In this document, we will discuss the principle of Trading with the trend.
- We will dissect the “Trade with the trend” discussion in:
- What is a trend
- Methods traders use to identify and trade a trend
- Time-frames and risk
- Conclusions and criticism
Bruce Babcock, in his classic “The four cardinal principles of trading,” states his firm belief that there must exist some price trend to profit from price movement in the markets. Even, if somebody says he trades against the trend,” those ‘countertrend’ traders are really trend traders in a shorter time frame.”
The key issue for him is whether we know what our trading time frame is, whether we have specific means of identifying the trend in that time frame.
According to Babcock, a trend seems to be some relatively persistent price movement– upward or downward- linked to a time frame.
Colin Alexander, one of his interviewees, shows the main captcha with trends: “Everybody will tell you that the trend is your friend, but unless you have a working definition of what a trend is, you have a real problem with putting the idea into practical effect. […] The practicality of using this concept requires that you have criteria for determining what a trend is for the purposes of trading.”
Also, Peter Brandt touches the point: “Trading with the trend is a wonderful idea conceptually, but it’s difficult to implement in everyday practical terms.” […] “Like everything else in trading, a trend is wonderfully identifiable in hindsight, but very difficult to grasp in real-time.”
James Kneafsey adds another bit to the puzzle. He says that, in theory, trading with the trend is a noble idea, but difficult in practice because markets are not trending all the time. He states that about one-third of the time markets are in choppy mode or minor trend and another third of the time there is a neutral or sideways move.
Glen Ring says that while trading with the trend is important, it’s not the key. It’s vital to adapt your trading style to your own personality, but the most forgiven way to trade in the way to expertise is with the trend, he said.
The first thing a trader needs to do, then, is to find a methodology for a definition of trend that fulfils its purpose, for him, as trading signal at the earliest possible moment (usually when the eye still doesn’t see it) with a compromise between reliability and risk size; or, more precisely, between success rate and risk to reward ratio.
Single moving average
Using a single moving average, a trading signal appears when the price crosses over/under the average. Another method is to wait until the average points up/down.
Good MA periods to define a trend range from 20-60 bars.
Two or more moving averages
In this case, there are two variations:
- Moving average crossovers
- All the averages are pointing in the same direction.
Typical periods are 10-25 for the fast MA, and 30-60 for the slower one.
As with the case of a single MA, a price retracement to touch the slower average is an opportunity to add to the position.
Moving averages on different timeframes
A pattern of higher highs and higher lows is a pattern of an uptrend while lower highs and lower lows reveal a downtrend.
Breakouts of a trading range
Oscillators, such as Stochastics or Williams %R, are used by some of those traders to tighten the trigger point to a lower risk. The problem with breakouts is the risk.
If we look at the above figure, it’s evident that going long at breakout point is riskier than going long at the bottom of previous retracements, as the distance from the entry to the level where the trend is negated is rather high (entry:108335, stop: 1.04495).
The way traders deal with this is to move to a lower time frame, in this case, intraday (hourly or smaller), and look for early signs of a breakout. The other way is using an oscillator that tells the trader the market is in oversold condition (in this case it’s the beginning of the EUR/USD uptrend) but ready to resume the main trend. Here the %R is beginning to move up (see below), breaking up the -80 level, hinting a short-term leg up.
Those points are good entries, with much less risk – about 50% of the breakout risk- that may be used to double the position size for the same dollar risk. It’s useful, also, to add to the position.
The usage of Stochastics as a proxy for moving averages:
Michael Chisholm says he prefers the use of three stochastics in three timeframes: daily, weekly and monthly. When all of them are in agreement “that’s a powerful indicator”. The use of Stochastics, he says, allows him to grasp the different market cycles better.
Trend lines: the use of trend lines at the highs or lows of the price formation.
Linear regression channel.
Sometimes there’s no easy way to see where the price is moving. The use of the linear regression channel may help there.
In cases such as this, when there is a downward channel, the use of an oscillator is key to profiting from sub-trends, as we see in the above figure. This kind of trade uses the old principle of “buying the dips and selling the rallies.”
We may observe, also that a 50-day MA is rather useless. A shorter 10-day MA helps, though, because the channel is wide enough.
The selection of the timeframe should be part of the process of money management, rather than just an entry rule.
Each chart pattern has an objective and stop-loss point where we know the pattern failed: That is the exit point on a losing trade. If the potential loss is higher than allowed by the account size, this particular time-frame isn’t tradable, or we should trade smaller. Then, a shift to a shorter timeframe, with lower dollar-risk, allows a trader to ramp up his position size.
- We need to assess the major trend direction to improve the chances of a trade being successful
- Even if we trade counter-trend, it’s important to know the direction of the higher-order trend
- The trend can be discovered using several methods, but the sooner we find it, the better
- The use of oscillators helps us spot better (less risky) entry points, and also add-to-position points
- The choice of timeframe is directly related to risk
When trading using short timeframes, it’s advantageous the use of oscillators or a trend channel to find better entry points at the end of minor corrections.
Sometimes it happens that, when a trend has been detected, the price has already traveled a long distance, reducing the Reward to risk ratio of the potential trade too much to be worth trading. The use of pivots to assess swing points may allow traders much better entry spots and profit targets.
Trend-following systems show very high Risk to reward trades (from 3 to 10), but usually, those come at the expense of less than 40% success rate. That means it’s prone to very large losing streaks (more than 5 are common, and sometimes it goes up to 20). Trend following requires a trader with a strong discipline to execute the entries and stop-loss trades; and a firm belief in the system or it will inevitably fail.
A way to deal with this is to split the trade into 3 lots, the first with a target close to the entry, the second with a target close to a resistance/support level and a third one trailed to let it run until is taken by price action.