By Hrishikesh Menon. Edited by Arjun Chandrasekar.
Trend trading is just how the title sounds, trading on a particular market trend for a specific timeframe. This trading strategy is very common among short-term traders and highly profitable if used correctly. This article will cover the various trends seen through the stock market and how traders can profit off of them.
Types of Trends
The basic trends which are seen throughout any security are uptrend, downtrend, or consolidation. An uptrend is where the prices are in a gradual rise, a downtrend is where the prices are dropping gradually, and consolidation is when neither an uptrend or downtrend is present (stagnation).
Trading on an Uptrend
The most common trend trading is done on uptrends as the common strategy of buy low sell high applies directly to this situation. Uptrends may vary in strength: there can be a weak or strong uptrend. A weak uptrend is when the rate of return on the security’s price is relatively low. Although there is only a modest amount of growth, it is steady and the growth will last longer, which are the optimal conditions which long term investors yearn for (along with strong fundamentals). A weak uptrend can also be beneficial for swing traders if the security’s trade volume is increasing because that is usually an indicator of a breakout in price. A strong uptrend is the exact opposite of a weak one: the rate of return on price will be exponentially larger. All day/swing traders look for these trends as it is the fastest way to make huge profits. However, there are disadvantages to trading on a strong uptrend: you would be risking higher losses as a reversal on the trend is imminent and entry and exit points will be hard to find due to the fast moving trend. Overall, the easiest way to minimize risk and make profits are through long positions on uptrends at the right entry and exit.
Trading on a Downtrend
As stated above, the best way to make profits on an uptrend is through long positions. On a downtrend, profits are best made through short positions. Short selling is basically the opposite of long buying a security. When you short sell a security, you are essentially borrowing shares of that security from a broker and holding those shares in the hope that the price of the security will go down. Once it is down, you would buy back the borrowed shares and your profit is whatever the difference is between the price you borrowed and the price you bought back. Applying this type of transaction to downtrends is best because in a downtrend the prices drop and short selling allows you to make profits off the declining price. In a way, shorting a declining security is more riskier than buying on a growing one since hypothetically, a security’s price could go up infinitely but it can only go down to zero so by shorting, you would be risking infinite losses which is what drives traders away from trading on downtrends. The same strength categories stated for uptrends apply to downtrends. A weak downtrend can be optimal for a long term short position but it is quite risky as a weak downtrend almost always reverses which is why shorting on strong trends is most lucrative.
Risks of Trend Trading
The trends stated above are relatively easy to make profits off of, but many trend traders struggle to limit their losses as they do not apply risk management strategies to their trades. All successful traders use risk management through limiting losses and profits by finding the correct entry and exit points. When looking to buy on an uptrend, the perfect entry point is right after a small pull back in price. For example: a stock at $100 is in uptrend and increases upto $120, starts to resist and pulls back 5% (puts it at $114). This is when the trader would start to closely watch the movement and see if that price will become the support or continue decline. If the price does create a support line and starts to increase, the trader would first confirm the growth and enter the trade on the candle after. To manage the risk, the trader would put a stop loss order at the previous low which is $114 and a take profit order depending on the risk ratio the trader will adopt. In this case, we assume it is 2:1 so the take profit order will be at the price where the profit will be twice as much as the estimated loss. This same strategy is used when shorting a stock but reversed. The trader will be watching for a pull up in price and use that lower high as the stop loss and use their risk ratio to put in their take profit order.
Although trend trading seems easy from the exterior, there are many factors involved–strength of trends, risks, entry and exit–which must be taken into consideration before traders can trade on trends and hope to make profits.