Trend following is an investment strategy that tries to take advantage of the small, medium or long-term moves. Many traders identify a trend following strategy, not to aim to predict certain price levels but to simply jump on the trend and ride it. Most trend traders enter a position after the trend “properly” establishes itself, anticipating that the identified trend will hold for a period of time.
If there is a turn contrary to the trend, the trader exits and wait for the trend to turn. Entry and exit rules are crucial here. So many fundamental principles are broken as there is a fine line between spotting a trend and/or anticipating one. Anticipating a trend to turn or reverse is very costly and would identify your style as that of a “contra-trader” or going against the trend. More on that in upcoming chapters. Keep in mind that one of the oldest clichés on Wall Street is that “the trend is your friend”.
Three Basic Types of Trends
An uptrend is made up of two or more consecutive higher pivot highs AND higher pivot lows. Time frames and your chosen chart platform are elements most use when identifying an uptrend. Uptrending stocks gain more validity each time the stock touches but doesn’t penetrate the uptrend line. An uptrend remains a trend until the series of higher highs and higher lows are broken.
A downtrend is made up of two more consecutive lower pivot lows AND lower pivot highs. Once a downtrend has been established (series of lower peaks) a trader should be cautious about entering any new long positions. Conversely to an uptrend, a downtrend remains a trend until the series of lower highs and lower lows is broken. Note: an upside break or penetration of a descending trend line is a buy signal, and usually is one of the first indications that the downtrend may soon end. The downtrend is deemed to be “over” with the formation of a HIGHER LOW or HIGHER HIGH.
Sideways or Range Trend:
A sideways/range trend is made up of two consecutive equal pivot highs AND pivot lows. Often regarded as a period of consolidation, demand, and supply are nearly equal. The sideways trend is generally a result of the stock moving between strong levels of support and resistance and many times will maintain those levels for a prolonged period of time. For stocks making big percentage moves, brief consolidation almost always happens.
What Changes a Trend?
At Tradeview Markets, our traders use three basic steps in identifying a change in trend. They are as follows and are in no particular order:
A Trend Line is Broken:
This chart shows the trendline HAS been broken. The trend has not yet changed but when stocks/indices break a trendline, they tend to move in the direction of the prevailing trend.
Price Falls Below Prior Low:
Here the stock has broken the previous low. There is now confirmation that the trend has changed because the stock is making LOWER HIGHERS and LOWER LOWS. A textbook definition of a stock in a downtrend.
There is a Retest and a Failure:
Let’s take stock in an uptrend. A stock in an uptrend makes higher highs and higher lows. When a stock fails to do this, one should start to question the current trend. This stock has tested the prior high and FAILED so this stock in question is no longer making higher highs but the note is not making lower lows so there is no confirmation yet that the trend has changed.