategies to use when using the trend following strategy.
The trend is your friend
In trading, a common phrase is that the trend is your trend until when it reverses. The general idea about this is that it may be wrong to attempt to go against the trend. For example, when a currency pair or any security is moving upwards strongly, it may be wrong to go against it. This is known as timing the market. This is because the security will always follow the path of least resistance. When the trend is nearing its end, you will see signs about it. A good example of this is in the Nasdaq chart shown below. After the crisis, the Nasdaq index – and other indices – started a sharp rally. Traders who went against it made huge losses while those who rose the wave have seen their returns more than double.
How to Identify Trends
Traders use different methods to identify the formation of new trends and confirmation of existing trends. The most important is fundamental analysis. In this, they use the news and economic data to predict how a certain security will move. For example, if a dovish Federal Reserve suddenly changes tune and becomes increasingly hawkish, the dollar value will likely increase. As a result, the dollar index will likely move in an uptrend while currencies pairs with the dollar as the base currency may accelerate higher.
The next important method is technical analysis. This involves the use of technical indicators and candlestick patterns to predict the future of a trend. There are three most common types of indicators. These are trend following indicators, oscillating indicators, and volume indicators. They are further classified into two: lagging and leading indicators. The former usually track the movement of the security while leading indicators move ahead of the price.
Trend indicators like the moving averages, parabolic SAR, and Bollinger Bands are lagging indicators which send a signal about the strength of the trend. For example, when a double moving average is used, a crossover could indicate that the trend is about to change direction. Similarly, when the parabolic SAR dot is below an upward-moving indicator, it is an indication that the trend may continue. A good example of the double MA is shown in the chart below.
Oscillator indicators are used to show important levels in a security. They are mostly show when the price of a security is overbought and oversold. Two of the most popular oscillator indicators are the Moving Average Convergence Divergence (MACD) and the Relative Strength Index (RSI). As shown below, the two indicators have been good indicators of the strength of the trend.
Volumes indicators on the other hand are good indicators on the strength of the indicator. They include Accumulation/Distribution and the Money Flow Index (MFI). They are good signals of when to avoid a false breakout. This happens when the reversal of a security is not supported by the volume.
In addition to these, there are tools like the Fibonacci Retracement which tells you where you expect the security to go. It might be a good tool to identify the potential support and resistance points as shown below.
Finally, it is important to understand the candle formations. There are many formations that may help you identify the formation of a new trend. There are multiple types of these. Examples of them are the Hammer and Hanging Man, Engulfing patterns, Dark Cloud cover, piercing patterns, morning star, evening star, shooting star, harami patterns, doji, and three black crows among others.
Understanding these key components of technical analysis may help you know when to enter a trade when a trend is starting and when to exit when it is reversing.
The post A Guide on How to do Trend Following Well appeared first on Forex.Info.