Trend following


Trend following

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 market.

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.

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. 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 miss the initial turning point.

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 Van K. Tharp, in the book "Trade Your Way to Financial Freedom"cite book
last = Tharp
first = Van K.
authorlink = Van K. Tharp
title = Trade Your Way to Financial Freedom
publisher = McGraw-Hill
date = 1998
location = 83
url =
id = ISBN 0-07-064762-3
]

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 will go next or what it should 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.

Example

A trader would identify a security to trade (curriencies/commodities/financials) and would come up with a preliminary strategy, such as [Covel, Michael W. (2007). Trend Following. HarperCollins. ISBN 0978-0-06-124170-3] :

*Commodity: soyabean 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%, stop loss could be set at 4x0.5% = 2%.

The trader would then backtest the strategy using actual data using a software system such as Wealth-Lab Pro, StrategyDesk or Trade2Win, 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.

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 followers

Trend following systems have enjoyed popularity over the years - well-known trend followers include Bill Dunn, Ed Seykota, John W. Henry, Richard Dennis, and Richard Donchian.

Many traders like original Turtles Paul Rabar and Jerry Parker say that following a market trend is their winning trading strategy.

Dennis and Donchian are the fathers of the trend following. During the 1980s Richard made a bet with partner William Eckhardt that he could train non-traders this technique; he won the bet and these people rank in the top 10 Commodity Trading Advisors rankings, they became known as the turtles. [Covel (2007), p.?]

Notes and references

Further reading

*cite book
last = Brown
first = Kedrick
title = Trend Trading: Timing Market Tides
publisher = John Wiley & Sons, Inc.
date = 2006
url =
id = ISBN 0-471-98021-8

*cite book
last = Covel
first = Michael W.
title = Trend Following
publisher = Financial Times Prentice Hall
date = 2005
url =
id = ISBN 0-13-134550-8

*cite book
last = Covel
first = Michael W.
title = Trend Following
publisher = HarperCollins
date = 2007
url =
id = ISBN 0978-0-06-124170-3

*cite book
title= The Complete TurtleTrader
last= Covel
first= Michael W.
authorlink= Michael W. Covel
year= 2007
publisher=
isbn= 0061241709

*cite web
last = Fahy
first = Tom
title = Arcadia Financial: Simple, Logical & Profitable
date = 2006
url = http://www.arcadiafinancial.biz
accessdate = 2006-10-29

*cite book
last = Faith
first = Curtis M.
title = Way of the Turtle:The Secret Methods that Turned Ordinary People into Legendary Traders
publisher = McGraw-Hill
date = 2007
location =
url =
id = ISBN 0-07-148664-X

*cite book
last = Markman
first = John D.
authorlink = John D. Markman
title = Swing Trading: Power Strategies to Cut Risk and Boost Profits
date = 2003
url =
id = ISBN 0 471 20678 4

*cite news
last = Reerink
first = Jack
title = Turtle bisque
publisher = Futures magazine
date = May 1995
url = http://www.allbusiness.com/periodicals/article/499193-1.html
accessdate = 2006-08-26

*cite web
last = Seykota
first = Ed
authorlink = Ed Seykota
title = How to determine the trend
work = FAQ
date = August 2006
url = http://www.seykota.com/tribe/TSP/Trends/index.htm
accessdate = 2006-08-21

*cite book
last = Tate
first = Christopher
authorlink = Christopher Tate
title = The Art of Trading
date = March 2001
url =
id = ISBN 1 876627 63 8

See also

Techniques
* Electronic trading
* Algorithmic Trading Platforms
* Swing trading
* Stock market cyclesRelated phenomena
* Chart patterns
* Information cascade
* Noise trader
* Keynesian beauty contest
* Herd behavior


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