Trend Trading For Dummies
Overview
Trend trading lets the market do the work for you
Is your portfolio doing all it should? Are you looking for a market-focused way to increase returns? Try your hand at trend trading. Instead of analyzing the performance of a company, analyze the performance of the market as a whole. When you spot a trend, jump on it and let it ride until it's time to move. Whether your strategy is short-term, intermediate-term, or long-term, trend trading can help you capitalize on the action of market and get the most out of every move you make.
Trend Trading For Dummies will get you up to speed on the ins and outs of this unique technique. You'll learn how to spot the trends and just how heavily market analysis figures into your success. You can get as complex as you like with the data for long-term predictions or just go for quick rides that pump up your gains. Before you jump in, you need to know the basics that can help ensure your success.
- Learn the rules of trend trading and why you need a solid system
- Understand technical analysis to make accurate predictions
- Analyze the market and learn what to look for before you trade
- Use leverage to your advantage to make better moves
Trend Trading For Dummies includes trading strategies that you can use as-is, or customize to suit your needs. Thorough preparation is the key to any good trading plan, and it's no different with trend trading. Trend Trading For Dummies allows you to trade using every angle, and will get you out of or into the market in a flash.
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About The Author
Dr. Barry Burns is the founder of TopDogTrading.com, which he created to help students shorten their learning curve in becoming professional traders. He was also the lead moderator for the FuturesTalk.net chat room, has written numerous articles, and has been featured in several books and online trading radio interviews.
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trend trading for dummies
CHEAT SHEET
The practicality of trend trading is that you're waiting for the market to "show its hand" by establishing a clear direction and then jumping onboard for the ride.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.
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One of the primary reasons traders fail is that their minds are filled with misconceptions about the reality of trading. Those misconceptions make trading seem easier than it is. Ten of those misconceptions are dispelled here.
If you back test successfully, it will work in the future.
One of the popular approaches to creating a trading system is to begin with a certain idea, translate that into a charting concept that’s mathematically measurable, and then back test it.
Trading is a performance-based profession. You’re pitting your wits and skills against the market, which essentially means you’re competing with other traders. Human beings are creatures of habit, and it’s those habits that create the results you get in your personal life and professional life. Here are ten habits that can lead to being a consistently profitable trader.
The most obvious indicator for measuring momentum for many traders is the aptly named momentum indicator. It simply measures the amount that a market’s price has changed (often referred to as rate of change) over a given period of time, which you designate (14 bars is a common time period).
Another way to express the momentum indicator is that it measures the current bar’s closing price to a specific number of previous closing prices (such as the closing prices of the last 14 bars) and gives a reading as to how fast price is moving in a direction.
The highest and lowest prices that a market has traded in the previous 52 weeks are extremely popular support/resistance levels watched by traders and investors. These price levels are viewed as significant because they represent new territory that the market hasn’t seen for an entire year.
Most investors and traders consider it a bullish signal if a stock breaks its 52-week high, and this is the most common strategy using these support/resistance levels.
Investing is defined as holding a position for more than a year. Here is a quick overview of the pros and cons of this long-term strategy. Remember investing isn’t actually trading (trading is defined as a short-term activity).
Advantages of investing
The investing time frame is the most popular. Because it’s less active, the term trading is not used for investing.
Placing trade after trade throughout the day, actively monitoring every movement of the market, and making fast money are all exciting aspects of day trading. You can be in and out of a trade within a matter of 5 to 15 minutes. When successful, seeing that you made hundreds of dollars in a matter of minutes can provide an adrenaline rush like no other.
Swing trading is a lot like day trading, but its differences bring some unique advantages. Swing trading provides benefits for people who have restrictive work schedules and also for those who need more time to make trading decisions.
Swing trading can be a good trading style for people who work during market hours but still want to be active, relatively short-term traders.
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Amateur traders often complain that they make some money trading and then they soon give it all back (and sometimes give back more than they made). This seesaw effect of making money and losing money over and over is common for many traders because, for example, markets aren’t always trending in a clear direction up or down.
Bollinger Bands were created by John Bollinger in the 1980s, trademarked by him in 2011, and have enjoyed a wide following by many technical analysis traders. You can use them to help determine trend, strength, and volatility — the variation of the price of a market over time — in a dynamic, adaptive manner.
A market that has high volatility makes a large price movement in a given period of time.
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Some traders prefer to buy and sell retraces in the trend. Some traders prefer to enter trades on breakouts — entering the market after price breaks above a previous high (or below a previous low if trading short).
Entering on retraces or breakouts are both valid trading techniques. The concept of trading a breakout is to wait for the market to make a commitment to the upside by moving above a previous high.
Your brokerage firm is the company that facilitates the transaction between the buyer and seller through a stock or futures exchange. It usually takes a commission for its service. However, the spot forex market doesn’t have a central exchange to match orders, so your brokerage firm may make its money on the spread — the difference between the bid price and the ask price of the market you’re trading.
More markets are available for trading today than ever in the history of the world. The markets aren’t just available, but public access to them is easier than ever before.
With the advent of computers, high-speed Internet access and online electronic trading, you can sit home and trade stocks, commodities, bonds, currencies, futures, and options all around the world from the comfort of your home.
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After determining the direction you want to trade, you then look at the momentum indicator to see whether momentum (strength) is behind the trend. The trend, as shown by the 50 SMA, tells you only the direction of the market at this snapshot in time. It doesn’t tell you whether the trend is strong or weak.
If you execute a trade in the direction of a weak trend, that trend will likely end right after you enter.
Day trading requires the most trading proficiency and skill of any type of trading simply because it’s so fast paced, and therefore you must analyze the market and make decisions quickly. Day trading is definitely not for everyone; it’s difficult, and most day traders lose money.
Also, for those who have a job during market hours (which is most people), day trading is impossible simply because their schedule doesn’t allow it.
Although swing trading has its benefits, those benefits come with trade-offs. The term swing trading originally referred to holding a position for just a few days. However, the term has expanded in popular usage and now often refers to holding a position overnight (at least two days to distinguish it from day trading), but not as a long-term investment of a year or more.
The term waves is most often associated with Elliott waves. Ralph Nelson Elliott developed the Elliott wave theory. Elliott wave theory can be very detailed in its rules and complicated in its application.
The alternation of optimism and pessimism among the masses of traders creates the waves in the market.
Traditional Elliott wave theory declares that every trend has five waves: three impulse moves and two corrective moves.
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You can trade when only four of the five energies align, giving you a buy or sell signal. That is true, with this one caveat: The energy of scale must always support your trade. This is the one energy that can’t be left out.
This energy acts as either a filter to keep you out of an otherwise valid trade setup on the short-term chart or as confirmation to take the trade.
After developing his Elliott wave theory, Ralph Nelson Elliott observed that the wave patterns relate to the Fibonacci sequence. The Fibonacci sequence is a series of numbers created by adding the sum of the previous two numbers to create the next number in the sequence:
1 + 2 = 3
2 + 3 = 5
3 + 5 = 8
5 + 8 = 13
8 + 13 = 21
13 + 21 = 34
Thus, the beginning of the sequence is 1, 2, 3, 5, 8, 13, 21, 34.
Trend trading begins with determining the trend. The trend of the market is defined as the long-term direction of the market. But how do you determine what that direction is?
You can look at a chart and see that from the left side of the chart to the right side of the chart, the market has been moving up. Based on that observation, you may say that the trend is up.
Floor trader pivots are support/resistance levels that floor traders have used in the pits of the exchanges for many years. They define an equilibrium point (considered a neutral market) called the pivot point or central pivot.
The market is considered bullish when it’s above the central pivot.
The market is considered bearish when it’s below the central pivot.
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Market sentiment indicators measure the feelings of the market participants regarding how positive or negative they regard the market. Primarily, they’re used to provide information of the mass psychology of average traders (not professional traders) as to how bullish or bearish they are about the market in general.
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Trend trading has been an extremely popular approach to making money in the markets for as long as trading has been documented. Even those who don’t consider themselves primarily trend traders often consider the trend as part of their market analysis. With so many people looking at market trends, the question, “Exactly how do you determine and measure the trend of any given market?
The five-energy method is fundamentally quite simple. Ideally, you want all five energies to give a buy or sell signal at the exact same moment. However, the markets, like most things in life, aren’t so neat, tidy, and generous as to give you all five energies aligning at the same time. So you can allow yourself to take a trade if a minimum of four of the five energies align.
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Trading doesn’t come with certainties. Successful trading isn’t the ability to tell the future. Professional traders are managers of probabilities. You discover how to put the odds on your side.
As wonderful as trend trading is, you should add a few things to your trading arsenal to improve the probability of your trades succeeding.
Consulting various time intervals of the same market provides you with a different perspective in a similar way that you can look at an object with your naked eye or with a microscope. The magnification you use in looking at that object allows you to see things you wouldn’t see with the naked eye.
Each time interval chart looks different and provides different signals.
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The first decision you make with the five-energy method is whether you’re going to go long, go short, or stay out. Trend simply refers to the direction of the market — up, down, or sideways.
Credit: Figure by Barry Burns
Trade in the direction of the trend when you can get early into a new trend. Consider early to mean the first two retraces (wave lows in an uptrend or wave highs in a downtrend).
One of the secrets to wealth is the use of leverage. In short, the principle of leverage, as applied to making money, is to use a small amount of money to control a large asset.
Here, you explore leverage and how it relates to and differs from the margin made available to you by your brokerage firm.
Leverage: A double-edged sword in the battle for wealth
A common example of using leverage is when you buy real estate.
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.
Moving averages may be the most common type of indicator used for charting the markets. Like Bollinger Bands, they’re plotted on the same graph as the price bars and provide not only an indication of the trend of the market but also support or resistance barriers as price moves into the moving average lines.
Support and resistance are price levels in the market that price bars may have trouble moving through and therefore often bounce off of them.
Stocks
The theory of the market moving in waves is a valid and useful concept to keep in mind. However, you may prefer to trade with completely objective rules.
The following method for measuring waves doesn’t impose a five-wave maximum rule for each trend (as the Elliot wave theory does). It simply defines a mathematically objective definition for what a wave is and allows a trend to have as many waves as it decides to make.
Overnight risk refers to the risk of what happens to the markets while you’re sleeping or while the exchanges are closed and you’re not able to exit your positions. During this time, your money is exposed, and if you’re trading on margin, you’re exposed to a margin call.
Some markets, such as forex, trade around the clock, so the nature of their overnight risk is different.
The trading hardware you require depends on the type of trading you’re doing. In this context, hardware refers to your computer, monitors, network, power supply, and so on.
Be sure to check the hardware recommendations of your trading software provider to see the minimum computer requirements for using its software.
Previous major highs and lows are one of the most common and reliable support/resistance levels. They work because they’re visible without traders having to use any particular indicator. They’re obvious to everyone looking at a price chart. Support/resistance levels work because the masses of people trading the market respond to them.
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You find wave and cycle highs and lows with the cycle indicator. The cycle indicator defines the highs and lows and shows that they’re significant; they draw a line in the sand as to whether the market is progressing up or down as the market wiggles within its trend. Here is an example of how the cycle indicator helps locate cycle highs and lows in price bar formations.
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ADX measures trend strength by calculating a moving average (typically the 14-period moving average) of price expansion, using average true range. These terms are defined in the following list:
A moving average is the average of the closing prices of a set number of previous bars. For example, to calculate the average of the last 14 days of a market, you simply add the closing price of the last 14 days and then divide by 14.
The ten commandments of disciplined trading are based on common mistakes made by traders. You dramatically increase your odds of being successful if you follow these commandments.
Thou shalt not chase a move. If you missed the best risk/reward entry, just let the trade go. Never chase the market.
Thou shalt not trade in choppy markets.
The advance/decline line is a broad market indicator. This index provides indications of what the market you’re trading may do. Like the up/down volume index, the advance/decline line measures the difference between two indexes. Instead of volume, however, it measures the number of issues moving up and down. (An issue in this context is a symbol, such as a stock.
Trading with the trend seems like an obvious choice for a trading methodology. It seems easy enough, but it’s deceptively difficult to do. Of course, if it were easy, everyone would be doing it.
The problem arises in not only determining the trend at the time you enter the market but also establishing a probability scenario indicating that the market will continue to trend in the direction of your trade after you enter.
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Even people with no knowledge of trading or investing have likely heard the phrase buy low, sell high. The key to timing the market profitably is to buy a cycle low in an uptrend or short a cycle high in a downtrend.
The problem is how to determine, with high probability, that you’re entering on the final cycle high or the final cycle low so that the market doesn’t turn around and stop you out.
All successful traders do essentially the same thing. They have a method that puts the odds, or probabilities, on their side. You can accomplish this in many ways, which is why many trading methods are available. They can all be reduced to a simple five-step process referred to as the five-energy methodology.
With this method, you simply look at five variables (or energies) and wait for them to align, giving a buy or sell signal at the same time.
Newbie traders are often targets of hype promoted on the Internet and elsewhere, promising get-rich-quick approaches to trading.
Beware of anyone promising overnight success. Trading is a real, legitimate profession and, like any other profession, requires a thorough education, a dedication to earnest study, development of skill, lots of experience, and a commitment to personal growth in the process.
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Support and resistance levels are simply prices at which the people trading the market feel that the market likely won’t pass through easily. Support levels are prices that traders feel the market is unlikely to go below. Resistance levels are prices that traders feel the market is unlikely to go above.
What makes these levels work?
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The relative strength index (RSI) is an indicator that compares upward and downward movements in closing price over a period of time of your choice (commonly 14 bars). As with any indicator, traders use the RSI in many ways. One of the most typical ways is to go long when RSI moves below a value of 40 and then rises above it.
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To find the best time to enter a trade in the direction of the trend, you need an objective instrument that helps you measure cycles accurately. The best you can realistically hope for is to develop a tool that puts the odds on your side. It won’t give you perfect certainty, but it can give you a probability scenario that favors you.
Depending on the time horizon you choose for your trading style, you need to choose an appropriate time interval to use on your charts for trading. The time interval of the market primarily refers to the length of time it takes for each bar to form on a chart.
You can set up your chart so each bar lasts for one day, one week, or one month if you plan on holding a position for a long period of time.
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One of the most important advantages of trading in the direction of the trend is that when done correctly, your winning trades are much bigger than your losing trades. This advantage is stated right in the definition of the word trend — “to extend in a general direction.”
The terms extend and general direction reveal that trends are long-term moves.
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It’s often said that trend trading gets in “late to the party” because trend is a lagging indicator. That statement definitely holds some truth. Amateurs often hear the term lagging indicator and run for the hills as though it’s an obscene term.
The bottom line is this: Lagging indicators are lagging because they take more time to provide a signal.
Market movement becomes less mysterious and more understandable when you realize one simple fact: People move the markets. Therefore, the nature of the markets is the nature of people, or human nature. The markets don’t move based on some magical, unknown principles, nor do they move randomly without any rhyme or reason.
Two elements to the ADX indicator that help determine whether the market is trending up or down are plus directional movement (+DM) and minus directional movement (–DM). These two elements indicate trend direction:
When +DM is above –DM, trend is up.
When –DM is above +DM, trend is down.
ADX measures the strength of either the uptrend or downtrend.
The practicality of trend trading is that you're waiting for the market to "show its hand" by establishing a clear direction and then jumping onboard for the ride.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.
Stocks
An area of risk in trend trading is at the exchange itself. Some of the following situations are rare, but they can and do occur.
One of the more common exchange-based risks is the trading halt, which occurs when the exchange stops a stock from trading for a short period of time. You aren’t able to enter or exit that stock until the halt is lifted by the exchange.
Trading to the long side or going long simply refers to buying the market first and then selling your market position later. The idea is to buy at a low price (relatively inexpensive price) and sell at a higher price to make a profit. In other words, “buy low, sell high.”
Most businesses trade to the long side.
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As good as trend trading is, trend shouldn't not 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.
Because trading is a business of probabilities, it’s important to have an advantage over other traders, usually in the form of you seeing something they don’t see. This type of advantage is an “invisible edge.”
Volume is closely related to trend because for the market to make a strong sustained move in one direction, it requires a lot of trading activity in terms of shares, lots, and contracts (volume).
On a chart, you see the price pattern of a stock, commodity, or currency make some short-term moves against the long-term moves of the trend. This oscillating pattern is akin to the human experience of moving toward a long-term goal, but on the path, people often make reference to taking “three steps forward and two steps back.
If you have reasons to believe that a market is going to go down, you can make money by short selling that market. Short selling (also known as going short or shorting the market) means that you’re selling the market first and then attempting to buy it later at a lower price.
It’s exactly the same principle of “buy low, sell high,” just in the reverse order — you sell high and then buy low.
Stocks
Timing entries is something many traders struggle with. You need to time your entries with extremely high probability and avoid getting stopped out frequently.
The following figure illustrates an example of how the chart looks when the trend is up, momentum is strong, and a mini-divergence pattern shows on the stochastic indicator (price makes a lower low, and %K on the stochastic indicator makes a higher low) on an early retrace in the trend.
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 mind-set 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.
The rationale to trend trading is if the market is already moving up, it’s given at least some evidence of its bullish bias so it makes sense to follow that.
For this reason, trend trading is also called “trend following” because instead of guessing which way the market is going to move, you wait for it to establish a direction.
Trend trading is one of the most popular approaches to trading. It’s been around for decades because it’s a proven approach to making money in the markets.
Understanding why trend trading works may give you more confidence in trading the trend. Trend trading has a rationale behind it that has its roots deep in human psychology.
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