A lot of the mistakes stock traders make comes from not identifying the type of market we are trading in, and adapting the right stock trading strategy to compensate. In this lesson, you will learn about trending vs trading markets and how it pays to adjust your trading strategy in each.
Trending vs Trading
When you think about it, everybody is trend trading for a living. Everybody needs an uptrend to begin after they go long or a downtrend to begin after they go short. Where we differ is how long we need the trend to go. If we are day trading then the trend we need to form after going long only needs to last for a very short period of time. If we are swing trading then the trend we need to form after going long needs to last for a couple of days. The only difference between day trading, swing trading, and investing is the length of time we need a trend to form to make money after taking a position.
A trading market is a market that goes sideways:
A trending market is a market that has either and upward or downward slant to it. A down-trending market begins with a series of lower lows and lower highs:
An up-trending market begins with a series of higher lows, and higher highs:
Trend Trading Software
I am often asked if there is any trend trading software that helps identify if a market is trending or trading. The good news is that there is! In fact, most charting software has the ADX indicator. If your charting software has the ADX indicator then you have trend trading software and you didn’t even realize it. Here’s how to use the ADX indicator to determine whether a market is trending or trading.
Trend Trading System
Below is a chart of the S&P 500 with the ADX technical indicator.
If the ADX line is rising, a market is trending. If the ADX line is falling, a market is trading. In the chart above, at the time of writing this lesson, the S&P 500 has an upward slant to it which suggests the market is trending. We can confirm the uptrend by looking at the ADX line. If you look closely you can see the ADX line curling up which confirms the market is trending.
Bollinger Bands are another excellent way to confirm if a market is trending or trading.
Bollinger Bands widen during range expansion, and they contract during range contraction. Range expansion is another way of saying a market is trending. Range contraction is another way of saying a market is trading. Markets alternate back and forth between range expansion and range contraction. In the chart above, the S&P 500 is clearly trending because the range is expanding and the Bollinger Bands are widening. A two day break of a Bollinger Band line usually markets the start of either an uptrend (upper Bollinger Band line is broke) or downtrend (lower Bollinger Band line is broke).
The three types of chart patterns that a chart transitions through are: oversold, continuation, and breakout. Oversold patterns are range expansion on the Bollinger Bands as they are usually the result of a downtrend. Continuation or consolidation patterns are range contraction on the Bollinger Bands as they result in sideways market action. Breakout patterns are range expansion on the Bollinger Bands as they often become uptrends. So the three chart patterns of oversold, continuation, and breakout are, at their essence, periods of range expansion, range contraction, and range expansion. This cycle repeats over and over again.
Trend Trading Strategies
There are two types of markets we trade in: trending and trading.
In a trending market, breakout patterns work well because the odds are greater that a stock or market will continue to head higher long enough for you to make money on the trade. This trend trading strategy is simple: establish whether the S&P 500 is in a trending phase (range expansion and widening of the Bollinger Bands) or a trading phase (range contraction and narrowing of the Bollinger Bands), and buy breakout patterns if the market is trending, or buy oversold patterns if the market is trading.
In a trading market, breakout patterns often turn into headfakes and are probably one of the worst patterns you can use.
Trend trading strategies all follow the buy high, sell higher method of trading. The problem with using that sort of trend trading strategy is that in a trading market where there is no trend, buy high and sell higher often becomes buy high and sell lower for a loss. Always check whether the S&P 500 is in a trading market (range contraction) or a trending market (range expansion) before buying a breakout pattern.
Frequently Asked Questions about Trend Trading
What is trend trading?
Trend trading is a technical analysis strategy that uses price, momentum, and chart patterns to anticipate the direction of a stock.
PSAdmin posted the popular video below called The Basics of Trend Trading.
What is counter trend trading?
Counter trend trading is a type of trend trading strategy that is based on the fact that a trend will eventually reverse. The goal is to profit from that trend reversal.
Admiral Markets posted this awesome video on counter trend trading. The lesson is talking about the FOREX markets but the same principles and lessons hold true for equity markets.
What is ETF trend trading?
ETF trend trading is a type of trend trading that focuses on trading ETFs. The idea is that ETFs produce smoother price action on charts and so they are easier to trade than individual stocks. Markets that are too choppy are harder to trend trade because they are easier to get stopped out of.
The idea behind ETF trend trading is that trend trading needs smooth trends. The smoother the better, simply because you can keep the inevitable stop losses smaller.
The MoneyShow posted this great video on strategies for trading ETFs.
What are Bollinger Bands?
Bollinger Bands represent the volatility in a stock. They are drawn two standard deviations away from a specified moving average.
When Bollinger Bands widen, volatility in a stock is increasing as evidenced by the greater distance between swings in a trending market. When Bollinger Bands contract, volatility is decreasing as evidenced by tighter ranges between swings in a trading market.
All markets alternate between range expansion (trending) and range contraction (trading) on the Bollinger Bands. If we plot an ADX indicator below the chart above, you can see how, when the ADX (white) line rises, a market is trending and when the ADX line is falling, a market is trading.
Being able to identify if you are in a trending market or a trading market will help you know which technical indicators you should use. Oscillators are better indicators to use in a trading market. In a trending market, oscillators like the RSI will gyrate above the 70 line, or below the 30 line, for long periods of time rendering them useless.
Knowing that markets alternate between range expansion and range contraction on the Bollinger Bands, will help you position before the next range expansion cycle begins.
InformedTrades posted the excellent video below called How to Trade Bollinger Bands.
How does ADX indicator work?
The ADX indicator identifies the strength of a trend.
There are three lines with the ADX indicator: the ADX line, the +DI line, and the -DI line. In StockCharts.com you have two indicators you can chart, the “Avg Directional Index (ADX)” and the “Directional Movement (w/ADX)”. The “Avg Directional Index (ADX)” just shows the ADX line, while the “Directional Movement (w/ADX)” shows the ADX line with the +DI and -DI lines.
The ADX line will rise in a trend, and will fall when the trend weakens.
The ADX oscillates between 0 and 100. The following ADX levels indicate the type of market you are trading:
0-25 = sideways, consolidating, trading market
25-50 = trending market
50-75 = strong trending market
75-100 = very strong trending market
* Readings above 60 are rare.
You can increase your odds of timing a breakout or channel breakout by only taking the entry when the ADX is 25 or higher.
If you are trying to time a bottom for a long entry, then you only want to take an entry in a sideways market when the ADX is 25 or lower.
StockMarketStrategy posted the excellent video below called How The Pro’s Trade Using Average Directional Index ADX.
Trend Stock Trading
Trend stock trading works well in a trending market when the ADX line is rising and the upper Bollinger Band line is broke. Trading breakout patterns works well in a trending market but the chart pattern that works well in all markets, no matter if they are trending or trading, is the oversold pattern. This is why mastering the oversold pattern should be your primary focus. The downside is that in a trending market, it becomes harder to find stocks with oversold chart patterns.