Table of Contents
Trend analysis is considered a type of technical analysis that traders use to forecast a security’s price direction. Trend analysis is a lagging indicator, which uses historical data to identify price trends, and help traders spot potential buy and sell opportunities.
Trend traders often rely on technical analysis tools such as momentum indicators, moving averages (MA), and support and resistance levels to identify trend patterns.
Depending on the direction of the trend, traders may take a long position (if prices show an upward trend) or a short position (if they’re moving downward).
Trend trading is a sophisticated strategy that comes with its own risks, as there are no guarantees a trend will hold, and trends frequently reverse.
Key Points
• Trend trading is a technical analysis strategy used to forecast price direction by identifying patterns in price movements.
• There are three main types of market trends: uptrends (bullish), downtrends (bearish), and sideways trends (ranging markets).
• Essential trend indicators include the use of moving averages, support and resistance charts, and momentum indicators.
• Common trend trading strategies involve breakout trading, moving average crossover strategies, and trading pullbacks and dips.
• While trend trading may help traders profit, there are no guarantees of success, given market volatility.
What Is Trend Trading?
Trend trading, sometimes called trend following, is an offshoot of technical analysis: using a set of tools and metrics to assess stock price movements over time, whether investing online or through a traditional brokerage. Technical analysis helps traders identify patterns in price movements in order to decide whether to enter or exit a position.
Traders may follow a trend over any period of time, including short- , medium-, and long-term trends.
A trend may go upward (a bullish trend), downward (a bearish trend), or sideways (a neutral or range-bound trend).
Trend Trading and Technical Analysis
Traders typically combine different types of analysis and technical tools to help decide when to enter and exit stock positions, how best to profit from a trend, and how to manage the inevitable risk factors.
Technical analysis is different from fundamental analysis, which examines a company’s core financials, like its earnings and revenue. Professional technical analysts are called Chartered Market Technicians or CMTs.
Although the time-honored market adage holds that past performance never guarantees future results, technical analysts often take into account how market psychology, and sentiments like fear and greed, may influence trends or cause them to repeat over time.
For example, if a trader believes that a stock price is on a downward trend, they might take a short position (a strategy known as short-selling), selling stock and potentially rebuying later at a lower price.
On the other hand, if a trader believes that a stock is on an upward trend, they might take a long position. In other words, they would buy stock with the belief that it might increase in value over a certain period, and that they would be able to sell it at a higher price.
Get up to $1,000 in stock when you fund a new Active Invest account.*
Access stock trading, options, alternative investments, IRAs, and more. Get started in just a few minutes.
Trend Trading Fundamentals
Trend trading may sound straightforward, but it requires a deep understanding of market dynamics and the factors that can help investors evaluate price movements. A few fundamentals to know:
Support and Resistance Levels
One of the patterns that analysts look out for when looking at stock charts are certain thresholds at which stock prices tend to rise or fall.
• The support level is a point to which a stock will sink but won’t usually fall any further before rising again. It is essentially the level at which demand is strong enough to bolster the price.
• The resistance level is the level at which selling is strong enough to prevent prices from rising further.
For traders who want to take a long position, they might enter a position near a known level of support and exit within a known level of resistance. Traders interested in taking a short position, would do the opposite.
The Impact of Volume
Trend traders may also take trading volume into consideration. Stock trading volume is a measure of the number of shares that are being bought and sold during a given period.
Another way to look at volume is that it represents investor interest in a stock. The more stock being traded, the heavier the volume and the greater the interest — although additional information is needed to determine the direction of a possible trend.
Recommended: Support and Resistance: A Beginner’s Guide
3 Types of Market Trends to Identify
You might also notice that asset prices during rising and falling trends tend to move in waves. For example, a stock price during a rising trend might rise a little, then make a brief dip before rising again, and so on. The inverse would be true for falling trends.
The end of a rising wave is known as swing high. It’s the price peak before a downturn. The end of a falling wave is called a swing low — the low point before prices rise.
Traders will often zero in on these moments, using them to their advantage, helping them make buy or sell decisions, or using them as key data points for other types of analysis.
1. The Uptrend (Higher Highs and Higher Lows)
You might hear rising trends described as “bullish” because of the way they’re moving forward. Typically during these periods, there is relatively low volatility.
These periods are characterized by short pullbacks on stock price, which are also known as countertrends. In general, however, the rising trend is a series of higher swing highs and higher swing lows, indicating that the price is rising over time, despite the dips along the way.
Because of their low volatility, rising trends may be relatively easy for the average investor to trade in. That said, the countertrends tend to be short and shallow, which means it’s not always easy to know when to jump on board.
2. The Downtrend (Lower Highs and Lower Lows)
“Bearish” or falling trends are characterized by a series of lower swing lows and lower swing highs. In other words the wave pattern starts to reverse itself. The falling trend often differs from a rising trend because there is more volatility, and highs and lows are quick to follow each other.
Falling trends can be tricky for the average investor to negotiate due to their inherent volatility. Price movements and countertrends can be big, which can make it difficult to profit from the trend.
3. The Sideways Trend (Ranging Market)
Neutral trends tend to represent a break between rising or falling trends during which stock price moves up and down in small increments during an extended period of time. This occurs as the price bounces back and forth between levels of support and resistance, with the range between the two possibly being more narrow than in a rising or falling trend.
Think of it a bit like ping-ponging between the floor and ceiling of supply and demand. At this point the price is moving “sideways,” and if you plot the trend lines they will look horizontal and relatively flat.
5 Essential Trend Indicators to Know
Following are some of the technical indicators that traders employ to help identify trends.
1. Moving Averages (MA)
A moving average (MA) is the average value of a security over a specific time. The MA can be:
• Exponential Moving Average (EMA)
• Weighted Moving Average (WMA).
By looking at moving averages traders are able to tune out stock price volatility to a degree, to focus on the signal rather than the noise, and gauge the direction a price may be headed. If the price is above the moving average, it’s considered an uptrend versus when the price moves below the MA, which can signal a downtrend.
Moving averages are typically used in combination with each other, or other stock indicators, to identify trends.
thumb_up
Pros:
• Using moving averages can filter out the noise that comes from price fluctuations and focus on the overall trend.
• Moving average crossovers are commonly used to pinpoint trend changes.
• You can customize moving average periods: common time frames include 20-day, 30-day, 50-day, 100-day, 200-day.
thumb_down
Cons:
• A simple moving average may not help some traders as much as an exponential moving average (EMA), which puts more weight on recent price changes.
• Market turbulence can make the MA less informative.
• Moving averages can be simple, exponential, or weighted, which might be confusing to new traders.
2. Relative Strength Index (RSI)
The relative strength index or RSI is an oscillator tool that looks at price fluctuations in a given period, and calculates average price losses and gains. It ranges from 0 to 100. Generally, above 70 is considered overbought and under 30 is thought to be oversold.
Traders often use the RSI in conjunction with the MACD (see below) to confirm a price trend. The RSI can sometimes identify a divergence, when the indicator moves in opposition to the price; this can show the price trend is weakening.
thumb_up
Pros:
• An RSI can help investors spot buy or sell signals.
• It may also help detect bull market or bear market trends.
• It can be combined with moving average indicators to spot breakout trends or reversals.
thumb_down
Cons:
• The RSI can move without exhibiting a clear trend.
• The RSI can remain at an overbought or oversold level for a long time, making this tool less useful.
• It does not give clues as to volume trends.
3. Moving Average Convergence Divergence (MACD)
The Moving Average Convergence Divergence (MACD) helps investors gauge whether a security’s movement is bullish or bearish, and helps gauge the momentum of the trend. The MACD uses two different exponential moving averages (EMAs) and a signal line to do so.
The 26-period EMA is subtracted from the 12-period EMA to generate the MACD line. Then a signal line, based on a nine-day EMA, is plotted on top of the MACD to help reveal buy and sell entry points.
If the MACD line crosses above the signal line, that can signal a potential buy opportunity. If it crosses below the signal line, that could signal a price decline and a potential opportunity to sell or take a short position.
thumb_up
Pros:
• The MACD, used in combination with the relative strength index (below) can help identify overbought or oversold conditions.
• It can be used to indicate a trend and also momentum.
• Can help spot reversals.
thumb_down
Cons:
• The MACD might provide false reversal signals.
• It responds mainly to the speed of price movements; less accurate in gauging the direction of a trend.
4. On-Balance Volume (OBV)
OBV is a little different from the other indicators mentioned. It primarily uses volume flow to gauge future price action on a security or market. When there’s a new OBV peak, it generally indicates that buyers are strong, sellers are weak, and the price of the security may increase.
Similarly, a new OBV low is taken to mean that sellers are strong and buyers are weak, and the price is trending down.
The numerical value of the OBV isn’t important — it’s the direction that matters. In that respect it can be used as a trend confirmation tool. It can also signal divergences, when the price and the volume move in opposite directions.
thumb_up
Pros:
• Volume-based indicator gauges market sentiment to predict a bullish or bearish outcome.
• OBV can be used to confirm price action and identify divergences.
thumb_down
Cons:
• It can be hard to find definitive buy and sell price levels.
• False signals can happen when divergences and confirmations fail.
• Volume surges can distort the indicator for short-term traders.
5. Average Directional Index (ADX)
The ADX is used to evaluate the strength of a given trend, and it’s typically used in conjunction with other indicators because alone it doesn’t show the direction of a trend, but measures its power.
As such, the ADX is a smoothed average of two directional movement indicators (DMI): +DMI (which measures the strength of an uptrend) and -DMI (which measures the strength of a downtrend), typically over a 14-period window. The three lines are typically plotted together on a chart, with the ADX providing a clear read of the +DMI or the -DMI. This can help traders decide when and whether it’s worth “trading the trend.”
The ADX has a range of 0 to 100. Values below 20 indicate a sideways or nonexistent trend; a value between 20 and 25 may show a trend developing; and scores above 20 indicate a strong trend.
thumb_up
Pros:
• The ADX is considered a reliable indicator of trend strength.
• It can also help traders gauge trend momentum.
• The ADX can help traders identify breakout trends.
thumb_down
Cons:
• The ADX is a lagging indicator, and can’t be considered predictive.
• It’s less effective in volatile conditions.
Common Trend Trading Strategies
Trend traders typically use technical indicators to execute certain types of strategies.
Breakout Trading
In a market that’s displaying strong trends, either up or down, traders may look to see signs of a breakout, i.e. a change in the trend direction. One signal of a potential breakout is when previously known indicators of support and resistance now show a reversal. Depending on the momentum of the trend, this could signal a breakout trend.
Simple Moving Average Crossover Strategy
A simple moving average (SMA) crossover strategy uses two different SMAs for relevant time periods (short, intermediate, and long), plotted on the security’s price chart, to gauge potential entry and exit points.
For example, a trader looking at short-term opportunities might take a 10-day SMA and a 20-day SMA to look for crossover points. When the shorter SMA line crosses over the longer SMA, that can signal an uptrend — and a possible buy opportunity.
If the shorter SMA crosses below the longer SMA, that could signal a reversal or a downtrend, and traders may consider selling.
Trading Pullbacks and Dips
Trading pullbacks and dips requires a different sensibility, because these patterns involve spotting a temporary break from a trend that isn’t a full reversal. The trader looks for a shorter pullback, so they can enter a position at a favorable price, while expecting the prevailing trend to resume. The challenge is being able to tell the difference between a temporary dip and reversal, which requires experience and technical savvy.
Retracement trading occurs when there are temporary reversals in price that nonetheless present traders with an opportunity to place a trade, and take advantage of the price change when the trend resumes.
Fibonacci retracements are a type of tool that some traders use to gauge the support and resistance levels for a certain stock price.
Benefits and Risks of Trend Trading
Because trend trading can be complex, and requires substantial technical know-how, it offers potential upsides and downsides.
Potential Benefits of Trend Trading
At its best, trend trading offers traders a time-tested system for anticipating price movements. As such, it can help guide traders to enter or exit certain positions, perhaps helping to manage risk or maximize certain outcomes.
Trend analysis is somewhat adaptable as well. Traders, as well as investors, can base their trend trading strategy on a range of applicable data points. This may include market data, fundamental analysis, economic indicators, and more. In short, there’s no one way to do trend trading; it’s a matter of experience and skill.
Potential Risks and How to Manage Them
That said, trend trading offers no guarantees of success. Traders have to be disciplined in their analysis, and resist the impulse to make decisions based on sudden price movements.
In addition, trend trading as a methodology cannot possibly take into account all market movements, never mind external factors. For that reason, experienced trend traders must learn to use a combination of tools when looking for trend confirmation, and accept a certain degree of risk.
Last, trend trading is based on historical data, i.e., past performance. While many traders believe that insights into an asset’s future movements can be gleaned this way, others debate the merits of this strategy.
How to Start Trend Trading in 5 Steps
It’s relatively easy to start trend trading, and many platforms provide a learning environment that simulates actual trend trading in order to help you get the hang of it. Here are a few steps to help get you started:
1. Start by opening an account that enables DIY trading.
2. Identify what you want to trade. It’s possible to take positions in a range of markets, but less experienced investors may want to start by mastering one.
3. Decide how you want to manage risk. Commonly, trend traders might use a combination of stop-loss and different types of limit orders to minimize losses.
4. Take advantage of demo testing where available. This enables you to build skills and confidence before investing in the markets.
5. Start trading, and be sure to monitor your positions and adjust as needed.
The Takeaway
Which strategy you use when buying stocks or other securities ultimately depends on your experience and understanding of different tools and techniques. If you’re a hands-on investor, trend trading is a strategy that might help you identify when to buy and sell individual stocks.
Other investors may be interested in a more hands-off approach, such as considering buying mutual funds or exchange-traded funds (ETFs) that hold large portfolios of securities that don’t require active trading strategies or technical analysis.
Ready to invest in your goals? It’s easy to get started when you open an investment account with SoFi Invest. You can invest in stocks, exchange-traded funds (ETFs), mutual funds, alternative funds, and more. SoFi doesn’t charge commissions, but other fees apply (full fee disclosure here).
FAQ
Is trend trading a good strategy?
Trend trading can be an effective strategy, especially for experienced traders who are skilled at using various technical analysis tools. While there is always risk involved in trend trading, it might be more risky for investors who don’t understand all that’s required to analyze the price movements of various assets.
Can trend trading be profitable?
It’s possible that trend trading might be profitable, and that the careful use of technical analysis could provide an advantage when making trades. But trend trading is a high-risk endeavor, and it’s not guaranteed to deliver a profit.
How do I analyze trends?
Analyzing trends requires understanding some of the factors that go into price movements (such as support and resistance levels, as well as volume), and knowing which technical indicators can provide the most relevant information for a possible trade.
How is trend trading different from day trading?
Day trading is the practice of buying and selling securities within a single trading day. Trend trader look to identify trends that may occur over several days, weeks, months, or even years. While some day traders may use trend-trading techniques, generally the much-shorter timeframe makes some trend trading strategies less useful.
Is trend trading the same as swing trading?
No. Trend trading is where a trader identifies a price trend and takes a position in order to ride out the trend (and ideally see a profit). Swing trading takes advantage of price changes, whether on the upswing or during a dip.
Photo credit: iStock/ArtistGNDphotography
INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE
For disclosures on SoFi Invest platforms visit SoFi.com/legal. For a full listing of the fees associated with Sofi Invest please view our fee schedule.
Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.
Mutual Funds (MFs): Investors should carefully consider the information contained in the prospectus, which contains the Fund’s investment objectives, risks, charges, expenses, and other relevant information. You may obtain a prospectus from the Fund company’s website or clicking the prospectus link on the fund's respective page at sofi.com. You may also contact customer service at: 1.855.456.7634. Please read the prospectus carefully prior to investing.Mutual Funds must be bought and sold at NAV (Net Asset Value); unless otherwise noted in the prospectus, trades are only done once per day after the markets close. Investment returns are subject to risk, include the risk of loss. Shares may be worth more or less their original value when redeemed. The diversification of a mutual fund will not protect against loss. A mutual fund may not achieve its stated investment objective. Rebalancing and other activities within the fund may be subject to tax consequences.
Exchange Traded Funds (ETFs): Investors should carefully consider the information contained in the prospectus, which contains the Fund’s investment objectives, risks, charges, expenses, and other relevant information. You may obtain a prospectus from the Fund company’s website or by emailing customer service at [email protected]. Please read the prospectus carefully prior to investing.
SOIN-Q325-052