Trend Trading: 4 Most Common Indicators

Trading in the financial markets is a dream for many, and stories of wealth amassed on Wall Street have drawn countless individuals to engage in market trading. While some traders have made significant profits, others have faced substantial losses. Achieving profitability in financial market trading is a lifelong goal for every trader.

In this market, filled with both risks and opportunities, there are some excellent trading strategies—trend trading being one of the most commonly used. The following text will explain the trend trading strategy and the technical indicators commonly used in trend trading.

What Is Trend Trading？

Trend trading has attracted many investors due to its broad applicability across various markets, such as the stock market, forex market, and commodities market. Trend trading involves determining the direction and timing of trades based on the prevailing price trend in the market. The core principle of trend trading is to “follow the trend,” meaning to align with the main direction of market prices rather than trading against it. Extensive practice has shown that trend trading is a robust and effective investment strategy in financial markets.

Three Types of Trend Trading

The premise of using trend trading is the ability to identify trends. There are three types of trend trading.

Uptrend: An uptrend is characterized by increasingly higher highs and increasingly higher lows in the asset's price.

Downtrend: A downtrend is the complete opposite of an uptrend. In a downtrend, both the highs and lows of the asset's price become progressively lower.

Sideways Trend (Range-Bound): A sideways trend, also known as a range-bound trend, occurs when the price fluctuates within a fixed range, repeatedly moving up and down but consistently failing to break above the upper boundary or below the lower boundary of the range.

Four Common Technical Indicators for Trend Trading

Classification of Technical Analysis Indicators

Technical indicators are derived from a series of mathematical calculations based on historical asset prices, trading volume, and open interest (in the case of futures). These indicators come in a wide variety of forms and are typically plotted as charts to help traders better observe and predict asset price movements. To better understand the underlying logic of technical indicators, they can be broadly categorized into four main types: trend indicators, momentum indicators, volatility indicators, and volume indicators.

Three Prerequisites for Technical Analysis

1. “Market behavior discounts everything” forms the cornerstone of technical analysis. Technical analysis posits that all factors influencing price—whether economic, political, or psychological—are already reflected in the supply and demand dynamics that determine price.

In other words, technical analysis does not concern itself with the underlying economic factors behind price movements but instead focuses on studying price charts or various technical indicators to let the market itself reveal its most likely future direction.

1. Trend is the core of technical analysis. Technical analysis asserts that for an emerging trend, the most likely scenario is that the existing trend will continue until a reversal signal appears.
2. Technical analysis and market behavior are closely tied to human emotions. The market reflects investors' bullish or bearish sentiments through price patterns. This is because when the market undergoes changes similar to those in the past, technical analysis suggests that people will likely react in similar ways, ultimately leading to similar market developments.

4 Most Common Indicators

Moving Average (MA)

Moving average (MA) strategies are classic methods within trend trading systems. A moving average essentially acts as a low-pass filter, smoothing out high-frequency noise in price time series while retaining the underlying low-frequency trend. However, this smoothing process inevitably introduces some lag. Moving averages are categorized based on how they weigh past price data, with the most common types being the Simple Moving Average (SMA) and theExponential Moving Average (EMA).

In today's markets, moving averages are widely used to identify and confirm current and future price trends. For medium- to long-term trend confirmation, traders often use EMA50 and EMA120. The principle is that if the long-term moving average is rising, it confirms a bullish trend,whereas if it is falling, it confirms a bearish trend.

Traders typically combine multiple moving averages of different periods to guide their trading decisions. First, they determine the medium to long-term trend using larger time frames. Then, they select shorter-period EMAs, such as EMA5 and EMA9, to guide intraday trading. This approach can significantly improve a trader's success rate by aligning short-term trades with the broader market trend.

Relative Strength Index (RSI)

The Relative Strength Index (RSI) is a momentum indicator initially used in the futures market, designed to evaluate the strength of bullish versus bearish forces and to measure the speed and magnitude of price movements. RSI values range from 0 to 100. When the RSI value exceeds 70, the market is considered overbought, indicating a higher probability of a future price decline. Conversely, when the RSI value falls below 30, the market is considered oversold, suggesting a higher probability of a future price increase.

RSI divergence is often used for trend trading. In the chart below showing the EUR/USD exchange rate, we can see that the exchange rate at point 2 is lower than at point 1, but the corresponding RSI value at point b is higher than at point a. This scenario indicates a bullish RSI divergence, suggesting that the exchange rate is likely to rise, making it a good time to enter a long position.

When the exchange rate rises as expected and reaches point 4, we observe that the high at point 4 is higher than at point 3, but the corresponding RSI value is lower than at point 3. This indicates a bearish RSI divergence, suggesting that the price is likely to decline. At this point, it would be prudent to take profits and exit trade.

Moving Average Convergence Divergence (MACD)

The MACD (Moving Average Convergence Divergence) is derived from moving averages and consists of the fast line (DIFF), the slow line (DEA), and a series of red and green histograms. The MACD is considered a trend indicator, with its histogram also displaying characteristics of an oscillator.

From a construction logic perspective, the MACD calculates the difference between two exponentially weighted moving averages (EWMA) to capture market speed (the fast line), while smoothing the DIFF line to achieve stability (the slow line). The MACD histogram, derived from the difference between DIFF and DEA, combines both stability and speed.

When the MACD histogram is significantly above the zero line, it indicates that the market is in overbought condition. Conversely, when the MACD histogram is significantly below the zero line, it indicates that the market is in oversold condition.

On-Balance Volume (OBV)

The OBV (On-Balance Volume) indicator, proposed by Joe Granville, calculates the cumulative volume by differentiating between positive volume (volume when prices are rising) and negative volume (volume when prices are falling). It is used to gauge market sentiment by examining the relationship between price changes and volume fluctuations. OBV posits that volume precedes price changes, suggesting that changes in market prices must be accompanied by corresponding changes in volume.

Bullish Divergence: Occurs when the price is falling but the OBV value is rising. This is seen as a buying signal.

Bearish Divergence: Occurs when the price is rising but the OBV value is falling. This is seen as a selling signal.

In the provided chart of USD/JPY, we can observe that the price at point B is higher than at point A, but the OBV value at point D is lower than at point C. This is a classic bearish divergence, indicating a potential selling opportunity or a time to take profits and consider shorting the market.

Pro & Cons of Trend Trading

Conclusion

In trend trading, the proficient use of technical indicators is essential for developing effective entry and exit strategies. Determining the “best” technical indicator is subjective and varies based on factors such as your trading style, methods, and overall strategy. The four commonly used technical indicators mentioned can be applied across different timeframes, with specific parameters adjustable to suit individual trading preferences. Trend trading requires patience, and refining your trading system is crucial for achieving substantial success in this strategy.

FAQs

What are the disadvantages of technical indicators？

Different technical indicators have different adaptability to market conditions, and some technical indicators are lagging. Therefore, different indicators may send conflicting signals, affecting investors' judgment.

Can technical indicators guarantee profit？

No single technical indicator can guarantee 100% profit. Investors must develop a comprehensive trading system and implement strict risk control measures to achieve profitability. Indicators are tools that assist in analysis but do not ensure success on their own.

What are the methods for using technical indicators？

The use of technical indicators is mainly divided into two major schools. One is the Chart-Based Approach, which analyzes the meaning of the price pattern of technical indicators from the perspective of qualitative observation. The other is the Quantitative Analysis Approach, which mainly relies on mathematical calculations and various statistical models, and uses quantitative methods to measure market price trends for technical indicators.