What is Trend Trading and the Different Types of Trends?

What Are the Types of Trends to Trade?

Trends can be broken down into three types.

• Uptrend
• Downtrend
• Sideways Trend (or lack of confirmed up or downtrend)

Each of these trending environments has distinct features which sets it apart, and we’ll explore what those are in this article. The first step for trend trading is being able to identify when a trend is present and which direction it is moving. Based on that information, a trader can then attempt to make trend trades utilizing a well-suited strategy.

Characteristics of an Uptrend

An uptrend is, simply enough, when the price of an asset is rising. Uptrends can occur in very short periods of time, or sometimes over long periods of time. Therefore, an uptrend is determined based on the time frame you are looking at.

If you are viewing a 1-minute chart and prices are rising, that could be uptrend on that time frame. If the price is raising on a weekly chart, spanning years of price history, that could be an uptrend on that time frame. Uptrends are classified by two major characteristics:

• The price makes higher swing highs than it did previously.
• The price makes higher swing lows than it did previously.

A “swing” high or low is a high or low point on the chart as the price progresses. No asset moves straight up or straight down for long. The price moves up then down, up then down, in waves or swings.

It is the direction of this overall movement that is important.  On the chart below I have highlighted this overall structured in the SPDR Select Financial Fund ETF (XLF).

Connecting one high to the next high and a low to the next low, we can see a framework of higher highs and higher lows.  When that structure is no longer present, the uptrend is in question. It could mean the price is entering either a downtrend or a range. The price could also briefly enter one of these other environments, and then go right back into an uptrend.

Characteristics of a Downtrend

A downtrend is when the price is trending towards the downside on the time frame being analyzed. Look for:

• Lower swing highs relative to prior swing highs.
• Lower swing lows relative to prior swing lows.

Below is a chart that shows how this unfolds.

I have removed the time scale on the charts because while these happen to be daily charts, the time scale doesn’t matter as much as whether the price is making higher/lower lows and higher/lower highs. This could just as easily be a 5-minute chart or a weekly chart.

Characteristics of a Sideways Trend or Lack of Trend

A sideways trend or lack of trend is when the price is not making much progress in either direction. The price isn’t making lower lows and lower highs, or higher highs and higher lows. It may be fulfilling one of these rules, but not both.

In sideways trends, the price is still moving up and down, which means there are small trends occurring on those up and down moves — but overall, the price is moving sideways.

The chart above shows a period where the price couldn’t make any progress higher or lower, even though it continued to move up and down in small blips. If you trace the small up and down movements within this “range” you can still see the uptrend and downtrend principles unfolding.

As the price moves up, it makes higher swing highs and swing lows, as the price moves down it makes lower swing highs and swing lows. But overall we can see that these movements were confined to an area where the price moved sideways.

Trend Trading Strategies

By understanding the basic building blocks of trends, you can develop trend trading strategies or utilize existing ones.

There are many different trend trading strategies, and hundreds of books written on different trend trading techniques. One of the most comprehensive books on the topic is Trend Following, by Michael Corvel, which is over 500 pages. Yet while there are many specific techniques, they can be distilled down some primary methods that I will cover here.

• Trading pullbacks in trends
• Trading momentum in trends
• Trading new swing highs in uptrends or new swing lows in downtrends

All these methods focus on how traders can enter at different times during different types of trends.

Trend Trading with a Pullback Method

You already know that an uptrend is created by higher swing highs and higher swing lows. The lows in that uptrend are formed by pullbacks. These are counter-trend moves that temporarily go against the overall trend direction.

The same concept applies to downtrends. While the price is making overall progress lower, there are temporary pullbacks against that overall trend which provide an opportunity to enter short trades.

Entering on pullbacks can be done in many ways. You can watch for the price to start moving in the trend direction after a pullback. In this case, you are watching for a price action signal to enter a trade, meaning the price movement itself tells you when to enter.

Technical indicators can also be used, such as when the price bounces off a drawn trendline or a moving average. They could also be used when an indicator, such as the MACD, signals the price is starting to move in the trending direction again (indicating the pullback is over).

A MACD indicator is shown on the chart below. Once the trend is identified, when the MACD crosses (blue) crosses above its signal line (orange) it can provide a potential entry signal.

This is just one example of how a technical indicator (or other method) can signal an entry during a pullabck once the price starts moving in the trend direction again.

Trend Trading with Momentum

Momentum trend trading consists of trying to capture a piece of large price moves, especially when the price is moving with great speed.

Momentum traders identify assets that are moving strongly in one direction and then enter trades in that asset attempting to capture any remaining price movement in that direction (or they could enter on a pullback). The chart below shows a momentum trend trade combined with a pullback trading technique.

At the time of the trade, the price has already exhibited downtrend behavior: lower lows and lower highs. The price is currently dropping, and quite quickly. That quickness is momentum.

The price then pulls back (shown here by the two big green candles). Once the price drops below a candle low in the pullback (blue horizontal line) a short trade is entered to capture remaining downside momentum.

A similar concept could be used if the price was in an utprend and spiking higher. An entry could be taken to captilize on potential further upside.

Trend Trading at New Highs or Lows

This can be a riskier method because it requires entering much later than our prior methods. However, it can be effective in very strong trends.

Entering on new highs or lows means:

• Buying during an uptrend when the price moves above its prior swing high.
• Shorting during a downtrend when the price moves below its prior swing low.

The following chart shows how that may look.

Once the price has made a higher swing high and a higher low, that indicates an uptrend. Wait until the price moves above the prior swing high and then execute a buy order. It works well as long as the trend persists.

Losing trades happen when the trend slows down or reverses. For downtrends, enter as the price moves below a prior swing low.

Trend Trading Exits (Stop Losses and Profit Targets)

The methods above discussed trade entry techniques, but the entry is only one part of a trade. There also needs to be risk management in the event the price moves against the position, as well as profit taking if the price moves favorably.

The risk management aspect, called a stop loss, is an order that gets you out of the trade at a pre-determined level if the price doesn’t do what you expect. It assures that a loss doesn’t get out of hand, and the amount lost is limited to small portion of the overall account. There are many different stop loss techniques:

• If using an indicator, exit when the indicator forms a similar signals (to the entry) in the opposite direction.
• If buying, place a stop loss below a recent swing low. If shorting, place a stop loss above a recent swing high.
• Place a stop loss a set percentage or dollar amount from the entry point.

Any of these methods can be combined with an entry to help manage the risk on that trade. In terms of profit taking, there are also many methods that can be used. Some of these include:

• If using an indicator, exit the profitable trade when there is a signal in the opposite direction (similar to what was used for entry).
• Take profit at a pre-determined level, in terms of percentage or dollar profit.
• Take profit based on risk/reward. For example, if the stop loss is 5% away from the entry, a 2:1 reward:risk is 10%. Set a target at 10%, or 15% for a 3:1 ratio.