Three of the Best Trend-Following Trading Strategies
In this comprehensive article, we explore effective strategies for identifying and capitalising on market trends. The article discusses some valuable insights and practical techniques to help traders manage the dynamic world of trading. Essential aspects covered include selecting the right indicators, managing risk, and maintaining discipline, all aimed at empowering informed, trend-following decisions in fast-paced markets.
What Is a Trend Following Trading Strategy?
A trend-following trading strategy is an approach used by traders to allow them to benefit from established price trends. The core principle is to buy in an uptrend and sell in a downtrend, aiming to benefit from the continuation of existing market directions. These strategies typically rely on various trend-following indicators and chart patterns to recognise trends and then provide and confirm entry and exit signals. The goal is to ride the trend as long as it persists while at the same time incorporating risk management techniques to safeguard against potential reversals.
Key Factors in Trend-Following Trading
Successfully riding market trends requires a keen understanding of several essential factors. Following these key elements may help you cope with the complexities of financial markets with confidence.
- Monitor market volatility: Whether you use day trading trend-following strategies or you are more of a long-term trend trader, consider that higher volatility can result in a constant breakout of trendlines, which may lead to incorrect reversal signals.
- Focus on liquid assets: Liquidity facilitates quick and efficient order execution, reducing the risk of slippage.
- Diversify your trades across different assets: To minimise the impact of adverse price movements in a single market, diversification is beneficial for both short-term day traders and longer-term trend followers.
- Incorporate both technical and fundamental analysis: Combining technical analysis, which helps identify trends, with fundamental analysis, which provides insights into the underlying forces driving them, can lead to well-informed trading decisions.
- Keep an eye on economic calendars: Scheduled economic events and corporate announcements can significantly influence market activity.
- Maintain discipline, avoid emotional reactions, and adhere to your trading plan: Regardless of the quality of your strategy and technical approach, irrational reactions can ruin your results.
Popular Strategies for Riding Price Trends
Below, you will find three strategies, each built around a specific trend trading strategy indicator, and valuable insights into using other key indicators to make precise trading decisions.
Bollinger Bands and ADX Strategy
This trend-following strategy combines the volatility-based Bollinger Bands indicator with the 20-period Moving Average, set as the central line, and a standard deviation setting of 2 for the upper and the lower bands. It also uses the trend strength measuring Average Directional Index (ADX) indicator with the default 14-period setting.
We look for a period of low volatility indicated by the Bollinger Bands squeezing together towards the centreline. This often signifies that the market is consolidating before a potential breakout. Once there is a Bollinger Bands squeeze, we observe ADX for confirmation, which would be an ADX value of above 25 and increasing.
If the upper Bollinger Band is crossed to the upside in the strong uptrend, you may consider a long trade. If the lower Bollinger Band is crossed to the downside in the solid downtrend, you may consider a short trade. After the Bollinger Bands expand again, it may be reasonable to consider taking profit when the price reverts back towards the indicator’s middle line, and the ADX starts to decline. Stop loss can be placed at a recent support/resistance level for a long/short trade.
Ichimoku Cloud and RSI Strategy
This trend-following strategy that aims to provide both trend direction and momentum confirmation combines the strengths of the Ichimoku Cloud with the RSI indicator. We utilise the Ichimoku Cloud with default settings for its components and plot RSI with a period of 14.
To enter a long position, we want the price to break above the cloud in a strong uptrend; conversely, if we trade a downtrend, the price should fall below the cloud. Once we spot these signals, we look for further confirmation. The most critical elements for this strategy are the Ichimoku Cloud's conversion and baselines. A crossover of the conversion line (blue) above the baseline (red) is a potential entry signal for a long trade, while a cross of the red line below blue would suggest a potential short trade.
Following the bullish or bearish signals from the Ichimoku Cloud, we check the RSI, which should also align: for a bullish trade, the RSI should be above 50 and rising; for a short trade, it should be below that level and pointing down.
Once we are in trade, we could look for a colour change in the Ichimoku Cloud to determine a profit-taking point. In an uptrend, if the cloud changes from green to red while the RSI is below 50, it may signal a trend reversal and may be used as a profit-taking signal. Respectively, a switch from red to green and the RSI above 50 in a short position may be a bearish exit signal. A stop loss may be set at a recent support/resistance level for long/short positions.
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SMA Crossovers and the Bearish Pennant Pattern
A trend-following strategy that combines the 10-period and 20-period Simple Moving Average (SMA) crossovers with the bearish pennant chart pattern can be a powerful approach to identifying and trading bearish trends. We plot the 10-hour and 20-hour SMAs on the chart and look for the formation of a bearish pennant.
If there is a bearish crossover of the 10-hour SMA below the 20-hour SMA, once a confirmed breakout from the lower boundary of the bearish pennant occurs, you can consider opening a short position.
To determine the take-profit point in this strategy, you could watch for a bullish crossover of the 10-hour SMA above the 20-hour SMA. Keep an eye on the bearish pennant pattern. A level above the upper boundary of the pennant may serve as a stop loss.
Summary
Trend-following strategies focus on trading in the direction of the prevailing market momentum. Commonly used strategies aim to employ a combination of tools and chart patterns in order to find and confirm precise entry and exit levels. Like any versatile and widely employed trading style, capturing profits within uptrends and downtrends relies heavily on proper risk management and protection against potential reversals.
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