Trend Following Indicators

Trend following is a widely respected methodology in the world of algorithmic trading that focuses on identifying the general direction of market prices. Trend-following strategies aim to profit by riding the wave of the market’s momentum. This section dives deep into the various trend-following indicators that traders utilize to make data-driven decisions. These indicators are potent tools that help traders to confirm existing trends and make predictions about future price movements.

Moving Averages (MA)

Moving Averages are perhaps the most commonly used trend-following indicators. They smooth out price data to help identify the direction of the trend over a specific period. There are several types of moving averages used in trading, including:

  1. Simple Moving Average (SMA): It calculates the average of a selected range of prices, typically closing prices, by the number of periods in that range.
  2. Exponential Moving Average (EMA): This type of moving average places more weight on recent prices, which makes it more responsive to new information.
  3. Weighted Moving Average (WMA): Similar to the EMA, but the weighting of each price decreases linearly.

Application in Trading

Traders use crossovers of MAs to generate buy/sell signals. For instance, a common strategy is the Golden Cross, where the 50-day SMA crosses above the 200-day SMA, signaling a potential uptrend. Conversely, a Death Cross occurs when the 50-day SMA crosses below the 200-day SMA, suggesting a potential downtrend.

Moving Average Convergence Divergence (MACD)

The MACD is a trend-following momentum indicator that captures the relationship between two moving averages of a security’s price. It is calculated by subtracting the 26-period EMA from the 12-period EMA. A nine-day EMA of the MACD, called the “signal line,” is then plotted on top of the MACD line, which can function as a trigger for buy and sell signals.

Components and Signals

  1. MACD Line: The difference between the 12-day EMA and the 26-day EMA.
  2. Signal Line: The 9-day EMA of the MACD Line.
  3. Histogram: Represents the difference between the MACD Line and the Signal Line.

MACD signals bullish trends when the MACD line crosses above the signal line and bearish trends when it crosses below.

Average Directional Index (ADX)

The ADX is a trend strength indicator, not a trend direction indicator. It consists of three lines: the ADX line, the +DI line, and the –DI line. The ADX itself only shows the strength of the trend, whereas the +DI and –DI lines show the direction.

How to Use ADX

Bollinger Bands

Bollinger Bands consist of a middle band being an N-period SMA (simple moving average), an upper band at K times an N-period standard deviation above the middle band, and a lower band at K times an N-period standard deviation below the middle band.

Utilization in Strategies

Ichimoku Cloud

Also called the Ichimoku Kinko Hyo, this tool is often used for identifying future areas of support and resistance. It is composed of five main components:

  1. Tenkan-sen (Conversion Line): The average of the highest high and the lowest low over the last 9 periods.
  2. Kijun-sen (Base Line): The average of the highest high and the lowest low over the last 26 periods.
  3. Senkou Span A (Leading Span A): The average of the Tenkan-sen and Kijun-sen plotted 26 periods ahead.
  4. Senkou Span B (Leading Span B): The average of the highest high and lowest low over the last 52 periods, plotted 26 periods ahead.
  5. Chikou Span (Lagging Span): Current closing price plotted 26 periods back.

Significance for Traders

Parabolic SAR

The Parabolic Stop and Reverse (SAR) is a trend-following indicator that is used to identify potential reversal points. It is denoted by dots that are placed above or below the price on a chart, depending on the direction of the trend.

Trading with Parabolic SAR

Supertrend Indicator

The Supertrend indicator is a trend-following overlay on the chart. Compared to other indicators, it is easier to use due to its simpler approach. The indicator changes its color depending on the direction of the trend.

Application

Donchian Channels

Donchian Channels were developed by Richard Donchian and consist of three lines: an upper, a lower, and a middle band. The upper band shows the highest price over a certain period while the lower band shows the lowest price. The middle band is the average of these two values.

Usage in Trading

Turtle Trading Strategy

Developed by Richard Dennis and William Eckhardt, this system employs breakout strategies to determine entry and exit points. This strategy heavily depends on Donchian Channels for trade signals and has specific rules for position sizing and risk management.

Rules

ADX + DI Strategy

This strategy utilizes the Average Directional Index in combination with the Directional Movement Index (DMI) to identify and trade based on the trend’s strength and direction.

Trading Signals

Coppock Curve

Developed by Edwin Coppock, this indicator was initially designed for identifying long-term buying opportunities. The curve consists of a 10-month weighted moving average of the sum of a 14-month rate of change and an 11-month rate of change.

Application

Conclusion

Trend-following indicators are indispensable tools for algorithmic traders aiming to capitalize on consistent market movements. Each indicator has its unique properties and is suited to different types of market conditions. Employing a combination of these indicators can help in creating a robust trading strategy that minimizes risk and maximizes return. By understanding the functions and applications of each, traders can optimize their approaches and make more informed trading decisions.