This handy Cheat Sheet provides an overview of how to follow the big-money market players to the glorious land of profitability. Get tips on why trend trading works so well, how to determine a trend that will continue after you enter the market, and how to manage your risk once you're in a trade.
Why trend trading is so effective
Trend trading is a common and long-standing approach to trading for good reason: It works! Following, are some reasons why, so you don’t have to blindly accept the premise — and also because understanding why can give you the confident mindset required for successful trading.
The “whales” control the market. The markets are priced-based on an auction model of bids and asks and buyers and sellers, so logically the big fish in the sea (the market participants with the big money — pension plans, mutual funds, banks, hedge funds, insurance companies, and other institutions) create the big moves in the market. This isn’t implying that they’re doing anything illegal; it’s simply a matter that large amounts of money invested in the markets cause them to move. If one market participant has a lot of money, it may be able to move the market by itself. As a group, the big-money players have even more market-moving power.
Trend trading (also known as trend following) is one of the easiest and most reliable ways to make money in the markets because you’re following the leaders (sometimes called “the smart money”).
Trend trading is one of the simplest approaches to trading. The world of trading has become increasingly complex, causing many traders to suffer from information overload. From an endless number of trading systems, indicators, automated computer trading programs, and trading theories (with more being created every day), new traders often feel the need to study everything available. As a result, they become overwhelmed and confused.
Trend trading is a simple approach to the markets that doesn’t require a lot of fancy technology or an intimate knowledge of mathematics, geometry, or market theory. Therefore, trend trading is one of the simplest approaches to trading.
Trend trading has stood the test of time. Documentation of trend trading dates back to the 19th and 20th centuries, and it continues to be popular to this day. One of the most famous trading experiments ever conducted, gathering a group of students with no trading experience in an attempt to turn them into successful traders (the “Turtle Traders”), was used with a trend following approach.
The other 'energies' you need to trend trade profitably
As good as trend trading is, trend shouldn’t be the only factor in considering whether or not to take a trade. Other factors must be added to it to provide enough variables to create a probability scenario that puts the odds on your side.
Trading in the direction of the trend (the dominant direction of the market) is a great place to start. Determining the direction of the market at any given time is easy. The more important question for a trader is, “Will the market continue in that direction after I enter the market?”
Knowing the strength of the trend will help you determine the probability of the market continuing to move in the direction of the trend after you enter your trade. Use an indicator that measures momentum to determine whether the trend is strong or weak before you take a position in the market.
Determining the time to enter your trend trade is critical. If you get in too early, the market may experience a steep correction against your position before the trend continues. If you enter too late, the trend may be coming to an end. Use a cycle indicator and wave counts to determine the ideal time to enter the trend.
Managing your risk
All types of trading are risky, including trend trading. No matter what type of trading you do, not employing risk-management techniques in your trading is fiscally irresponsible. Here are few techniques to get you started managing risk:
Manage leverage responsibly. Leverage is a two-edged sword. It can help you make money faster, but it can also cause you to lose money faster. Consult with your broker regarding the amount of leverage made available to you to help you decide whether you should use leverage. Be conservative in your decision.
Don’t risk more money than you can afford to lose without disrupting your overall financial life plan.
Practice diversification. Trading various uncorrelated markets concurrently can help dilute the risk of having all your money committed to one financial vehicle.
Consider hedging your positions with options and/or futures. These highly leveraged tools can help offset the risk of your primary position with a relatively small amount of money. It’s similar to buying insurance.
Utilize effective money-management techniques. Use protective stops to help limit the amount of loss you’ll accept on every trade. Note: You shouldn’t use protective stops only for each trade but also to limit the amount of money you’re willing to lose in a given day, week, month, quarter, and year.