Trend Trading: The 4 Most Common Indicators

Trend traders attempt to isolate and extract profit from trends. The method of trend trading tries to capture gains through the analysis of an asset's momentum in a particular direction. This can be done in multiple ways.

No single technical indicator will punch your ticket to market riches. Traders should also be well-versed in risk management and trading psychology in addition to analysis. But certain strategies have stood the test of time and remain popular tools for trend traders who are interested in analyzing certain market indicators.

Moving Averages

Moving average is a technical analysis tool that smooths out price data by creating a constantly updated average price. A moving average creates a single, flat line on a price chart that effectively eliminates any variations due to random price fluctuations.

The average is taken over a specific period: 10 days, 20 minutes, 30 weeks, or any time the trader chooses. The 200-day, 100-day, and 50-day simple moving average are popular choices for investors and long-term trend followers.

The moving average can be used in several ways. The first is to look at the angle of the moving average. The price isn't trending but ranging if it's mostly moving horizontally for an extended time. A trading range occurs when a security trades between consistent high and low prices for a period such as days, weeks, or months. Many traders use strategies that follow these trading patterns.

An uptrend is underway if the moving average line is angled up but moving averages don't make predictions about the future value of a stock. They simply reveal what the price is doing on average over a period of time.

Crossovers are another way to use moving averages. A buy signal occurs when the 50-day crosses above the 200-day by plotting a 200-day and 50-day moving average on your chart. A sell signal occurs when the 50-day drops below the 200-day. The time frames can be altered to suit your individual trading timeframe.

It can also be used as a buy signal when the price crosses above a moving average and it can be used as a sell signal when the price crosses below a moving average. But this method is prone to more false signals because the price is more volatile than the moving average.

Moving averages can also provide support or resistance to the price. This chart shows a 100-day moving average acting as support. The price bounces off it.

Moving Average Convergence Divergence (MACD)

The moving average convergence divergence (MACD) is a kind of oscillating indicator. One basic MACD strategy is to look at which side of zero the MACD lines are on in the histogram below the chart.

The stock is likely trending upward if the MACD lines are above zero for a sustained period. The trend is likely downward if the MACD lines are below zero for a sustained period. Potential buy signals occur using this strategy when the MACD moves above zero. Potential sell signals occur when it crosses below zero.

Signal line crossovers can also provide additional buy and sell signals. A MACD has two lines: a fast line and a slow line.

A buy signal occurs when the fast line crosses through and above the slow line. A sell signal occurs when the fast line crosses through and below the slow line.

Relative Strength Index (RSI)

The relative strength index (RSI) is another oscillating indicator but its movement is contained between zero and 100 so it provides different information than the MACD.

The price will often reach 70 and above for sustained periods in a strong uptrend. The price can stay at 30 or below for a long time in a downtrend. General overbought and oversold levels can be accurate occasionally but they may not provide the most timely signals for trend traders. An alternative is to buy close to oversold conditions when the trend is up and place a short trade near an overbought condition in a downtrend.

Suppose the long-term trend of a stock is up. A buy signal occurs when the RSI moves below 50 and then back above it. This essentially means that a pullback in price has occurred so the trader buys when the pullback appears to have ended according to the RSI and the trend is resuming.

The 50 levels are used because the RSI doesn't typically reach 30 in an uptrend unless a potential reversal is underway. A short-trade signal occurs when the trend is down and the RSI moves above 50 and then back below it.

Trendlines or a moving average can help establish the trend direction and in which direction to take trade signals.

On-Balance Volume (OBV)

Volume itself is a valuable indicator and on-balance volume (OBV) takes a significant amount of volume information and compiles it into a single one-line indicator. The indicator measures cumulative buying and selling pressure by adding the volume on "up" days and subtracting volume on "down" days.

The volume should ideally confirm trends. A rising price should be accompanied by a rising OBV. A falling price should be accompanied by a falling OBV.

This figure shows the shares of Netflix Inc. (NFLX) trending higher along with OBV. It was a good indication that the price was likely to continue trending higher even after the pullbacks because OBV didn't drop below its trendline.

The price will likely follow the OBV in the future and start rising if OBV is rising and the price isn't. The price may be near a top if it's rising and the OBV is flat-lining or falling. The price could be nearing a bottom if it's falling and OBV is flat-lining or rising.

The Bottom Line

Indicators can simplify price information in addition to providing trend trade signals and providing warnings about reversals. They can be used on all time frames and they generally have variables that can be adjusted to suit each trader's specific preferences.

Traders can combine indicator strategies or come up with their own guidelines so entry and exit criteria are clearly established for trades. Complementary trend indicators include pairing the MACD and stochastic. Another popular pair is the stochastic oscillator combined with the Average Directional Index (ADX) indicator.

Learning to trade on indicators can be a tricky process. You may decide to research it further if a particular indicator appeals to you. It's a good idea to test it out before using it to make live trades. Opening a brokerage account is a necessary first step in gaining access to the stock market.

Disclosure: This article is not intended to provide investment advice. Investing in securities entails varying degrees of risk and can result in partial or total loss of principal. The trading strategies discussed in this article are complex and should not be undertaken by novice investors. Readers seeking to engage in such trading strategies should seek extensive education on the topic.