What it means
Markets do not move randomly in a straight line, but they often show stretches of persistent movement. In an uptrend, each rally goes a little higher than the last and each pullback stops above the previous low.
The opposite holds in a downtrend, where each bounce fails at a lower level and each fall reaches a lower low. A market that does neither, and bounces between a floor and a ceiling, is called range-bound or sideways.
Trend followers use tools to confirm direction. Moving averages smooth out price changes, trend lines connect successive highs or lows, and indicators such as the average directional index measure how strong a trend is.
No single tool is perfect, so many analysts use two or three together. For a business or long-term investor, the idea matters because markets in a trend can affect decisions on pricing, timing of purchases and hedging.
A company buying a commodity in a rising market may choose to lock in a price early, while one selling in a falling market may speed up sales. Trends end, often suddenly, and the signs of a reversal can be missed.
Following a trend after it has run for a long time can mean buying near the top, so most disciplined traders use stop-loss orders (instructions to sell if the price falls to a set level). Academic views differ on whether trends can be used for profit.
Supporters point to momentum, the tendency of recent winners to keep rising for a time, while sceptics argue that prices already reflect all available information, so trend signals add little.
In practice
Real-world examples.
Example
A commodity trader sees that oil prices have made higher lows for six months. She buys, with a plan to sell if the price falls below the most recent low. She sizes the position so that a stop-out costs no more than 1% of her account.
Example
A retailer notes that the cost of cotton has been rising steadily. It signs a fixed-price contract with its supplier for the next year to lock in costs. The purchasing team records the price against the market so it can show the saving later.
Example
A fund manager reviews a share that has dropped to lower lows for three months. She decides that the downtrend is strong enough that buying it now would be a gamble, and she waits for evidence of a turn. She keeps the share on a watch list and reviews it every week.
Formula
Calculation
A common test of a trend is to compare the price with a moving average:
Simple moving average = Sum of closing prices over n days / n
Percentage above average = (Price - Moving average) / Moving average x 100
Suppose an illustrative share has an average closing price of $50 over the last 50 days, and it now trades at $56. The share is $56 - $50 = $6 above its average, which is $6 / $50 x 100 = 12% above. A price consistently above a rising average is read as an uptrend, while a close that falls below the average by a wide margin may signal that the trend is weakening.Case study
Seen in the real world.
Redwater Metals is an illustrative, fictional firm that buys copper for its cable factory. The purchasing manager noticed that the price had risen in steps over eight months, with each dip stopping above the previous one.
She worked with the finance director to hedge 60% of the next year's needs with forward contracts. They kept 40% unhedged so that the company could still benefit if the trend reversed and prices fell.
Prices continued to rise for another four months before they fell back. In this illustrative case the hedge saved about $700,000 against what the company would have paid in the market, and the finance director recorded the hedging policy for use in future years. The board also asked for a quarterly report on the hedge ratio and the cost of the contracts.
Watch out
Common mistakes.
- Assuming a trend will continue forever, when trends end, often without warning.
- Reading a short rise or fall as a trend, when it may be normal noise in prices. A few days of movement rarely tells you much on its own.
- Following a trend without an exit plan, which can turn a gain into a large loss.
Questions
People also ask.
How long must a move last to count as a trend?
There is no fixed rule, but most analysts want several higher highs and lows, or lower highs and lows, over weeks or months.
What is the difference between a trending and a range-bound market?
A trending market moves steadily in one direction, while a range-bound market oscillates between support and resistance levels.
Do trends exist in all markets?
They appear in shares, currencies, commodities and bonds, though their strength and length vary widely. Thinly traded markets can show false trends caused by a few large orders.
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