BY PAUL ROBINSON , STRATEGIST

THE FUNDAMENTALS OF TREND TRADING

DailyFX Research Team

Contents
The Fundamentals of Trend Trading ............................................................................................ 3

Why Do Trends Form? ......................................................................................................................... 3

Pros and Cons of Trading Trends ...................................................................................................... 4
Trends Develop on All Time Frames .................................................................................................. 4
How to Identify a Trend....................................................................................................................... 4
Trading Strategies for Trends ............................................................................................................ 8
Trend Trading Strategy Checklist – 3 Ticks for Traders ..............................................................16

Disclaimer..................................................................................................................................17

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The Fundamentals of Trend Trading

There are three general market types traders should learn to navigate – trend, breakout, and range.
You will most likely gravitate more towards one versus another, but it’s a good idea to have the
flexibility to operate in each type, as markets cycle through volatility regimes.

A breakout strategy focuses on selling once support is lost or focuses on buying once resistance is
breached.

Range trading rests on the belief that “traders should sell high and buy low” as prices will stay flat
over a period. In other words, “the range will hold.”

In this guide, we will discuss the ins-and-outs of trending markets: why trends form, pros/cons of
trading trends, how to identify good trends, and various tactics for taking advantage of them.

Why Do Trends Form?

Technical analysis is often a misunderstood discipline, and even misrepresented by some of its
biggest proponents. Technical analysis doesn’t so much drive the market (although there is an
element of technically driven trading occurring), but rather represents market participants’ collective
perception of the underlying fundamental drivers and catalysts, or theme when one develops.

In a choppy, range-bound market there is an equilibrium between buyers and sellers in the absence
of an underlying driver. In a breakout market there is a gear switch towards a theme. In a trending
market the theme strengthens and becomes sustainable. A good trend won’t be derailed by individual
fundamental events and data releases, as these act only as short-lived setbacks with market
participants’ attention quickly turning back towards the broader underlying theme.

In the beginning of a trend, the theme isn’t visible to many, but as it matures it becomes apparent to
an increasingly less sophisticated crowd of traders until the trend eventually reaches a point of
exhaustion and changes course. For a more in-depth look at this process, check out Market Cycles |
Phases, Stages, and Common Characteristics.

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Pros and Cons of Trading Trends

One of the biggest advantages of trading trends can be the potential reward. Strong trends are known
for lasting much longer than most people estimate, which is exactly why they can go well beyond
‘reasonable’ expectation. Risk/reward ratios for trend-following strategies are typically higher than,
say, range strategies, but they also come with a lower win/loss percentage. This is fine as long as the
rewards are worth the lower probabilities of success on a per trade basis.

One of the drawbacks to trend-trading, is that good trends aren’t frequent. Often markets spend time
chopping around in search of a direction. This can make for a lot of starting and stopping before a
tailwind can push a market for a sustained period. Therefore, it is a good idea to also have strategies
for those markets that are caught in a range prior to a breakout.

Trends Develop on All Time Frames

Trends develop on all time frames, and as a result what is an uptrend on a short-term timeframe can
be nothing more than a counter trend on a longer-term time frame.

A trader’s focus should be on the time frame that most closely matches their objectives. For example,
a short-term swing trader with intentions of holding positions for several days to weeks will focus
primarily on the daily and 4-hr charts. By contrast, day traders will mostly focus on intra-day time
frames.

A good rule of thumb is that the higher time frame takes precedence, i.e., weekly > daily, daily > 4-hr,
and so on. Due to the effectiveness and popularity of the short-term swing trade, in this guide we will
focus on the daily and 4-hr timeframes.

How to Identify a Trend

Aside from making a general observation by looking at a chart, there are quantifiable ways to
determine and measure trends. Methods range from price action to moving averages to using more
sophisticated indicators derived from mathematical formulas. Two of the simplest and most robust
ways to identify a trend involve observing basic price action and moving averages.

When looking at price action, an uptrend is marked by a series of higher highs and higher lows, while
downtrends consist of lower lows and lower highs.

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Another straightforward way to identify the trend is by using moving averages. The simplest approach
is to use one moving average (it can be SMA or EMA, just be consistent in what you use) and how
price relates to it (price > MA = uptrend, price < MA = downtrend). Another method is by looking at the
tilt of the angle of the moving average (angled upward = uptrend, angled downward = downtrend).

Uptrend – Higher highs, higher lows | Above Moving Average (EURUSD)

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Downtrend – Lower highs, lower lows | Below Moving Average (AUDUSD)

You can also use more than one moving average and look at how the moving averages (MA) relate to
one another. If using two MAs, when the shorter is above the longer the market is trending higher.
Conversely if the shorter MA is below the longer MA, then the market is considered to be in a
downtrend. For example, if the 50-day MA > 200-day MA, the trend is considered up and if the 50-day
MA is below the 200-day MA, then the trend is down.

It’s worth noting that when a moving average trend signal exists, you generally have the corresponding
price action of higher highs/higher lows (up) or lower lows/lower highs (down).

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Uptrend with Two Moving Averages (S&P 500)

There are also a host of mathematically derived indicators to measure trends and their strength.
Average Directional Index (ADX) and Moving Average Convergence Divergence (MACD) are popular
choices you may want to explore.

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Downtrend with Two Moving Averages (GBPUSD)

Trading Strategies for Trends

There are several ways to enter into a trend, but two of the most common methods are via pullbacks
and continuation patterns.

Pullback trading is when you enter the market on a counter-trend price swing, or correction. Markets
rarely go straight up or down, which means they undergo corrective periods where price moves
counter to the prevailing trend and works off overbought (in an uptrend) or oversold (in a downtrend)
conditions that may have built up during the most recent leg of the trend.

Using support and resistance can be a highly effective way to determine when a pullback has run its
course and price is ready to resume in the direction of the prevailing trend. Price levels, trend-lines,
moving averages, and Fibonacci retracements are the most popular forms of support and resistance,
but other disciplines can be used as well.

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Confluence between two or more types of support/resistance helps strengthen the case for a
particular price level or zone acting as the most optimal level to watch for buyers or sellers to come
in. For example, if Brent Crude Oil (see below) is trending higher and it pulls back into price support
that is in confluence with a moving average, it is considered a stronger level than if it were just one of
the two technical events on their own.

Pullback to Support Offers Entry for Longs (Brent Crude Oil)

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Pullback to Trend-line Resistance Offers Entry for Shorts (AUDUSD)

Traders can enter into a position upon price touching a level or wait for a price action event to develop
that creates a swing-low (for longs) or swing-high (for shorts). Candlesticks can be highly effective
for doing just this. There are a host of candlestick configurations but looking at some of the simpler
variations is enough. Bullish hammers and bearish shooting stars are great for seeing the rejection
at support or resistance, respectively.

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Bullish Candlestick at Confluent Support for Long Entry (DAX 30)

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Bearish Candlestick at Confluent Resistance for Short Entry (AUDUSD)

Continuation patterns are another way to jump aboard a trend. These formations are a pause in price
action that indicates an increased likelihood that the trend will resume once the digestion period has
concluded. A few of the most popular patterns are triangles/wedges, rectangles, and bear/bull-flags.

A triangle/wedge is exactly as it sounds, and simply a congestion pattern formed as volatility shrinks
price towards the apex of the formation. These can take on a variety of shapes; symmetrical,
ascending, and descending. The symmetrical variation is simply two converging lines representing a
pending breakout. An ascending wedge has a flat top with higher lows. A descending wedge has a
flat bottom with lower highs. The key to trading these patterns is waiting for a confirmed breakout
above the top or bottom trendline of the formation to avoid false signals.

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Triangle Breakout in Uptrend (US Dollar Index)

Triangle Breakout in Downtrend (GBPUSD)

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Rectangles are sideways patterns that show very limited ability to reverse the trend. This horizontal
price action acts as a pause and once price breaks free from it, traders can take advantage of the
next leg higher or lower.

Bullish Rectangle in Uptrend (WTI Crude Oil)

Bull and Bear Flags develop as a retracement fails to garner much power, marked by overlapping price
action running counter to the trend. A bull flag triggers once the topside parallel of the pattern is
broken, while a bear flag triggers on a break of the under-side parallel. For further confirmation, one
can wait for the parallel to break and the most recent swing-high (for longs) or swing-low (for shorts)
inside the formation.

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Bearish Rectangle in Downtrend (Silver)

Bull-flag in Uptrend (GBPUSD)

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Trend Trading Strategy Checklist – 3 Ticks for

Traders
Trend trading is one of the most popular ways to capture market price swings. With the right rules
and approach one can develop a solid way to take advantage of sustained trends. Here are three key
steps:

1. Learn to Identify and Measure Trends

Methods range from price action to moving averages to more sophisticated indicators derived from
mathematical formulas. Two simple and robust ways involve observing basic price action and moving
averages

2. Find Opportunities for Trend Trades that Others Don’t See

Look for pullback trading and continuation patterns. Triangles/wedges, rectangles, and bear/bull-
flags are a few of the more popular continuation patterns.

3. Understand the Pros and Cons of Trend Trading

One of the biggest advantages of trading trends can be the potential reward. Strong trends are known
for lasting longer than most estimate. The drawback? Good trends aren’t frequent.

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