The Basics of Trend Trading

December 27, 2019 · 10 minute read

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The Basics of Trend Trading

When you think of trends, you might think of that time when everyone thought trucker hats were really cool, or how right now it seems like you can’t throw a rock without hitting a poke bowl spot.

And while a trend can be a current style or preference, the word can also mean a line of development or a more general shift in direction.

When it comes to trend-trading strategies to buy and sell stocks, these latter meanings are what traders are concerned with.

Here’s a look at what trend trading is and some common strategies with which it is associated.

What Is Trend Trading?

Trend trading, also called trend following, is essentially an offshoot of technical analysis—a set of strategies used by traders to examine stock prices over time, identifying patterns to help them know when it is potentially a good time to buy or sell.

To use the aforementioned trucker hat as an analogy for a moment: You basically want to start wearing those hats before they are cool and ditch them before the trend has played out.

Trend traders are often trying to make a similar move, buying stocks when they’re cheap, before there’s too much demand, then selling before the stocks are expensive and the trend is about to end.

Trend-trading strategies attempt to identify whether stock prices are moving up or down, and how fast—then using that information to decide when to buy and sell stock positions.

When prices move in one of these directions it can represent a trend. Generally there is an assumption that prices will continue to move in one direction unless acted upon by an event or outside influence.

Think of it a bit like the laws of inertia in physics. In physical science, an object in motion or at rest will stay in motion or at rest unless acted upon by an outside force. The same applies in trend trading, and when an outside force causes a change in a stock, this moment is called a pivot.

Traders will use a number of strategies to try to take advantage of trends and pivots. For example, if a trader believes that a stock price is on a downward trend, they might take a short position, 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 under the assumption that it will increase in value over the long haul and that they’ll be able to sell it at a higher price.

A Closer Look at the Types of Trends

While rising and falling trends are perhaps the most obvious and spottable types of trends, there is also a third, or neutral trend. If you were to look at a chart of stock prices, a neutral trend would basically be a flat, or horizontal, line.

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 a local, or swing, high. The end of a falling wave is a local, or swing, low. 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.

Trends can extend over short or long periods of time. Traders may look at months- or days-long trends, or they may zoom in and look for opportunities in hour-by-hour trends.

Rising Trends

You might hear rising trends described as “bullish” for the way they are moving forward. Generally, during these periods, there is relatively low volatility and low trading volume. 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 lows and higher swing highs.

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 can mean it’s not always easy to know when to jump on board.

Falling Trends

Falling, or “bearish” 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 markedly 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 them exciting to investors, but can also make it difficult to profit off the trend.

Neutral Trends

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 what is known as levels of support and resistance.

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 flat.

Trend-Trading Strategies and Indicators

Here are a few of the most common trend-trading factors, strategies, and indicators that help traders take advantage of trends:

Stop-Loss Order

A stop-loss order is a tool investors use to help manage the risk that prices will fall. They work when you place a stop-loss order with a stockbroker, who will then automatically sell a stock when its price falls to a certain predetermined level.

For example, say you bought a stock during an uptrend at a swing low. You might then set a stop-loss order at that price—your purchase price—in case the stock price begins to fall. (A stop-loss order may execute at a price lower than the purchase price, even if it is set at the purchase price, so it is not a guarantee against losses.)

For longer-term trend trading, investors may set the stop-loss order further away from the purchase price to allow for some of the natural ups and downs that can occur during an uptrend.

Stop-loss orders help investors lower their risk by hedging against decreases in the prices of their holdings.

Reading Trend Lines

Traders use trend lines plotted against a stock price chart as a sort of map to help them know when to make trades. Trend lines either connect swing lows or swing highs. The lines connecting swing lows represent uptrends, and the lines connecting swing highs represent downtrends.

As we’ve already mentioned, there can also be neutral trend lines that move sideways.

A typical chart might have multiple trend lines plotted against it, which can help traders identify opportunities to buy and sell. For example, there might be a long ascending trend line representing an upward trend in stock price.

A trader may look for short downward trends over the same period, and the points at which those short trend lines meet the long upward line could represent opportunities to buy.

The opposite may also be true—during a long downward trend, short upward trends may provide an opportunity to sell the stock position.

Trend lines are dynamic and frequently need adjusting. That’s because stock prices don’t move in a predictable fashion.

It’s important for investors to keep in mind that stock prices may move up and down away from the trend line and that doesn’t necessarily mean that the trend has ended.

Sometimes, traders may draw a trend line that represents a line of “best fit,” which can keep them from having to adjust too frequently when new data points fall outside previous trend lines.

Because trend lines can be imprecise, it may make sense for investors to think of them more as a guide than as a hard and fast indicator of when to buy and sell.

Momentum Indicators

One of the most important factors traders often try to identify within a trend is how strong the trend is, which helps them answer the question: is it likely to continue? This factor is known as momentum.

Momentum indicators compare a recent closing price with a closing price from the past. The time span between the two closing prices can be any length, and the momentum indicator can be calculated using one of two methods.

The first way to calculate momentum is simply by taking the difference between the current closing price and the closing price from a previous period. When the resulting number is positive the current closing price is higher than the previous price, and when it’s negative the current closing price is lower.

How far the difference is above or below zero is the indicator of how fast the price is moving. So a difference of 0.75 represents greater upward momentum than a difference of 0.45.

The second way to calculate momentum gives you a rate of change. You divide current closing price by past closing price and multiply by 100. When the resulting percentage is above 100, currently closing price is higher than past closing price, and when it’s below 100, the current closing price is lower. How far above or below 100 is the indicator of momentum. A rate of 90%, for example, is falling faster than a rate of 95%.

Increasing or decreasing momentum can provide buy or sell signals to investors. When looking at a momentum chart, these signals may occur when the momentum line crosses above or below the zero line. Momentum can also be used to help validate trades based on other price movements.

Moving Averages

When you look at a stock price chart it can be a bit messy, and the jagged lines can be hard to read. A moving average provides a way to organize that data more smoothly by taking the average of past closing prices over a given period of time. This much simpler line can help investors spot trends more easily.

When a stock price is above its moving average, it can indicate upward trends. When it’s below the moving average, it can indicate downward movements.

Investors may encounter two different types of moving averages: simple moving averages (SMAs) and exponential moving averages (EMAs). SMAs are the basic average of closing prices, whereas EMAs give more weight to more recent closing prices and adapt more quickly to recent price changes.

Neither method is necessarily better than the other, though depending on the other strategies you’re using, one may work better.

When You’re Ready to Buy or Sell

Which strategy you use when buying stocks or other securities ultimately depends on your own situation. If you’re a hands-on investor, trend trading is a strategy that might help you identify individual stocks. Other investors may be interested in a more hands-off approach, buying mutual funds or index funds that already hold large baskets of stocks.

Once trend traders have identified a stock to buy or sell and the moment to do so, they can execute a trade inside a brokerage account by placing an order with a stockbroker. This is also the time when investors would place a stop-loss order on a stock if they wish to use one.

Trend trading is markedly different from the long-term investment strategies that many investors use. For example, some investors use a goals-based investing strategy in which an investor is saving for long-term goals, such as retirement; others might use a buy-and-hold strategy.

These strategies hold investments for long periods, theoretically allowing them to grow and ride out any short-term market volatility.

When trend traders add any individual stock to a portfolio, they should be sure that it aligns with their long-term goals, their asset allocation, and diversification plans.

Whether you’re looking to be a hands-on or hands-off investor, SoFi Invest® has a platform for you. Active investing lets you buy and sell your own stocks — with zero SoFi transaction fees (subject to change).

If you don’t have time for making charts and tracking trend lines, automated investing may be the right fit for you. (SoFi does not offer stop-loss orders, but investors can place limit orders. There is a difference between these order types and investors should do additional research before placing a limit order on the SoFi platform.) RNDIP. Retail Nondeposit Investment Product.

If you think you’re ready to invest and want to learn more, visit SoFi Invest®.

SoFi Invest®
The information provided is not meant to provide investment or financial advice. Investment decisions should be based on an individual’s specific financial needs, goals and risk profile. SoFi can’t guarantee future financial performance. Advisory services offered through SoFi Wealth, LLC. SoFi Securities, LLC, member FINRA / SIPC . The umbrella term “SoFi Invest” refers to the three investment and trading platforms operated by Social Finance, LLC and its affiliates (described below). Individual customer accounts may be subject to the terms applicable to one or more of the platforms below.

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