What are Trend Indicators or Trend Following Indicators?

Trend-following indicators are technical tools that measure the direction and strength of trends within a chosen time frame.

Some trend-following indicators are plotted directly on the price panel.

These indicators issue a bearish signal when positioned above the price and a bullish signal when situated below the price.

Others are drawn below the panel, generating upticks and downticks from 0 to 100 or across a central ‘zero’ line.

These indicators create bullish or bearish divergences when their signals oppose the price action.

Characteristics of Trend-Following Indicators

Most trend-following indicators are ‘lagging,’ meaning they generate a buy or sell signal after a trend or reversal is already underway.

The moving average is the most popular lagging trend-following indicator.

These indicators can also be ‘leading,’ predicting price action before it begins by using multiple calculations and comparing momentum across different time frames.

Parabolic Stop and Reverse (Parabolic SAR) is a well-known leading trend-following indicator.

Functions of Trend-Following Indicators

Trend-following indicators serve three primary functions:

1. Alerting the Technician: They alert the technician to a developing trend or an impending reversal.
2. Predicting Price Direction: They predict short- and long-term price direction.
3. Confirming Observations: They confirm observations and signals in the price pattern and other technical indicators.

Signal reliability is dependent on the settings used for drawing the trend-following indicator.

For example, a 50-day moving average and a 200-day moving average generate unique buy and sell signals that may work in one time frame but not in another.

Types of Trend-Following Indicators

Simple Moving Average (SMA)

The Simple Moving Average (SMA) measures the average price across a range of price bars chosen by the technician.

It is a highly effective tool for evaluating the strength of the current trend and determining whether an established trend will continue or reverse.

The SMA is less effective in sideways and range-bound markets.

Interactions between the price and the moving average generate bullish and bearish divergences, which evaluate trend strength and direction.

Exponential Moving Average (EMA)

The Exponential Moving Average (EMA) measures the average price across a range of price bars but places greater weight on more recent data points.

This ‘weighted moving average’ responds more quickly to recent price action than the SMA, theoretically generating earlier buy and sell signals.

However, this weighting also tends to generate more false signals than the SMA.

Average Directional Index (ADX/DMS)

The Average Directional Index (ADX/DMS) measures the strength or weakness of an active trend.

It uses moving averages in several time frames to generate three lines—ADX, +DMI, and -DMI.

These lines cross higher or lower through a panel with values between 0 and 100.

ADX measures the strength of an uptrend when +DMI is above -DMI and the strength of a downtrend when +DMI is below -DMI.

Moving Average Convergence-Divergence (MACD)

Moving Average Convergence-Divergence (MACD) is a widely used technical tool that analyzes the relationship between moving averages set at different intervals.

MACD generates directional lines or a histogram that gauges current momentum and price direction.

It is calculated by subtracting a 26-period EMA from a 12-period EMA, with a 9-period EMA of the MACD, called the ‘signal line,’ added to the plot.

Parabolic Stop and Reverse (Parabolic SAR)

Developed by RSI creator Welles Wilder Jr., the Parabolic Stop and Reverse (Parabolic SAR) is used to confirm trend direction and generate reversal signals.

Indicator data points generate dots above or below the price on the main chart panel.

The calculation applies an ‘invisible’ trailing stop, forcing the indicator to change direction when hit, marking a potential trend reversal.

Additional Trend-Following Indicators

• Accumulative Swing Index: Evaluates the long-term trend through changes in opening, closing, high, and low prices.
• Alligator: Uses three Fibonacci-tuned moving averages to identify trends and reversals.
• Aroon: Evaluates whether a security is trending or range-bound and, if trending, the strength or weakness of the advance or decline.
• Elder Ray Index: Evaluates buying and selling pressure by separating price action into bull and bear power.
• ZigZag: Connects plot points on a price chart that reverse whenever the asset reverses by more than a specified percentage.

Concluding Thoughts

Trend-following indicators are essential tools for traders and investors aiming to capitalize on market trends.

While they offer valuable insights into the direction and strength of trends, their effectiveness can vary based on the settings and market conditions.

Using these indicators in conjunction with other technical analysis tools can enhance their reliability and help traders make more informed decisions.