Financial markets can move in two distinct trends: up or down. One of the most basic - and often underrated - rules of trading is to trade in the direction of the prevailing trend. Learn how to identify trends, and what to do when a market is moving sideways.
In this lesson you can learn:
One of the most popular quotes in trading - and you’ve probably come across it before - is ‘the trend is your friend.’
What it means is this: trading the path of least resistance by always trading in the direction of the prevailing trend. Imagine a wave moving towards the shore; the easiest thing a trader can do is ride atop the crest of that wave, not swim against it.
Of course, a trend can change at any given time, but you can use technical indicators to try to pinpoint at which point a trend is likely to change direction.
Up, Down, Sideways
All financial markets move in two distinct trends: up or down. When markets are not in a trend, they are then moving sideways, where there is an ongoing battle between sellers and buyers. Correctly identifying which type of trend a market is currently in can help to present strong opportunities that come with transparent guidelines.
A Rising Market
If a market is rising, you may consider buying that market and trade with the prevailing trend, i.e. take the path of least resistance. The key will be picking the right moment to get into a buy position. Ideally you want to get into the buy position as low as possible, to maximise your potential upside. Some traders may wait for a pullback (a small dip in the market), but this carries the risk of waiting too long to get into the market and you could miss out on further upside.
A rising market, also known as an uptrend or bullish market, shows a series of higher highs and higher lows. In other words, each bottom (support) is higher than the previous one.
A Falling Market
Conversely, if a market is falling you may consider selling that market. To maximise your potential downside, you would need to enter that market as high as possible, which would enable you to maximise any downward move in price.
A falling market, also known as a downtrend or bearish market, is where the market creates lower lows and lower highs.
How to Determine the Trend
Conventional technical analysis says that during an uptrend you have higher highs, because buyers are in the majority and push prices higher, and lows are also higher because buyers keep buying the dips earlier and earlier. This also applies during a downtrend: lows are lower when the seller surplus moves prices lower, while highs are lower because sellers sell earlier and buyers are not as interested. That is why the easiest way to identify a trend is to connect two highs or two lows that you identified on the chart with a line.
The Trend Is Your Friend - Until It Ends
However, markets do not always trade in clear trends 24 hours a day, 7 days a week. There are stabilisation periods in every market, which are also known as sideways trends.
A market moves sideways when it’s at a point of indecision and buyers or sellers are at an impasse. Buyers and sellers test each other, but no pure consensus emerges. Here, most traders face two potential strategies: range trading or waiting for a breakout.
As you can see in the example below, the EURUSD was trading sideways before a downtrend was established and sellers overpowered buyers, driving prices downwards.
When Identifying a Trend
One of the most important things when identifying a trend is determining your time frame. Usually, when you are analysing a long-term trend, you’ll use a long-term time frame over a short-time frame. However, for intraday purposes, shorter time-frames are of greater value. Large commercial traders might be interested in the fate of a currency or company over a period of months or years. For retail traders however, a weekly chart can be used as a ‘long-term’ reference.
Riding the Waves of the Trend
By definition, trend analysis is based on historical price movements. That means that traders are looking at the past to predict the future.
Knowing the direction of the trend does help in taking positions, but bear in mind that markets tend to move in waves. These waves are called impulse waves when they are in the direction of the trend, and corrective waves when contrary to the trend.
By counting the waves or pivots in each wave, you can attempt to anticipate whether a trading opportunity will be against the trend or with the trend.
Test your knowledge of this lesson with our quiz:START QUIZ
During an uptrend you should expect:
A market that is not posting new highs or lows is generally known to be in a:
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