In Part I, I looked at the basics behind finding a trend. In Part II, I’m going to go a step further, introducing a simple trend following system using moving average crossovers. After that, I’ll look at when trends end and how to decide when to get out of your trade. I’ll finish with the distinction between the dangerous activity of forecasting a trend versus the simpler task of following a trend.

A Trend Following System
This trend following system uses moving averages (MA). They are the average price for a certain number of periods. So, for example, if you are using a daily chart, a period would be one day and the 20 day MA would be the average price for the last 20 days. Mr FT does a great job of explaining moving averages, so if you need a quick refresher on the subject, I couldn’t direct you to a better source.

Now that you’re up-to-date on moving averages, you need to pick two. What you’re looking for is a fast moving average (e.g. 20 period MA) and a slow moving average (e.g. 50 period MA). There’s no hard and fast rule to deciding what the levels of the fast and slow moving averages should be. I like the 20 and 50 period MA. By trial and error, you might find a combination that better suit you’re trading patterns. Also deciding on what period to use is down to personal preference too. A day trader might set their charts to two minute periods, whereas someone looking to hold a trade for a few days may use hourly periods.

Whatever two moving averages you go with, the trend following rules for them is always the same. Bear with me for this important bit.

• Fast moving average crossing the slow moving average from below is a signal of an uptrend. Long signal.
• Fast moving average crossing the slow moving average from above is a signal of a downtrend. Short signal.

For those of you interested in some financial jargon, a long signal crossover is known as a golden cross and a short signal crossover is a death cross.

When you get into a trade, you’ll need to have an exit signal to help you to close out at the optimal time. For this trend following system, the exit signal is simply cross-over the other way.

The major drawback of this trend following method is the potential for ‘false signals.’ These signals happen in ranging markets when the two moving averages constantly crossover. To avoid ‘false signals,’ you might want to wait for further confirmation that a trend is happening. One possible method is to wait four more periods and make sure that the moving averages don’t re-cross each other. Another method is to simply look at the chart and go with your gut feeling as to whether the trend will hold or not. Technical analysis tools improve your chances of getting a trade right but good trading interpretation is always necessary too.

The End Of A Trend
All good things come to an end and so do even the longest running trends. No matter how successful your trade have been, you have to be able to get out at the right time to protect your profits.

One popular method to see if a trend is ending is to check if the trendline (check Part I if needed) has been penetrated. Similar to support and resistance lines, it’s very significant when an established trendline is broken. Looking at it logically, traders generally don’t want to go against the grain as it’s a risky play. Therefore they are often unwilling to be the one to short near an up trendline or long near a down trendline. So when this sort of price action does take place, there is usually a good reason for it and often it’s a good signal to get out of your trade.

As a general rule, when the period closes beyond the trendline, that is more significant than just an intra-period penetration. Most traders will look for confirmation of that penetration by waiting until the price closes beyond the trendline for a second successive day before they close their trade.

Forecasting The Trend Vs Following The Trend
There is a clear distinction between forecasting the trend and following the current trend. Forecasting, predicting the future trend, is more desirable but is very complicated and fraught with danger. You would make more money if you successfully called the very start of a trend but you’re more likely to end up with more losing trades. On the other hand, following a trend means getting in around the middle of the trend and getting out near the end. It’s a less greedy way of trading and has lower risk.

Also remember that moving averages are a lagging indicator, which means that they are slow to identify the beginning of a trend and are thus pretty useless in forecasting. Instead they are damn useful in finding the middle of a healthy trend. My advice is to leave it to the high powered professionals to start the trend and just piggyback on half way through, picking up a nice chunk of profit.

Conclusion
You may have come across the phrases “the trend is your friend” and “always trade in the direction of a trend” before. These sayings have lasted the pace because, time after time, trend following has proven to be a successful trading method. Herd mentality in financial markets drive trends on and on. Finding these trends early enough can be difficult – watching them go your way is pretty easy. Hopefully you’ll be better placed to spot them from now on.