Trend Following

1. Trend following is a simple yet powerful trading strategy based on price action

"Trend following works by focusing on price and price alone."

Price is truth. Trend followers ignore fundamentals, news, and predictions. They simply react to price movements, entering when a trend begins and exiting when it ends. This allows them to profit from major price moves in any market and any direction. Trend following systems use rules to determine entry and exit points based on breakouts from trading ranges, moving averages, or other technical indicators. The goal is to ride trends for maximum profit while using stops to limit losses on losing trades.

Key aspects of trend following include:

• Following the trend - "the trend is your friend"
• Cutting losses quickly
• Letting profits run
• Trading multiple markets
• Having a long-term perspective

2. Successful trend followers focus on risk management and position sizing

"Money management is the true survival key."

Limit risk per trade. Top trend followers risk only a small percentage (often 1-2%) of capital on any single trade. This allows them to withstand strings of losses while waiting for big winning trades. Position sizing is adjusted based on volatility and account equity. As accounts grow, position sizes increase proportionally to maintain consistent risk levels.

Risk management techniques include:

• Using stop losses on every trade
• Scaling into positions as trends develop
• Adjusting position sizes based on volatility
• Maintaining overall portfolio risk targets
• Compound returns by reinvesting profits

3. Market behavior is driven by human psychology and irrationality

"Win or lose, everybody gets what they want out of the market. Some people seem to like to lose, so they win by losing money."

Markets are not efficient. Contrary to academic theories, markets are driven by human emotions like fear and greed rather than rational analysis. This creates persistent trends as investors herd into and out of positions. Trend followers exploit these behavioral biases by riding trends to their conclusion rather than trying to predict tops and bottoms.

Key psychological factors in markets:

• Herding behavior and crowd psychology
• Overreaction to news and events
• Cognitive biases like loss aversion
• Tendency to hold losers and sell winners too early
• Cycles of fear and greed

4. Diversification across uncorrelated markets is crucial for trend following success

"To freshen a room, open a window. Works for minds, too, and for hearts."

Trade multiple markets. Top trend followers trade dozens or even hundreds of global markets across stocks, bonds, currencies, and commodities. This diversification allows them to profit from trends wherever they occur while reducing overall portfolio volatility. Correlations between markets tend to break down during crises, providing opportunities for trend followers.

Benefits of diversification include:

• Reduced portfolio volatility
• More trading opportunities
• Ability to profit in any economic environment
• Protection against single-market risks
• Improved risk-adjusted returns

5. Trend followers profit from major market events and crashes

"Trend followers know that attempting to pinpoint the beginning of a trending market is futile."

Capitalize on volatility. While most investors fear market crashes, trend followers embrace them as opportunities for outsized profits. By maintaining short positions and using stops, trend followers are positioned to benefit from sharp declines. Major trend following profits have come from events like the 1987 crash, the 2000 tech bubble bursting, and the 2008 financial crisis.

Examples of trend following profits from crashes:

• 1987 stock market crash: +50-100% returns
• 1990 Gulf War oil shock: +30-40% returns
• 2000-2002 tech bubble bursting: +40-60% returns
• 2008 financial crisis: +30-50% returns

6. Mechanical trading systems remove emotion and improve results

"I don't predict the future, but we do know that the next five years will not look like the last five years. That just doesn't happen. Markets change."

Rules-based trading. Successful trend followers use mechanical systems to generate buy and sell signals. This removes emotion and second-guessing from trading decisions. Strict adherence to system rules is essential, even when it feels uncomfortable. Backtesting on historical data helps validate system performance before real money is risked.

Key elements of trend following systems:

• Entry rules based on breakouts or moving averages
• Exit rules for both winning and losing trades
• Position sizing algorithms
• Portfolio allocation across markets
• Risk management parameters

7. Patience and discipline are essential for long-term trend following success

"Playing it safe is dangerous. Far more often than you would realize, the real risk in life turns out to be the refusal to take a risk."

Stay the course. Trend following requires the patience to sit through periods of losses and drawdowns while waiting for big trends to develop. Discipline is needed to follow system rules even when they conflict with personal opinions or emotions. A long-term perspective focused on overall returns rather than individual trades is crucial.

Challenges of trend following:

• Extended periods of losses and drawdowns
• Frequent small losses from whipsaws
• Potentially high volatility of returns
• Difficulty sticking to system during drawdowns
• Temptation to override system rules

8. Trend following can be applied successfully to stocks, not just futures

"Technical traders do not need to have a particular expertise in each market that they trade."

Trends exist in all markets. While trend following is often associated with futures trading, the same principles can be applied successfully to stocks. Trend following systems work on any freely traded market with sufficient liquidity and volatility. Applying trend following to stocks provides opportunities to profit from both bull and bear markets.

Advantages of trend following stocks:

• Larger universe of tradable instruments
• Ability to profit from both long and short positions
• Lower leverage compared to futures
• More familiar to many investors
• Can complement traditional stock investing approaches

9. Avoid common pitfalls like averaging down and using profit targets

"Losers average losers."

Let winners run. Many failed traders make the mistake of averaging down on losing positions, hoping for a rebound. This often leads to larger losses. Similarly, using fixed profit targets caps gains on winning trades. Successful trend followers do the opposite - they cut losses quickly while allowing profits to run as far as possible.

Common trading mistakes to avoid:

• Averaging down on losing trades
• Using fixed profit targets
• Trying to pick tops and bottoms
• Overtrading or forcing trades
• Ignoring stop losses
• Risking too much on any single trade

Last updated: October 20, 2024