Trend trading is an investment strategy that attempts to leverage momentum for financial gain. If a stock is trending upward, the trader enters into a long position on it, whereas if it’s trending downward the trader enters into a short position.
By “trend” we mean that the stock is moving in a particular direction without much back-and-forth (that is, up-and-down) movement. A trend trader is assuming that the stock in question is going to continue in its particular direction for a significant enough amount of time to make it worthwhile to invest in that momentum and profit from it.
What that significant time frame is all depends on the trader in question. In fact, that time frame can be as short as, say, 15 minutes or as long as a few months. But however long his chosen time horizon is, the trend trader will remain in the position he opened until he feels that the stock has reached its resistance and is about to reverse its trending. He then closes his position and takes profits.
Clearly, the great risk with trending trading is that the wrong assumption has been made. This would mean that the stock is not going to continue in its particular direction, at least not for a significant amount of time. If there is too much volatility, it can be hard to read a trend, or easy to misread one (see one that doesn’t exist).
Trend trading is one of the most widely used of all stock and options trading strategies. Institutional fund managers routinely use it to try to get the biggest gains for their clients (and the biggest fees or commissions for themselves at the same time). The most commonly used tool for trying to spot these trends is the A-D Index, or the Advance-Decline Index. The A-D Index represents the total of the difference between the number of advancing securities and the number of declining securities. The simple formula that is used to calculate it is:
(Advances – Declines) + Previous Advance/Decline Index Value
An “advance” simply means that a stock has ended the last trading session up for that session, while a “decline” is the opposite. Traders follow these sessions and how they ended up by plotting an A-D chart, and this creates an “Advance/Decline Line”. In this way, they seek to avoid being taken in by any day-to-day market mood swings–either too much greedy enthusiasm or too much unwarranted fear.
It’s pretty easy to interpret the A-D Index or Line:
*Market down but A-D up means strong uptrend
*Market down plus A-D down means weak uptrend
*Market down plus A-D down means strong downtrend
*Market down but A-D up means weak downtrend
So, trend trading is a way of seeking to make money from a rational approach to an irrational environment. Other people create the trends, and then as the trader you simply leverage them for your gain.
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