Five Indicators To Build A Trend Following Strategy

Build Trend Following Strategy Using Trend Indicator

By Shipra Tripathi

Any occurrence of public interest causes turbulence in the stock market. People are quick to react to it. The reason being a general desire to be on the winning side. Emotions drive people. What could be the primary sentiments governing a trader?

An impulse to grow the financial base, to begin with, but with an outlook to slowly and steadily build on the existing resources, or fear and greed, fear of missing out, losing out and the greed to keep acquiring more and more?

How Sentiments Frame Decision-Making

In the two scenarios stated above, the first reflects sentiments that balance risk. The sentiments in the first situation will not cause impulsive action. Someone who is looking to increase his financial capability in a sustainable manner will not make impulsive decisions, will not be driven by fear and greed but by a vision.

Five Indicators To Build A Trend-Following StrategyClick To Tweet

This thought process is easier to practice if the objective of your investments is wealth management. A wealth manager has more time to think and plan. Trading, on the other hand, is far more enterprising. The objective of trading is not wealth management, it is wealth generation. The plan of action for trading is highly dynamic because it is heavily dependent on market dynamics. The fluctuations in market prices are a mix of predictable, random and short-lived. Hence an intraday trader has to be both composed of mind and agile in action. He needs a constantly vigilant mind that is equally observant and far-sighted and equally calm and active. Quite a paradox, I admit. To summarise in one word – a Superhuman.

An aspiration for one and all – acquiring superhuman control over one’s mind and body.

How many of us have actually reached that zen stage where we can actually look at every situation from a third person’s view and always act with a calm mind?

Most of us aspire. When given the time to think and act, we do. In case of intraday trading, you do not have that luxury of extra time. The decisions have to be quick and on-the-feet. When speed and accuracy is the need of the hour, man uses a machine. For this reason, we employ computer programmes for trading. Algorithmic trading works on machine languages and is devoid of sentimental decision-making.

Sentiments And Strategies

While we use algorithmic trading i.e quantitative trading strategies to curb sentimental trading, the same can also be used to utilize and monetize sentiments. Sentiments that are trending and bringing about a trend. For example during Brexit, the popular sentiment before the voting was in favour of the vote. The direct correlation was an expected fall in the value of British pound. The practical thought for action was to sell from the British markets. Consequently, there was a noteworthy drift of money flow in the stock markets and the pound slumped to a 31 year low following the Brexit vote.

Pound vs. Dollar

Trend Following strategies aims to leverage market scenarios profitably. Reason being the high amount of risk and equally high amount of benefits attached to the same. Opinions of influencers and market leaders formulate a general perception and create an on-going buzz around matters of general interest. Elaborating further on this specific investment strategy – the functionality of the trend following strategy is based on the technical analysis of the market data. Since the objective is to measure the intangible aspects pertaining to trading, the first and foremost task is to identify the parameters that govern the situation.

Five Most-Used Indicators:

No single indicator can predict a secure way to buy or sell a security. However, there are a few famous ones which are employed very frequently to gain an analytical perspective and logical decision-making. These are the best trading indicators which will help create a trend following strategy

1. Bollinger Bands

Bollinger Bands

Bollinger band indicators are signals plotted on a singular line which represent the price fluctuations for a particular stock. A Bollinger band is plotted two standard deviations away from the mean average. The two signals or the bands are plotted to measure the volatility of the price fluctuations. When markets become more volatile, the distance between the signals increases or in short the bandwidth widens and the reverse for low volatility. The wider opposite the signals move indicating high volatility, higher the cue for quitting the trade.

2. Moving Averages

Moving Averages

Moving Averages indicator is another widely used technical indicator that is used to arrive at a decision that is not based on one or two episodes of price fluctuations. A set of historical data can be employed to observe the price fluctuations of the stock for a predetermined period of time. The same assists in depicting the general direction of the trend flow. This technique is used for generating support and building resilience for future outcomes.

Moving averages provide a clear idea whether to take a long or short position on the stock. If the stock depicts a negative trend – that indicates the price is below the moving average. Take a short position (sell) on the stock. On the other hand, if the stock price is above the simple moving average, one has to take a long position (buy) on the stock because there is an expectancy of the stock price rising further.

3. MACD (Moving Average Convergence Divergence)

MACD (Moving Average Convergence Divergence)

The Moving Average Convergence Divergence indicator (MACD) is a comparative analysis of two moving averages for two different datasets. Depending on the bandwidth of the time series, you can assess the price fluctuations for two different stretches of time. Say one for a span of a month and another for 200 days. Comparison of the moving average for these two data sets is done based on three main observations viz convergence, divergence and dramatic rise. Example, if the price fluctuations for one data set is less than the moving average while for the other data the fluctuations are above the moving average, it is wiser to take a short position on the stock because the price variation is not stable.

4. RSI (Relative Strength Index)

RSI (Relative Strength Index)

Source: http://www.stock-charts-made-easy.com/relative-strength-index.html

The relative strength index is calculated using the following formula: RSI = 100 – 100 / (1 + RS)

The RSI Indicator, where RS = Average gain of up periods during the specified time frame / Average loss of down periods during the specified timeframe

RSI is used to measure speed and change of the price fluctuations. This indicator provides an idea of the security’s recent performance in the stock market. It measures the strength of the stock in the range of zero to hundred. A stock is considered overbought over the range of 70 and oversold below 30.

5. On Balance Volume (OBV)

On Balance Volume (OBV)

OBV Indicator is a momentum based indicator which measures volume flow to gauge the direction of the trend. Volume and price rise are directly proportional. A rising price is depicted by a rising OBV and a falling OBV stands for a falling price. OBV being the leading indicator if OBV depicts a rise in the same pattern as the prices this is a positive indicator. While a contrast with the pattern depicts a negative indicator.

Next Step

The Long Call Butterfly is a popular strategy deployed by traders when little price movement is expected in the underlying security. Learn to write a Long Call Butterfly strategy on Python Programming Language in our post ‘Long Call Butterfly Strategy on Python‘. It is a popular strategy deployed by traders when little price movement is expected.

 

Disclaimer: All investments and trading in the stock market involve risk. Any decisions to place trades in the financial markets, including trading in stock or options or other financial instruments is a personal decision that should only be made after thorough research, including a personal risk and financial assessment and the engagement of professional assistance to the extent you believe necessary. The trading strategies or related information mentioned in this article is for informational purposes only.