An Introduction to Momentum and Trend Trading
Trend following trading remains one of the most popular trading strategies among retail traders in nearly all markets; forex, stocks, and cryptocurrencies alike. But before you jump into this potentially profitable approach to trading, it’s important to educate yourself on a few key concepts related to it.
Remember, in trend trading we don’t make guesses about where the market is headed. Instead, we let the market do its thing and then simply react to what is happening. This way, we turn trading into a game of statistics and probabilities, instead of relying on our own gut feeling. Once you have a trading strategy with an edge, let the law of large numbers work for you!
In this article, we will cover the most important tools you can use to determine if a trend is worth trading and whether momentum is building up or fading in the trend. These tools are all extremely simple to use – all you need to do is apply them to your chart and wait for the market to give you a signal.
Moving Averages
Among the best-known tools for trend traders, moving averages are popular among both professional traders and amateurs – and they continue to work year after year. In fact, some of the most successful trend following traders in history – people like Ed Seykota and others – have consistently made millions of dollars, year after year, using very simple trading strategies based only on moving averages.
A good way to determine the strength of a trend using moving averages is simply to apply two moving average lines to a chart, for example the 20 and 50 period moving average.
As you probably know, the 20 period moving average reacts to changes in price faster than the 50 moving average. This means that during a strong uptrend, these two lines should both move upwards, with the price above the 20 moving average, which in turn is above the 50 moving average.
In this situation, we can say that the trend is gaining momentum if the distance between the two moving averages increases. Likewise, the trend is losing momentum if the distance between the two lines is shrinking.
When the two moving average lines cross over each other, trend followers take this as a sign that the trend in the market is reversing. For example, a faster moving average that crosses over a slower moving average could be taken as a buy signal. Similarly, a slower moving average crossing over a faster moving average could be taken as a sell signal.
Candlestick price rejection
Those of you who are familiar with Japanese candlestick charts will know what I mean by “wicks.” They are the vertical lines sticking out above and/or below the “body” of a candle, and they can provide important clues about where the market is headed next.
Price rejection is the what happens when we see large wicks sticking out in the same direction as the general trend. In an uptrend, this signals to traders that the bulls tried to drive prices higher, but sellers took over the market, effectively “rejecting” the higher prices. We then see the price falling back down, and we are left with long wicks sticking out from the candles.
Price rejection following a strong trend in either direction is one of the strongest signals we have that a trend is about to end or even reverse, as in the example above.
Size of trend waves
Market trends always move in waves. The price moves up, falls back a little, and then continues back up to make a higher high. What’s lesser known is that the size of these temporary pull-backs in price can tell us a lot about when the trend might be coming to an end.
Small pullbacks during an uptrend generally signals strength in the trend. In an uptrend where the pullbacks are getting smaller and smaller, we can say that the trend is picking up momentum. Alternatively, we may even have a situation where the pullbacks aren’t even really pullbacks, but rather just sideways price consolidation. This is a strong sign that bulls are clearly in control of the market.
In the opposite case, we may see that pullbacks become deeper and deeper as the trend moves along. This is a sign that momentum is fading, and it is becoming increasingly risky to take a position in the same direction as the trend.
Relative Strength Index (RSI) divergences
As you may have guessed, the RSI measures strength in the market. A low reading generally means that the market is oversold and is likely to reverse to an uptrend, while a high reading would indicate that the market is overbought and therefore may fall.
While that’s the conventional way of using the RSI, another great way to use it is to look for divergencesbetween the RSI line and the price. Look for situations where price continues to make higher highs, but the RSI fails to make a higher high, as in the screenshot below. This is a very reliable signal that the trend is losing momentum and may reverse.
Which one should you pick?
While all of the tools presented here work, you may find some of them easier to use than others. Some traders prefer to only look at what the price is doing, and avoid using any technical indicators such as the RSI. Others, however, prefer technical indicators and even combine them to optimize their trading strategy.
Find out what you like, and whether you are a pure “price action trader” or if you like to rely on the signals that indicators can provide you with. Remember that there are many good and potentially profitable strategies out there, but to really become a good trader, it is best to stick with one of them until you truly master it.
