Three popular trend-following indicators are moving averages, moving average convergence divergence (MACD), and Parabolic SAR
Get to know trend-following indicators by experimenting with different ones
Trend-following indicators can be used on their own or combined with other indicators
Many traders, especially those using technical analysis in their trading, often focus on trends. And for good reason: Prices are constantly changing; sometimes very quickly. Traders like to catch these changing prices hoping to ride them out, regardless of whether they’re short- or long-lived. Trend identification is so popular that there are many sayings related to trends, such as:
- Don’t fight the trend.The trend is your friend.The trend is your friend until the end when it bends.
But how do you find the trend in the first place?
Pull up a chart of the Dow Jones Industrial Average ($DJI) for the last 100 years and it’s easy to spot the overriding trend—up—but that’s not necessarily going to help you trade or manage your portfolio. In that 100-year period, there have been numerous uptrends and downtrends; some lasting years and even decades.
Trends occur across all different time frames, and it’s often said the earlier you spot a trend, the more opportunity you may have to capitalize on it. But that’s easier said than done. The nice thing is there are many indicators you can use to identify possible trends, such as linear regression, price envelopes, ADX, and Keltner channels. Three of the more popular ones are moving averages, moving average convergence divergence (MACD), and Parabolic SAR.
1. Moving Averages
A moving average is one of the more popular ways to identify a trend, but there are different types. And not all moving averages are created equal. Two of the more common types of moving averages are the simple moving average (SMA) and exponential moving average (EMA).
An SMA is calculated by totaling the closing price of a security over a set period and then dividing that total by the number of time periods.
For example, the calculation for a 10-period SMA would be:
- CP = closing priceNumber = periodSMA = (CP1 + CP2 + CP3 + CP4 + CP5 + CP6 + CP7 + CP8 +CP9 + CP10) / 10
The periods used for the calculation could be anything from minutes to years.
The SMA gives equal weighting to each time period, which makes it well suited for identifying longer-term trends. If the security is above the moving average and the moving average is going up, it’s an indication of an uptrend. If the stock is trading below an uptrending moving average, it’s still an uptrend, but it might be weakening. A downtrend occurs when the price is below the moving average and the moving average is pointing down.
Adding indicators to the thinkorswim platform from is a breeze. Say you want to overlay an SMA on a price chart. From the Charts tab, bring up a chart. Select Studies > Add study > Moving Averages. You’ll see a pretty extensive list of the different types of moving averages. Select SimpleMovingAvg and you’ll see the SMA plotted on the chart. The default is the nine-period SMA. To change it, select the indicator, then Edit study SimpleMovingAvg (CLOSE, 9, 0, no) and change the length to 50. This will plot the 50-period SMA on the chart (see figure 1).
FIGURE 1: SPX WITH 50-DAY SMA. On this chart of the S&P 500 Index (SPX) with the 50-day SMA overlaid on it (purple), the overall trend looks to be up. If price fell below the moving average, it’d be an indication the index is getting weaker. Chart source: the thinkorswim platform. For illustrative purposes only. Past performance does not guarantee future results.
One of the choices under the Moving Averages thinkorswim studies is the EMA, listed as MovAvgExponential. The EMA differs from the SMA in that its calculation assigns more weight to recent prices, making it more responsive to short-term price action. Thus, the EMA tends to be favored among many short-term traders. Try adding the EMA on an intraday chart (see figure 2).
FIGURE 2: SPX 10-MIN INTRADAY CHART WITH 10-MIN EMA. In this intraday chart of the SPX, you can see a 10-minute EMA (blue). Because the more recent prices have a higher weighting, the EMA tends to adjust to price action quicker than an SMA. Chart source: the thinkorswim platform. For illustrative purposes only. Past performance does not guarantee future results.
The type of moving average and time periods you might choose will depend on your preferred trading style and time horizon, so you might want to experiment with them to see which is optimal for your purposes.
2. Moving Average Convergence Divergence (MACD)
The moving average convergence divergence indicator, or MACD, combines both trend identification and timing into one tool. The MACD belongs to a group of technical indicators called oscillators because they tend to move back and forth from one side to the other over a period of time.
The MACD is built on the idea that when moving averages begin to diverge from each other, momentum is generally thought to be increasing, and a trend may be starting. The creator of the MACD, Gerald Appel, recommends using the settings of 8 and 17 periods to enter a position on the daily chart but suggests a different combination 12 and 26 period for selling opportunities. The 9-period MACD average would apply to both.
When a 9-period average of the MACD itself is plotted, thereby creating a signal line. When the indicator line crosses above that signal line, it means an upward trend may be starting, and when it crosses below, it may signal the start of a downtrend. The MACD can also be plotted as a histogram. When bars are above the zero line, it indicates an upward trend, and when the bars are below the zero line, it could mean a downtrend. In figure 3, the two-line and histogram MACD is plotted in the subchart below the price chart.
FIGURE 3: APPLYING THE MACD. The MACD indicator is plotted in a subchart below the stock chart as two lines and a histogram. As the indicator line (blue) crosses above and below the signal line (yellow) and the histogram bars move above and below the zero line, you may be able to identify potential trend changes. Chart source: the thinkorswim platform. For illustrative purposes only. Past performance does not guarantee future results.
The 12-26-9 configuration is the default setting in thinkorswim, but you can go in and adjust the inputs, depending on your trading preferences. Just select the indicator, then Edit study MACD. In the MACD Customizing window, change the input parameters and then select Apply.
3. Parabolic SAR
Another potential thinkorswim indicator for your trend-finding arsenal, especially for swing traders, is the Parabolic SAR.
The “SAR” in Parabolic SAR stands for “stop and reverse,” and the indicator is designed so that when a security is in an uptrend, the indicator is plotted below the price in the form of a dot (see figure 4). This dot is the theoretical “stop” in the stop and reverse, the point at which (if the price touches it) the trend may have changed. When this happens, the SAR is then automatically plotted above the price, indicating a downtrend is in effect. Some traders use the Parabolic SAR to help them determine where to place stop orders.
FIGURE 4: USING PARABOLIC SAR TO IDENTIFY TRENDS. The Parabolic SAR, plotted as a yellow dot above or below the daily close, indicates trend direction. A series of dots below the price bars indicates an uptrend, whereas a series of dots above the price bars indicates a downtrend. When the price moves below or above these dots, it could indicate a change in trend direction. Chart source: the thinkorswim platform. For illustrative purposes only. Past performance does not guarantee future results.
As you can see from figure 4, the longer the SAR is below (or above) the prevailing price, the stronger the trend may be. However, on short-term time frames, the Parabolic SAR may be more susceptible to false signals (what some traders call “whipsaws”). Like all trend-following thinkorswim indicators, the inputs for the Parabolic SAR can be customized and used with any time frame.
These are just a few of the thinkorswim studies you can choose from when trying to identify and analyze trends in your trading and investing. They can be used as stand-alone indicators or in conjunction with others. But however you wish to use them, make sure you take the time to familiarize yourself with each to find the strategy that works best for you.