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Trend Trading: Pros & Cons

Trend Trading: Pros & Cons

Paul Robinson, Strategist

All trading strategies have their positives and negatives that a trader must get comfortable with in order to execute a strategy confidently and efficiently. At the end of the day a trader should have strategies that allow them to take advantage of various market conditions, but typically there will be a bias towards one approach and market environment versus another. For example, some favor high volatility over lower volatility or breakout vs range. In this piece, we’ll discuss the pros and cons of trend trading, a discipline I tend to gravitate towards.

The Fundamentals of Trend Trading
The Fundamentals of Trend Trading
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The Fundamentals of Trend Trading
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One of the biggest advantages of trading trends is the potential reward relative to risk. Strong trends are known for lasting much longer than most participants think is possible. In the past two decades alone, there have been a vast number of trends that far exceeded what was “reasonably justified” by the factors driving it, and the expectations of most market participants.

Risk/reward ratios for good trend-following strategies are much higher than those typically found in other strategies, such as mean reversion or range-trading. This is because trends by nature are expansive and generally unbound, while strategies geared towards mean reversion and ranges have finite expectations.

Higher risk/reward ratios do come at a cost, however. Trend trading strategies typically have lower winning percentages, but this is offset by the positive skew in reward relative to risk. As long as the math works out where the risk/reward relative to the win% provides an edge, then it doesn’t matter. For example, if you are winning at a clip of only 40%, but are making 3x more on your winners than losers, it doesn’t matter that you are wrong 60% of the time. The math works. Just as if you were right 60% of the time, but making 1.5x your risk on trades. Again, the math works.

Let’s say out of a sample of 10 trades, 40% of traders are winners and your average win is 3x your average loss: 4 x 3 units of reward = 12 units, 6 x 1 unit of risk = 6 units lost. This nets out to 6 units of reward.

40% w/l @ 3:1 r/r over 10 trades equates to: 12 units gained – 6 units lost = +6 units

And if you were running a strategy that has a winning percentage of 60% with a risk/reward ratio of 1.5, the math would look like this; 6 x 1.5 units of reward = 9 units of reward, 4 x 1 unit of risk = 4 units lost. In this scenario you would net out +5 units.

60% w/l @ 1.5:1 r/r over 10 trades equates to: 9 units gained – 4 units lost = +5 units

The reason for the lower win percentage is that that markets tend to range or behave in a choppy manner more often than they trend, and as a result there are a lot of trends that stop as quickly as they begin to form. Which, again, is fine because when a good trend does form, if properly taken advantage of, it should provide plenty of reward to offset the times when there are false breakouts that create losses. The downside for many traders is that this requires a lot of patience and willingness accept frequent losses, something that can take some getting used to. As humans we don’t like to lose, and so to accept losing frequently in favor of an infrequent winner, even if it is outsized, can create an internal struggle.

Trend forming after false breakout (USD/JPY 2021/22)

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USD/JPY Chart by TradingView

Trends form on a time-frames, so whether you are looking to take advantage of them for short-term trades lasting a few days or less, or longer such a few weeks or longer, there are opportunities to be found. What is an uptrend on a short-term time-frame may very well be occurring within the context of a longer-term trend. The key here is to understand which time-frame you are focusing on, so you don’t mix yourself up getting caught between trends on different time-frames. Pick a couple and stick to them. Trying to catch trends on too many time-frames is likely to lead to sloppy and inconsistent trading.

Trend on Daily Chart of S&P 500

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S&P 500 Chart by TradingView

Trend unfolding on 1-hour chart of EUR/USD

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EUR/USD Chart by TradingView

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Summary:

  • Like any trading style trend trading has its positives and negatives
  • High risk/reward ratios is a positive with trend trading, but it does come at the expense of a lower win percentage (something a trader has to learn to accept)
  • Markets are often caught between trends, so patience is required to find good trends that will offer up good reward relative to risk
  • Trends can be traded on any time-frame – the key is to stick to only a couple so you don’t get the execution on the time-frames mixed up

Market participants should be aware of the risk of loss in trading commodities, forex, futures and options.

DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.

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