Trend following strategy: how to identify and utilise market trends

Trend following strategy is one of the most popular and effective trading techniques in the financial markets. It is based on the idea that assets that are trending are likely to continue moving in the same direction. In this guide, we will look at how to identify trends, confirm trend signals and manage risk when using this strategy.

Identifying a trend

The first step in a trend following strategy is to identify the current trend. There are various methods to do this:

• Using moving averages: One of the most common ways to identify a trend is by using moving averages (SMA or EMA). For example, if the price of an asset is above a moving average with a period of 50 days, this may indicate an uptrend.
• Chart Analysis: Visual analysis of charts also helps to identify trends. Pay attention to the sequence of peaks and troughs – an uptrend is characterised by rising peaks and troughs, while a downtrend has falling peaks and troughs.
• Trend Indicators: Using indicators such as the Relative Strength Index (RSI) or Bollinger Bands can help in identifying a trend. An RSI above 70 indicates oversold and below 30 indicates oversold, which can help identify trend signals.

Confirming trend signals

Once a trend has been identified, it is important to confirm its signals to avoid false signals and improve the probability of successful trading.

• Confirmation using volume: One way to confirm a trend is to analyse trading volume. Increasing volume can confirm the strength of a trend. For example, rising volume in an uptrend indicates that interest in an asset is increasing.
• Using additional indicators: Combining multiple indicators can increase the accuracy of signals. For example, using moving averages together with oscillator indicators such as MACD can confirm the strength and direction of a trend.
• Pattern Analysis: Chartpatterns such as flags, pennants and triangles can also help confirm trends. These patterns often precede a continuation of the current trend.

Risk Management

Effective risk management is critical to success in a trend following strategy. Here are a few key tips:

• Set stop losses: Place stop losses to protect capital in case the trend changes. The stop loss should be set at a level that minimises losses in case the forecast is wrong.
• Regularly review your positions: Regularly review your positions and adjust them according to market changes. If the trend starts to weaken, consider exiting the position.
• Capital allocation: Do not invest all of your capital in one position. Allocate capital among several assets to reduce risk and protect your investment.

A trend following strategy can be a powerful tool in a trader’s arsenal if you identify trends correctly, confirm signals and manage risk effectively. Continued education and practice will help you improve your skills and increase your likelihood of trading success.