Trend following
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In finance, trend following is an investment strategy that tries to take advantage of long-term moves that seem to play out in various markets. The system aims to work on the market trend mechanism and take benefit from both sides of the market enjoying the profits from the ups and downs of the stock or futures markets.
Traders who use this approach can use current market price calculation, moving averages and channel breakouts to determine the general direction of the market and to generate trade signals. Traders who subscribe to a trend following strategy do not aim to forecast or predict markets or price levels; they simply jump on the trend and ride it.
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[edit] Definition
This trading method involves a risk management component that uses three elements; the current market price, equity level in an account and current market volatility. An initial risk rule determines position size at time of entry. Exactly how much to buy or sell is based on the size of the trading account and the volatility of the issue. Changes in price may lead to a gradual reduction or increase of the initial trade. On the other hand, adverse price movements may lead to an exit for the entire trade.
These systems traders normally enter in the market after the trend properly establishes itself and for this reason, they ignore the initial turning point profit.
If there is a turn contrary to the trend, these systems signal a pre-programmed exit or wait until the turn establishes itself as a trend in the opposite direction. In case the system signals an exit, the trader re-enters when the trend re-establishes.
In the words of Tom Basso, in the book Trade Your Way to Financial Freedom[1]
| “ | 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..."Following" is the next part of the term. We use this word because trend followers always wait for the trend to shift first, then "follow" it. | ” |
[edit] Considerations
Price: One of the first rules of trend following is that price is the main concern. Traders may use other indicators showing where price may go next or what it should be but as a general rule these should be disregarded. A trader need only be worried about what the market is doing, not what the market might do. The current price and only the price tells you what the market is doing.
Money Management: Another decisive factor of trend following is not the timing of the trade or the indicator, but rather the decision of how much to trade over the course of the trend.
Risk Control: Cut losses is the rule. This means that during periods of higher market volatility, the trading size is reduced. During losing periods, positions are reduced and trade size is cut back. The main objective is to preserve capital until more positive price trends reappear.
Rules: Trend following should be systematic. Price and time are pivotal at all times. This technique is not based on an analysis of fundamental supply or demand factors.
Trend Following answers the questions:
- How and when to enter the market.
- How many contracts or shares to trade at any time.
- How much money to risk on each trade.
- How to exit the trade if it becomes unprofitable.
- How to exit the trade if it becomes profitable.
[edit] Example
A trader would identify a security to trade (curriencies/commodities/financials) and would come up with a preliminary strategy, such as[2]:
- Commodity: soybean oil
- Trading approach: long and short alternatively.
- Entrance: When the 50 period Simple moving average(SMA) crosses over the 100 period SMA, go long when the market opens. The crossover suggests that the trend has recently turned up.
- Exit: Exit long and go short the next day when 100 period SMA crosses over 50 period SMA. The crossover suggests that the trend has turned down.
- Stop loss: Set a stop loss based on maximum loss acceptable. For example if the recent, say 10 day, Average True Range is 0.5% of current market price, stop loss could be set at 4x0.5% = 2%.
The trader would then backtest the strategy using actual data and would evaluate the strategy. The simulator would generate estimated number of trades, the fraction of winning/losing trades, average profit/loss, average holding time, maximum drawdown and the overall profit/loss. The trader can then experiment and refine the strategy. Care must be taken, however, to avoid over-optimization.
It is possible that a large fraction (perhaps majority) of the trades may be unprofitable, but by "cutting the losses" and "letting profits run", the overall strategy may be profitable. Trend trading is most effective for a market that is quiet (relative low volatility) and trending. For this reason trend traders often focus on commodities which show a stronger tendency to trend than stocks which are more likely to be mean reverting (which favors swing traders).
[edit] Notes and references
- ^ Tharp, Van K. (1998). Trade Your Way to Financial Freedom. 83: McGraw-Hill. ISBN 0-07-064762-3.
- ^ Covel, Michael W. (2007). Trend Following. HarperCollins. ISBN 0978-0-06-124170-3
[edit] External links
- Trading Strategies: Long-Term - Trend following
- Interactive Java Applet "Investing Based on Crossings Moving Averages ... Does It Work?"
[edit] Further reading
- Brown, Kedrick (2006). Trend Trading: Timing Market Tides. John Wiley & Sons, Inc.. ISBN 0-471-98021-8.
- Covel, Michael W. (2007). Trend Following: How Great Traders Make Millions in Up or Down Markets, New Expanded Edition. Financial Times Prentice Hall (March 19, 2007). ISBN 0-13-613718-0.
- Covel, Michael W. (2009). Trend Following (Updated Edition): Learn to Make Millions in Up or Down Markets. FT Press; 1 Updated edition (February 25, 2009). ISBN 0-13-702018-X.
- Covel, Michael W. (2007). The Complete TurtleTrader: The Legend, the Lessons, the Results. Collins (October 9, 2007). ISBN 0-06-124170-9.
- Covel, Michael W. (2009). The Complete TurtleTrader: How 23 Novice Investors Became Overnight Millionaires. Collins Business (February 24, 2009). ISBN 0-06-124171-7.
- Faith, Curtis M. (2007). Way of the Turtle:The Secret Methods that Turned Ordinary People into Legendary Traders. McGraw-Hill. ISBN 0-07-148664-X.
- Markman, John D. (2003). Swing Trading: Power Strategies to Cut Risk and Boost Profits. ISBN 0 471 20678 4.
- Seykota, Ed (August 2006). "How to determine the trend". FAQ. http://www.seykota.com/tribe/TSP/Trends/index.htm. Retrieved 2006-08-21.
- Tate, Christopher (March 2001). The Art of Trading. ISBN 1 876627 63 8.
[edit] See also
Techniques
Related phenomena
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