Long-term trends can be highly lucrative for astute traders who can correctly identify them and then properly manage their position - and their emotions - for the duration of the trade.
Trend traders can have a longer-term approach to trading. They will try to find a great up trending stock, buy it and ride it until the trend changes. After all, if a stock keeps going up, wouldn’t it be great to just buy it and let it double, triple, do what it does?
Because up trending stocks go through stages of higher highs and higher lows, these traders should have a loose stop and should not be worried about outside factors such as their stock being overextended, as long as the stock is still going up.
Trend-following trading is reactive by nature. It does not forecast or predict markets or price levels. Prediction is impossible. Trend trading demands self-discipline to follow precise rules (no guessing or wild emotions). It involves a risk management system that uses current market price, the equity level in the trader’s account and current market volatility. Trend traders use an initial risk rule that determines position size at the time of entry. This means they know exactly how much to buy or sell based on how much money they have. Changes in price may lead to a gradual reduction or increase of their initial trade. On the other hand, adverse price movements may lead to an exit for the entire trade. Historically, a trend trader’s average profit per trade is significantly higher than the average loss per trade.
Within trend trading there are systematic trend traders who can be identified as:
….traders following non-emotional sets of trading rules often based on mathematical models of market behavior. Systematic trend traders use their judgment and intuition in designing their market models and trading systems.
Trend trading is based around the human element - this is the core to succeed in trend trading. It takes discipline and emotional control to stick with trend trading through inevitable market ups and downs. Trend traders seek to capture the majority of a market trend, up or down, for profit. It aims for huge profits in all major asset classes - stocks, ETFs (exchange-traded funds), LEAPS® (long-term equity anticipation securities), options, bonds, currencies, futures and commodities.
Trading the trend
Trend traders believe that the real money is made on established trends. Financial success is about repeatedly identifying high-probability candidates and taking a chunk out of the proven market momentum. Therefore, when trading trends, the trend trader:
- Identifies the trend - Trend traders trading with the trend of the markets significantly increase the chances, or probabilities, for a trade to be successful. This approach is very straightforward until they need to break down the trend time frame. The yearly, monthly or weekly trends can be moving in different directions and it is important that they only choose candidates that have internal forces working together. They see the longest time frame as the overriding trend that must be respected as the driver of direction.
- Trades breakouts - Trend traders use the price breakout strategy by looking for new highs/lows on a monthly, weekly, daily or minute interval basis and the high odds of the future continuation of this momentum strength.
Benefits of trend trading
As long as a trend trader has market data each day, such as CNBC, news, fundamentals, broker opinions, talking heads, etc., everything else is unneeded or unimportant for making the big money.
The trend trader can benefit from this strategy in many ways, such as:
- Profit in up and down markets - Either a bull or bear market by following the trend to conclusion.
- No more buy and hold, analysts, or news is needed - Trend traders’ decision-making doesn’t involve discretion, guesses, gut feelings, or hunches. It’s not day trading or “buy and hope.” It doesn’t involve passive indexing, in and out trading, or fundamental analysis. No more 24-hour news cycles, daily turbulence, or sensational hype.
- No predictions necessary - Market trends are always happening - trending up and down. The trend trader reacts to the trend but never anticipates the beginning or end of a trend, only acting when the trend changes.
- Big money is made by letting profits run - Trend traders try to compound absolute returns.
- Risk management receives top priority - Trend traders always have defined exit protocols to control management of trades executed. Stop losses and proper leverage usage are standard practice.
- Takes advantage of mass psychology - Trend traders take advantage of other traders’ panicky mob behavior. Strict discipline minimizes behavioral biases. It solves the eagerness to realize gains and reluctance to crystallize losses.
- Scientific approach to trading - Trend traders follow strict scientific principles. They follow a process, not an outcome, because of rigid rules based around numbers.
- Strong historical performance in crisis periods - Trend traders are adaptable to differing climates and environments performing best during periods of rising volatility and uncertainty.
- No traditional diversification - Trend traders are not restricted to any single market or instrument. A focus on price action allows trend following to be applied to an exceptionally large variety of markets. Price is the one thing that all markets have in common - e.g., a trend trading system for treasury bonds should also work on the Euro and stocks.
Rules for trend trading
- Believe what you see, not what you hear or read - In other words, read the charts - not the news! Trust that price and price patterns are accurate reflections of the underlying fundamentals - sustained price movement with supporting economics.
- Determine the market trend - This could be a corollary of the above point - The markets can vary greatly from day to day. Volatility is certainly part of the market scenario. Therefore, the direction of the market needs to be determined and the trend established before trading - hence the following of charts by the trend trader.
- Finding Breakout Candidates - A trend trader will be looking for breakout candidates if the major indices are all bullish.
Example of a breakout
As you can see below, the current price pattern on the chart for Stemline Therapeutics Inc. (Nasdaq: STML) is showing a clear pattern of higher lows and higher highs. Traders must regard that information as being more valuable than what is said or written about the market.
- Market correlations should not be over-emphasized - Correlations from yesterday do not mean they will be the same today - market movement of one security can affect the behavior of another security, and vice-versa.
- Set and forget trades - Money-management rules are necessary in order to maximize profits.
- Buy dips in uptrends and sell rallies in downtrends - This is the “golden rule” of trading. No matter the strength of a trend, there will always be intra-day or intra-week countertrend reactions that provide opportunities for astute traders. Often times, these countertrend moves follow news that contradicts the prevailing pattern or trend. This generally leads to an opportunity to buy a dip in the uptrend, or sell a rally in the downtrend.
- Don’t try to pick the top or bottom - “Buy high, sell higher.” Trend traders usually want to participate in the top third of a move because that is when the rewards are greatest and occur fastest. They rely on two triggers to time their trades:
- Zone trades - Wherein they buy or sell at support or resistance; and
- Momentum trades - Wherein they buy based on overall pattern and shorter-term momentum.
Trend traders, no matter what the time frame, are likely to encounter these major problems:-
- False starts - Also known as whipsaws, false starts occur when the setup gives a positive signal, immediately followed by a reversal. Trend traders are stopped out of their position when the setup gives another buy signal.
- Shakeouts - This happens when a dramatic change in market conditions occurs, such as uncertainty or recent bad news circulating around a particular security or industry that forces traders to sell their positions, often as a loss. When a stock price is moving up - even though the trend trader may continually move the stops up - sometimes they are shaken out, no matter how strong the trend, even when applying some kind of filter. And they are going to be expensive because of the filter.
This classic fast-trending stock, Nu Skin Enterprises, Inc. (NYSE: NUS) increased by more than 100% in the months of January to August 2013. The stock completed a broad double bottom, with a breakout at [A] and again at [B], and is continuing its upward momentum.
Staying with the trend is difficult. Insiders or professionals had recognized the stock's value and tried every trick in the book to shake out existing positions and claim a bigger stake for themselves. There are many potential false breaks or shakeouts.
- Late exits - Trend-following systems either suffer from a large number of shakeouts or are slow to exit when the trend reverses, and often both.
- Taking profits too early - Apart from systemic problems, the human aspect has to be considered.A trend trading system builds psychological pressure as the trader witnesses repeated gains followed by significant retracements and frequent late exits at trend reversals. Pressure can build to such an extent that the trader attempts to take profits at a perceived high point in the trend. At this point the trader is following emotions rather than a system - a recipe for disaster.
When developing their trading system, trend traders should consider the time frame that they are trading; their transaction costs; their ability to endure frequent stops; and their tolerance for strong corrections. Finally, they need to decide whether they are going to trade fast-moving, highly volatile stocks (with greater risk) or slower, steadier blue chips.
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