By Rob Colville on
February 27, 2013 in
It is very likely you have heard the expression: “the trend is your friend”? This may be a cliché but it’s no over-exaggeration. It really is as trend following will be the ACE up your sleeve for long term success in trading financial markets.
Trading with the trend and trend following is a smart move. By simply buying in an ‘up trend’ (going ‘long’) and selling in a ‘down trend’ (going ‘short’), you will have already dramatically increased your chances of success compared to simply trying to swim upstream by trading against the trend (counter-trend trading).
In order to do this properly, first of all, we need to identify the trend by identifying key swings in the market, known as peaks and troughs. If we have higher peaks and higher troughs (‘higher highs’ and ‘higher lows’) it is considered to be an uptrend.
Conversely, if we can see lower peaks and lower troughs (known as ‘lower highs’ and ‘lower lows’) then we have confirmation that we are in a down-trend. Once you can do that, trading from trend following can be done easily.
Yes, but how can I profit from the trend following?
Every trend flows in two phases: Phase 1 is the extension in the direction of the prevailing trend, extending from a higher low to a higher high (in an up trend) or a the extension from lower high to a lower low in a down-trend.
Phase 2 is the retracement/pullback phase, which occurs after a higher high is formed and price action retraces/ pullback to form a lower high (in an uptrend) or after a lower low is made in a downtrend and price action retraces back to form a lower high.
In an ideal world, we would simply hope to make money from trend following by buying in an up-trending market and selling in a down-trending market, very much the same was as we can expect to get a bulls eye by tossing a dart at a darts board blindfolded.
However, it is not that simple as we could find ourselves rapidly offside by getting into the trade just before the ‘phase 2’ retracement occurs. As retracements go against the prevailing direction of the t rend
The good news is that it does not have to be much more complicated than that when it comes to trend following. All price action, like a river, ebbs and flow, extends and retraces, we want to take advantage of both having the certainty of trading in the same direction as the trend and also get into our position at an efficient price point so that we can get the best reward:risk as possible.
The million dollar question is where is the best point or optimal level for us in to go long or short in an up or down trend respectively?
It is imperative that we buy at the most efficient entry point possible and we can do this by simply buying the bounce in an ‘uptrend’ or selling the bounce in a downtrend. We can typically do this after a ‘phase 2’ retracement or pullback has completed itself and has intersected with a technical level, just in advance of a phase 1 extension.
A technical level could be a variety of different things: previous swing high/low, previously respected moving average, a Fibonacci Retracement level, a horizontal level, a big psychological number or a weekly or monthly pivot or trend line.
Often, we are able to discover more than one technical reasons to support our trading decision, long or short, and such confluences give us a higher probability outcome. Suffice to say; the more technical reasons we have in support of our trading decision, the more self-fulfilling the move is likely to be.
Once we have, preferably, a confluence of reasons to buy the bounce after the pullback in an uptrend, or to sell the bounce after a pullback in a downtrend, we need to wait for our ‘activator’ bar which could taken on the form of a pin bar reversal (also known as a test bar) or doji bar. These are specific price action set-ups which give us a powerful edge in the market as we are able to read the sentiment in the market based on the very profile of this type of activator bar.
So, we have gone through our trend following method to identify both the trend and an efficient entry point before anticipating an activator bar to serve as our ‘launch pad’ into the trade. What next?
As you have selected the tradable opportunity and waited for the optimal time for entry, it makes sense to set a target which is the point where we can ‘take profit’ and walk away from the trade.
Remember, when selecting a target, you will need to be very sure to select a point at which you wish to exit the trade while ahead and at a profit which is within reason and thus likely to happen rather than at a point which is beyond the realms of probability but more at a place where you would like the market to go ‘in an ideal world’.
Do not fall into this trap! The market will do ‘its thing’ regardless of what we want. As technical traders, we are simply working with probabilities of what is most likely to happen over and above what we want to happen.
For trading continuation trades in a trending market, it is very probable that price action will make a ‘higher high’ after you have bought the bounce in an uptrend which is already making higher highs and higher lows. It is even more likely to reach the reach the same price point as the previous swing high.
So, for an outcome where you accept a slightly less reward in exchange for more probability then target the previous swing high. Otherwise target a higher high for a trade outcome with higher reward potential but slightly less likely.
In contrast in a downtrend, a target at the previous swing low will give you a heightened probability with less reward whereas targeting a new lower low would be slightly less probable but would give you greater reward potential.
Suffice to say, for trade targeting there is often a trade-off between reward and probability. What would you rather have? A trade outcome higher in probability but lower in reward potential or an outcome which is lower in probability but higher in reward? It is a humdinger of a question but it is one which you can answer.
Trend Following Summary:
The trend will always be your friend. Buy in an uptrend and sell in a down trend, after a pullback/retracement (‘phase 2’) in anticipation for the continuation of the trend (‘phase 1’). Do not trade against the trend (counter-trend) or in phase 2.
Before taking the trade, make sure that you have several technical reasons to validate your trading decision and set a target according to your appetite for reward Vs probability. If you want an outcome with an increased probability but are happy to accept a lesser reward then a more conservative target will serve you better. However, if you are in pursuit of an outcome with higher reward potential but accept an outcome with less probability then a more aggressive target will work for your personality.
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