Tools for trend trading

Trend following as a strategy has a long and venerable history, but what are the tools that investors use to help find trends?

Chart trading
Source: Bloomberg

Moving Averages

These provide a smoothing effect to the price data, creating a line that can help aid the visual identification of trends. There are popular choices, such as the 50-day and 200-day moving averages, but in reality the choice will depend on the individual, and on the time frame used.

Like many indicators, moving averages are frequently misunderstood. They are, crucially, lagging indicators, i.e. they move slower than the price. They do not predict the future direction, but rather, tell you what has happened in the past. However, they are very useful, since their direction can help the trader identify whether the market is moving up, down or sideways.

A crossover between two moving averages can signal a change in the price direction, as we can see below in this chart of the Euro Stoxx 50:

Euro Stoxx 50 chart

Here we can see the blue 50-period moving average cross above the red 200-period; the price then continues to move higher. This can suggest a trader should move from shorting the market (when the quicker moving average is below the slower one) to buying it (when the quicker is above the slower).

It is important to note that the crossover reflects what has already happened, and we could see a retracement before another move higher. Thus, careful risk management is called for. It is also important to bear in mind that the shorter the periods of moving averages used, say for example 10- and 20-period, rather than 100- and 200-period, will give more frequent crossovers that may be quickly reversed, leading to a run of losses.

However, as a basic tool, moving averages can help to keep a trader on the right side of the trend.

Relative Strength Index

The Relative Strength Index (RSI) is an oscillator (one that is banded between two extreme values) that helps to identify direction in prices.

The RSI is perhaps one of the most incorrectly-used indicators; when the indicator moves above 70, it is said to be ‘overbought’, and when below 30, ‘oversold’. This is used by commentators as a reason why prices should move back down, or back up again, after significant moves in one specific direction.

Yet, these overbought and oversold conditions indicate trend strength, not an impending reversal. The oscillator can only go so high, whereas prices can move up or down for greatly extended periods. The chart of the Dow Jones shows this:

Dow Jones chart

Here, the price is overbought for a number of consecutive sessions, yet it does not stop rallying. Indeed, even the moves back below the 70 level (signifying dropping out of overbought conditions) do not prompt significant falls in the price. This is an uptrend, and an RSI reading above 50 shows that buyers are in control. Conversely, a reading below 50 in a downtrend shows the sellers have the upper hand.

What the RSI is useful for is identifying retracements in a trend, i.e. pullbacks on the way up, and rallies on the way down. This can, potentially, be used to highlight areas where new positions can be entered, or existing ones added to. In the USD/JPY chart below, the circled areas indicate retracements in the downtrend that a trader can use to identify entry points:

USD/JPY chart

Average Directional Index

The Average Directional Index (ADX) helps to identify the strength of a trend. Traders want to find the strongest trends, hop on board, and then ride them as long as possible.

ADX is a single line with values from 0 to 100. It is usually plotted in the same window as the Directional Movement Index (DMI), from which the ADX is derived. Values from 25–100 indicate a strong trend, with the strength increasing the higher the number. A value below 25 indicates drift.

It is very important to note that the direction of the ADX does not follow the price. Thus ADX can rise when the price is falling, which is therefore an indication of a strengthening downtrend. An example for the DAX is seen below:

DAX chart

The ADX in the bottom panel drifts down during summer, but then in mid-September it rises above 25, indicating a strong rally that does indeed continue. It does not work all the time, as the rally from February to April when the ADX remains below 25 shows.

The above indicators are not foolproof, crystal-ball methods of finding and catching every trend. But they can be used to filter out markets that are not trending, or are trending weakly. Traders must continue to employ good risk management and the appropriate psychology, but the above examples should help a trader develop an understanding of trend following. 

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