When it comes to forex trading, it’s often said that the trend is your friend. As you’ll soon find out, the trend is a powerful tool that may transform a lackluster portfolio into a profitable one. That’s because trend trading is one of the most common strategies used by forex traders. It doesn’t require a complicated setup and can be executed quickly once identified.
The rationale behind trend following is simple: strong trends may produce the most significant results. By identifying an uptrend or downtrend, you can trade in its direction and count dozens, if not hundreds, of pips.
What is Trend Trading, Exactly?
In the most basic terms, trend trading is a strategy that attempts to capture gains by looking at an asset’s momentum in a particular direction. The trend trader enters a long position when a forex pair is trending upward through a series of successfully higher highs. The trend trader will take a short position when the pair is in a downtrend, or successfully lower highs.
The trend strategy assumes that the present direction of the forex pair may continue in the future. What constitutes the “future” depends on your frame of reference. For day traders, the future is short-term. For value investors, their outlook is medium- or long-term. Regardless of their time frame, a trend trader will remain in their position until they believe the trend has reversed.
You may be thinking: how do you know that a trend has reversed? While there is no foolproof way to know whether a trend reversal has occurred, there are tools you can use to identify a possible reversal. These include looking at pivot points, Fibonacci retracements and trend lines. Any technical analysis tool that shows the breakdown of support or resistance may suggest that a trend reversal has occurred or is about to occur.
Retracement vs. Reversal
If you’re trading the trend, it’s important not to confuse a reversal with a retracement. A retracement usually occurs after large price movements in one direction. For example, if the EUR/USD just shot up 100 pips, there’s a good chance the market will do a temporary retrace back toward a lower level as the market “absorbs” the gains. In this event, the EUR/USD may shoot up to 1.21 on Monday before paring back down to 1.2075 later in the session or the following day. These are short-term retracements and not trend reversals.
A reversal usually involves long-term price movement, and is often accompanied by a change in fundamentals. If the EUR/USD has been gaining ground for several months, only to reverse sharply in the opposite direction over the span of days and weeks, it probably means investors expect the U.S. Federal Reserve to raise interest rates. Expectations of higher interest rates usually support the domestic currency. This is true of the dollar, euro and virtually every other currency.
Benefits of Trend Trading
There are two main benefits of trading the trend:
#1 it teaches you to trade in an imperfect world
#2 helps you identify the best opportunity to achieve aimed goal
Trend trading never claims to be a perfect strategy, but it is simple enough to identify and execute quickly. You can hold this position for as long as you believe the market will trade in that direction.
Additionally, trend trading identifies the best opportunity for making an aimed trade. After all, if you had the choice of fishing in a pond with lots of fish or one with hardly any, which would you choose? An uptrend or a downtrend is a pond with many fish, and gives you the best opportunity to catch pips.
These benefits will become apparent the more you think about and execute trend trading strategies.
In the world of forex trading, very few strategies are relied upon more than the trend. The trend is utilized by both new and experienced traders, and is talked about regularly by analysts, news commentators and other market participants. After all, the sole purpose of trading forex is determining which direction a pair will take. Trend trading strategies help us identify what that trend might be, and how to lock-in until the market shows us otherwise.