QuickOverview

Trend Trading is a trading strategy that involves buying or selling short a stock after a trend has been established and ultimately exiting that position before the trend finishes. The factors that go into a profitable trend trade are determining the general direction of the market, identifying a trending stock, picking the appropriate entrance, and picking the appropriate exit of the trade.

Determine and Monitor the Broad Direction of the Market

Most traders only want to pick a trend that is going in the same direction as the market is heading. Of course it is still possible to profit from a rising stock when the market is headed down, however, that is a much harder trend to identify properly.

One way to identify the direction of the market is to look at market internals such as the advance / decline line or a comparison of 52 week highs and lows. Once a trader forecast the most likely market trend going forward, you can decide whether to look for a stock trending upward or downward.

Market internals should continue to be monitored even after a trend trade has been entered. A reversal in the internals is a major development that most times, but not always, means a trend trade should be exited.

Stocks often gap in price in between trading days due to news, action in overseas markets, and other factors unrelated to the stock. This variability can complicate trend trades, but which can be avoided by entering and exiting trend trades within a single day. Since trend trades should last long enough to develop a nice profit, it is most useful to examine the market internals early in the day so as to have enough time in the trend trade. However, investors should take care in making conclusions based on internals of the first few minutes of trading. Often, orders are queued up since the previous close, and initial market internals may not correctly reflect the mood of the current market. It is best to give the market at least 45 minutes of trading before trying to predict the broader trend.

Pick Correct Trending Stock

Once a trader predicts the broader market direction, it is time to select a stock. Some traders like to familiarize themselves with a small list of stocks (20 or less) and observe their actions daily and only trade those with the hope that they know the underlying companies and patterns of how they trade. Others run electronic filters on thousands of stocks to pick the right one.

A popular way to pick a trending stock is to identify those that have been outperforming a rising market or underperforming a sinking market. Another frequent consideration is to give a preference for stocks that have recently broken out of a trading range.

Besides the trend for a given stock, it is also important to consider the liquidity and volatility of a stock. Large bid/ask spreads are a sign of a lack of liquidity for a stock and depending on the severity of the problem, can prevent a stock from being a good trend trade candidate. In addition, stocks that have wild volatility swings can make it harder to discern a trend versus just another swing that is about to reverse. Volatile stocks can also make stop losses less effective because they will either wipe out a stop less before continuing a trend, or force a stop loss so far below the current price so as to be less effective for protection.

Use Stop Losses

Once in a trend trade, it is advisable to use a stop loss to protect from a large loss. The price of the stop loss is a balancing act. If it is too far from the trade price, it still allows considerable losses. If it is too close to the trade price, normal volatility can exit the trade before the trend is fully taken advantage of.

One way to protect profit is to keep moving the stop loss for winning trades so that if the trend reverses, not all the profits are lost. This way, long running trends can yield a large gains while losing trades suffer only small losses.

Pick Your Exit

Traders that enter a trend trade need to vigilantly evaluate the fundamentals that led to the trend in the first place. One frequent reasons for exiting a trade is a change in market internals or general direction for the broader market. Even in the event that the broader market continues on its trend, if the individual stock chosen meets resistance, it can also signal that it's time to exit the trade.

Though trend trades can span days and even weeks or months, many traders exit the positions before the end of the trading day in order to avoid the gaps that often occur in stock prices in between sessions.

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