In trading on financial markets, numerous strategies and trading systems are employed to maximize profit. A significant portion of these strategies is based on trend-following — the directional movement of an asset’s price. However, to utilize them, a trader must answer a number of questions, such as how to identify trends on charts and when to enter the market to capitalize on its potential.
What Is a Trend
In financial markets, a “trend” refers to the movement of an asset’s price in one direction. It can be upward (bullish, up-trend), downward (bearish, down-trend), or sideways. In the latter case, it is generally said that there is no trend, and a special term — “flat” — is used for this situation.
It is believed that the concept of a trend in stock market trading (from where it subsequently spread to other financial markets) was introduced by the founder of technical analysis theory, Charles Dow. He provided its definition and examined the trends and their phases operating in the markets.
According to Dow, a trend should be defined as a movement where each subsequent high and low is higher (in an uptrend) or lower (in a downtrend) than the previous ones. This definition allows traders to identify both the trend itself and the moments of its termination. This is the definition that most traders use today when drawing trend lines to determine trends.
Important note. Dow’s definition is not interpreted unambiguously. For instance, traders primarily focus on successive local highs and lows when identifying trends. However, W.D. Gann, well-known for his success in the stock market, used a different approach. He suggested considering a trend if the highest and lowest prices of each trading day were higher/lower than those of the previous day.
Types of Trends
The theory states that several trends operate in any market:
- Primary (global, long-term). Develops over years and shows the most general trend.
- Intermediate (medium-term). Lasts from several months to a few years.
- Minor (short-term). Shows the fastest, often speculative, market movements, lasting from a few days to several months.
All these trends exist simultaneously in the market. As a result, price movement is uneven and has local highs and lows. Traders use trend analysis to determine the optimal moments to open positions and lock in profits.
Note. The global trend of the stock market is upward (bullish), driven by global factors such as the development of the world economy and the increase in the number of investors.
Trend Phases
Dow proposed three main phases of a trend in the market:
- Accumulation.
- Public Participation.
- Distribution.
Accumulation phase occurs after the end of a downtrend. At this point, market makers, large players, and experienced traders believe that the price has become attractive enough to start buying. They begin opening long positions, accumulating the asset in their accounts. Since the volumes of their trades are substantial, the price of the instrument starts to rise.
Other traders react to the rising prices and also start buying the asset. The involvement of the mass market participants (“the crowd”) significantly increases the trading volumes and accelerates the price growth process. Since the crowd is heterogeneous, its market entry is spread over time. As a result, this phase provides the maximum price increase and has the longest duration.
In distribution phase, large holders believe that the profit level on their open positions has reached the planned level. They start reducing their positions, selling the asset to those members of the crowd who still wish to join the movement. The sales volumes partially or completely offset the purchase volumes, causing the trend to slow down or transition into a flat.
A downtrend develops similarly, but for it, the first and last phases are distribution and accumulation, respectively.
Note. An ordinary investor is almost unable to participate in the first phase of a trend because the volumes of their trades are insufficient to significantly change the asset’s price. To maximize profit, their task is identifying trends on charts. They need to recognize the emergence of directional price movement as early as possible and join it. Entering late, at the end of the public participation phase, can lead to significant losses instead of profits.
Trend Characteristics and Properties
All market trends have specific characteristics and general properties.
Characteristics:
- Direction. Indicates the vector of price movement. Based on this criterion, trends are classified as upward or downward.
- Duration. Trends are classified as short-term, medium-term, or long-term based on the time the price remains in a directional movement.
- Strength. This measure reflects the activity of traders participating in the formation and development of the movement. The more market participants join and the larger the total volume of their trades, the more pronounced the advantage of one side (buyers or sellers), and consequently, the faster prices rise. On charts, the strength of a trend is represented by the slope of a line that best approximates the market movement.
The line that best approximates the trend movement of the price is called a trend line. There are several ways to draw it on charts. However, the most common method involves connecting several local extremes opposite to the direction of the vector. For an upward trend, the trend line connects local lows, and for a downward trend, it connects local highs.
According to Dow’s theory, some key properties of a trend are:
- A trend is more likely to continue than to end or reverse.
- The stronger the trend, the higher the probability of its continuation.
- A trend can end at any moment.
- The occurrence or continuation of a trend under certain past conditions does not guarantee the formation or continuation of a trend under the same conditions in the present.
Attention. This set of properties determines the use of trends in trading systems on financial markets.
How to Identify and Use Trends
In stock market trading, various methods are used to determine whether the price is truly trending:
- Fundamental analysis. If a company repeatedly shows positive financial results in its reports as stock prices rise, and economic news reflects an improvement in the industry and country, there is a high probability of further appreciation of the securities.
- Chart analysis. The most well-known method is the construction of the aforementioned trend line. As long as prices remain above it in an upward trend or below it in a downward trend, the trend is said to continue.
- Technical analysis trends. Various tools, such as trend indicators, are used. The most well-known and widely used are moving averages. They reflect not only the direction but also the strength of the trend.
- Volume analysis. During a developing trend, price increases are accompanied by stable volumes or a gradual increase in volumes. A significant drop in volumes or an unpredictable peak can be considered a signal of the trend’s end.
Note. In a clearly expressed trend, almost any trade in the direction of price movement is considered potentially profitable. However, to execute a truly profitable trade, one must meticulously choose the entry point.
The importance of trends in trading lies in the fact that most trades in the direction of the trend yield profits, while most trades against it result in losses. The strategy of trading with the trend direction includes several general principles:
- Trades are opened only in the direction of the trend.
- The entire amount allocated for the asset is not used immediately for trades. It is better to open several positions (if the trading platform allows) or increase the overall volume at each entry point. The optimal entry point is considered to be local extremes (lows in an upward trend, highs in a downward trend).
- It is essential to set Stop orders to limit losses. They are typically placed beyond the classic trend line and moved as the price progresses.
- Exit the trade when the next extreme contradicts the trend definition (usually automatic with proper Stop order placement) or when the planned profit level is reached.
Note. This last rule is rarely followed by novice traders who strive to hold positions to increase profit levels. They forget that the trend can end or change at any moment, resulting in unrealized profits quickly converting into significant losses.
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