The Disadvantages of Trend Trading - dummies

The Disadvantages of Trend Trading

By Barry Burns

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.

To be a successful trend trader, you need to be aware of some of the challenges you’ll encounter before you start. Following are some of the more notorious obstacles you’ll face.

Having more losers than winners

People who are pure trend traders may find that they have more losing trades than winning trades. One reason for this is that by many estimates, markets trend only approximately 20 percent of the time.

Trying to catch the beginning of a new trend can be very difficult. Because the market is moving chaotically most of the time, timing the end of a chaotic cycle and the beginning of a trend cycle can result in a lot of false signals before you catch one of the 20 percent opportunities.

This may contradict the principle of a lagging indicator being more accurate, but it’s accurate at the cost of giving a late signal late.

So how can pure trend traders make money if they lose more trades than they win? Here’s how:

  • They’re very good at cutting their losses quickly when they’re wrong, thus making sure their losing trades are very small.

  • They’re excellent at holding onto their winning trades for the big profits that a long trend will supply them.

  • They offset their negative win/loss trade ratio with an excellent risk/reward ratio.

Getting bored

Because the market trends only about 20 percent of the time, that can lead to a psychological challenge of boredom because traders like to trade! As a trader, you want to be involved in the market and make money. Sitting around and waiting when there aren’t any high-probability trades isn’t fun.

Getting bored is especially challenging for day traders who sit in front of computer screens for hours every day. Hours can go by, and even entire days, when the market is in a chaotic cycle, not providing any high-probability trading opportunities.

This constant waiting can lead a day trader to distraction. You may start checking your emails, texting, watching the news, sports, or a movie . . . and then when you look back at your screen, you may find that you just missed a great trade setup by a minute.

Not getting the earliest entry

Trend indicators are lagging indicators, but their lagging nature carries a benefit. They’re waiting for the accumulation of more information before they give a signal, and that tends to make them more accurate than so-called leading indicators.

That accuracy does come with the price of the lag, though, so by the time the signal is given, the trend may be close to an end. Whether the trend continues long after the trend indicator provides the signal, it will never provide you the earliest entry.

Trend indicators provide new trend signals only after the market has already been moving in the direction of the trend for a certain period of time (depending on the trend indicator you use and the settings you employ)

A common trend indicator is the 50-period simple moving average (SMA), which draws a line on your chart that represents the average closing prices of the last 50 bars (or periods). An uptrend is indicated by an upward angling 50 SMA, and a downtrend is indicated by a downward angling 50 SMA.

The figure illustrates how the 50 SMA begins indicating an uptrend only after the price bars on the chart have already been moving up for a period of time.

[Credit: Figure by Barry Burns]
Credit: Figure by Barry Burns