Definition of ‘Trend Following’

Also known as “trend trading,” trend following is a trading strategy which attempts to analyze the price movement rather than the fundamentals of the traded asset. Traders who use this strategy do not aim to forecast or predict specific price levels. They simply jump in on the trend and ride it.

The trend trader’s goal is to make profits by entering into a long position when a stock is trending upward (successively higher highs). Conversely, a short position is taken when the stock is in a down trend (successively lower highs).

These trend traders normally enter in the market after the trend “properly” establishes itself, betting that the trend will continue. If there is a turn contrary to the trend, they exit and wait until the turn establishes itself as a trend in the opposite direction. In case their rules signals an exit, the trader exits but re-enters when the trend re-establishes.

More on Trend Following

Many successful traders fall into a group called trend followers.

This following post describes what trend following is all about and why traders should be interested in using these general principles in their investing and trading endeavors.

Let’s break down the term trend following into its components.

The first part is trend. Every trader needs a trend to make money. If you think about it, no matter what the technique, if there is not a trend after you buy, then you will not be able to sell at higher prices. You will take a loss on the trade.

There must be a trend up after you buy in order to sell at higher prices. Conversely, if you sell first, then there must be a subsequent rend down for you to buy back at lower prices.

Following is the next part of the term. We use this word because trend followers always wait for the trend to shift first, then they “follow” it. If the market is moving down and then indicates a major shift to the upside, the trend follower immediately buys that market. In doing so, the trader follows the trend.

“Let your profits run. Cut your losses short.” This old trader’s axiom describes trend following perfectly. Trend-following indicators tell the investor when the direction of a market has shifted from up to down or from down to up. Various charts or mathematical representations of the market are used to measure the current direction and observe the shift.

Once in a trend, the trader sits back and enjoys the ride, as long as the trend keeps going in the trader’s direction. This is “letting profits run.”

I once heard a new trader questioning a very successful trend follower. The trend follower had just bought a stock, and the novice asked, “Where’s your objective on this trade?” The trend follower wisely answered, “To the moon. I’ve never had one get there yet, but maybe some day..”

That tells alot about the philosophy of trend following. If the market cooperates, the trend follower would get into the trade as soon as the market met his or her criteria for “trending” and would stay in it for the rest of his life.

Unfortunately, the trend usually ends at some point. As a result, when the direction shifts, then the cutting-losses-short aspect of the axiom should come into play. The trader, sensing the direction of the market has shifted against the position, immediately liquidates.

If the position is ahead at that point, then the trader has made a profit. If, at the time, the position is behind, then the trader has aborted the trade, preventing a runaway loss. Either way, the trader is out of a position that is currently going against him or her.

The Advantage of Trend Following

The advantage of trend following is simple: you will never miss a major move of any market. If the market you are watching turns from a down to an up direction, any trend-following indicator must flash a buy signal. It’s just a question of when.

If it’s a major move, you will get the signal. The longer term the trend-following indicators are, the lower the transaction costs — a definite advantage of trend following.

Strategically, the investor must realize that if he or she can get onboard a major move in almost any market, the profits from just one trade can be substantial.

In essence, one trade can make your whole year. Thus, the reliability of one’s strategy can be far below 50 percent and you’ll still show profit. This is because the average size of one’s winning trades is so much greater than the size of one’s losing trades.

The Disadvantage of Trend Following

The disadvantage of trend following is that your indicator cannot detect the difference between a major profitable move and a short-lived unprofitable move. As a result, trend followers often get whipsawed as signals immediately turn against them, resulting in small losses.

Multiple whipsaws can add up, creating concern for the trend follower and tempting him to abandon the strategy.

Most markets spend a large amount of time in nontrending conditions. Trending periods could be as little as 15-25 percent of the time. Yet the trend follower must be willing to trade in these unfavorable markets so as not to miss the big trend.

Does Trend Following Still Work?

Yes, of course! First, if there were no trends, there would be no need for organized markets. Producers could sell to the marketplace without worrying about having to hedge to protect themselves. End users would know that they could obtain the products they need at a reasonable price. And people would buy shares of companies purely for the income from dividends. Thus, should trends disappear for any length of time, those markets would probably cease to exist.

Second, if there were no trends, you could expect a fairly random distribution of price changes. Yet if you look at the distribution of price changes over time in almost any market, you’ll see a very long tail in the direction of large price changes. This is because there are abnormally large price changes that you’d never expect to see by chance over a given period of time.

For example, the S&P futures market opened in 1982, and within five years it had a price move that you might expect to see once every hundred years. The abnormally large price changes over a short period of time are what make trend following work, and you see them all the time.

Is Trend Following for Everyone?

Trend following is probably one of the easiest techniques for the new trader or investor to understand and use. The longer term the indicators, the less that total transaction costs will affect profits.

Short-term models tend to have difficulty overcoming the costs of many transactions. Costs include not only commissions but also slippage on the trades. The fewer trades you make, provided you have the patience for it, the less you spend in transaction costs and the easier it is for you to make a profit.

There are numerous examples where trend following is not appropriate. Floor traders who are scalping ticks are not likely to use a trend-following concept. Hedging investors may find it more risky to hedge their risk by using trend-following indicators than by choosing some form of passive economic hedge approach.

If trend following fits your personality and your needs, then give it a try. There are many examples of successful traders and investors who consistently use this time-tested approach to the markets. With the economic world becoming more unstable, there are constantly new trends for the trend follower to exploit.