Trend following strategies

1. Trend Following Strategies: A Beginner's Guide

Trend following is a popular and often profitable trading strategy that aims to capitalize on existing trends in financial markets. Rather than attempting to predict the *direction* of the market, trend followers identify trends *after* they have begun and position themselves to profit from their continuation. This article will provide a comprehensive overview of trend following strategies, suitable for beginners, covering the underlying principles, common methods, risk management, and potential pitfalls.

What is Trend Following?

At its core, trend following is based on the principle that trends, whether upward (bull markets) or downward (bear markets), tend to persist for a period of time. The idea is not to pick tops and bottoms, a notoriously difficult task, but to ride the trend until it shows signs of reversing. It’s a reactive, rather than predictive, approach. Think of surfing – a trend follower doesn’t create the wave, they ride it.

This contrasts sharply with mean reversion strategies, which attempt to identify situations where prices have deviated from their average and will revert back to that average. Trend following thrives in periods of strong, sustained price movement, while mean reversion performs better in choppy, range-bound markets.

The Psychology Behind Trend Following

Understanding the psychology driving trends is crucial. Trends are often fueled by momentum – as prices rise, more buyers are attracted, pushing prices higher still. This creates a self-reinforcing cycle. Conversely, falling prices can trigger selling pressure, accelerating the downward move.

Trend following exploits this momentum. By entering a trade *after* a trend has established itself, the trend follower aims to benefit from the continued psychological forces driving the price movement. It's about acknowledging that markets are often irrational and that investor behavior can create prolonged trends. Behavioral finance plays a significant role in understanding these forces.

Identifying Trends

Identifying a trend is the first step in implementing a trend following strategy. Several methods can be used, ranging from simple visual inspection to sophisticated technical analysis.

• **Visual Inspection:** Examining a price chart and looking for a series of higher highs and higher lows (in an uptrend) or lower highs and lower lows (in a downtrend). While subjective, it’s a good starting point.
• **Moving Averages:** Perhaps the most popular tool for identifying trends. A moving average smooths out price data over a specified period, making it easier to see the underlying trend. Common periods include 50-day, 100-day, and 200-day moving averages. When the price is consistently above the moving average, it suggests an uptrend; when it’s consistently below, it suggests a downtrend. Moving Average Convergence Divergence (MACD) often uses moving averages as its foundation.
• **Trendlines:** Drawing lines connecting a series of highs (in a downtrend) or lows (in an uptrend). A break of a trendline can signal a potential trend reversal.
• **Ichimoku Cloud:** A comprehensive technical indicator that identifies trends, support and resistance levels, and momentum. Ichimoku Kinko Hyo provides a visual representation of these elements.
• **Average Directional Index (ADX):** Measures the strength of a trend, regardless of its direction. An ADX value above 25 generally indicates a strong trend. [1]
• **Donchian Channels:** Display the highest high and lowest low for a specified period, creating a channel around the price. A breakout above the upper channel suggests an uptrend, while a breakout below the lower channel suggests a downtrend. [2]

Common Trend Following Strategies

Once a trend has been identified, several strategies can be employed to capitalize on it.

• **Moving Average Crossover:** This strategy uses two moving averages – a shorter-period moving average and a longer-period moving average. When the shorter-period moving average crosses *above* the longer-period moving average, it generates a buy signal (indicating the start of an uptrend). When the shorter-period moving average crosses *below* the longer-period moving average, it generates a sell signal (indicating the start of a downtrend). [3]
• **Breakout Strategies:** These strategies involve entering a trade when the price breaks through a significant level of resistance (in an uptrend) or support (in a downtrend). The breakout is seen as confirmation that the trend is likely to continue. [4]
• **Channel Breakout:** Similar to breakout strategies, but focuses on breaking out of a defined price channel.
• **Parabolic SAR:** A technical indicator that places dots above or below the price, depending on the trend. A dot below the price suggests an uptrend, while a dot above the price suggests a downtrend. [5]
• **Dual Moving Average:** Utilizes two moving averages to generate trade signals, focusing on the distance between them. [6]
• **Turtle Trading System:** A famous trend following system developed by Richard Dennis and William Eckhardt. It involves specific rules for entry, exit, and position sizing. Richard Dennis’s approach revolutionized trend following. [7]
• **MACD Histogram Strategy:** Trading based on changes in the MACD histogram, identifying accelerating or decelerating trends. [8]
• **Heikin Ashi:** A modified candlestick chart that smooths price data, making trends easier to identify. Trading signals are based on the color of the Heikin Ashi candles. [9]
• **Three Moving Average Strategy:** Combines three moving averages to generate buy and sell signals based on their intersections. [10]
• **Bollinger Bands Squeeze:** Identifying periods of low volatility (a "squeeze") followed by a breakout, indicating the potential start of a new trend. Bollinger Bands are a key component. [11]

Risk Management in Trend Following

Trend following, while potentially profitable, is not without risk. Proper risk management is essential to protect your capital.

• **Stop-Loss Orders:** Crucial for limiting potential losses. A stop-loss order automatically closes your trade if the price reaches a predetermined level. Place stop-losses strategically, based on support and resistance levels or volatility.
• **Position Sizing:** Determine the appropriate amount of capital to allocate to each trade. A common rule of thumb is to risk no more than 1-2% of your total trading capital on any single trade. Kelly Criterion offers a more sophisticated approach to position sizing.
• **Diversification:** Don't put all your eggs in one basket. Diversify your trades across different markets and asset classes to reduce your overall risk.
• **Trailing Stops:** Adjust your stop-loss order as the trend progresses, locking in profits and minimizing potential losses.
• **Volatility Adjustment:** Adjust position sizes based on market volatility. Higher volatility requires smaller positions. Consider using the Average True Range (ATR) to measure volatility. [12]
• **Risk-Reward Ratio:** Aim for trades with a favorable risk-reward ratio – ideally, at least 1:2 or 1:3 (meaning your potential profit is at least twice or three times your potential loss).

Pitfalls of Trend Following

• **Whipsaws:** False breakouts or sudden reversals can lead to losing trades. This is particularly common in choppy markets.
• **Late Entry:** Trend following strategies often involve entering a trade after the trend has already begun, meaning you may miss out on some of the initial gains.
• **Trend Reversals:** Trends don't last forever. Eventually, all trends will reverse, and a trend follower needs to be able to identify these reversals and exit their trades before incurring significant losses.
• **Over-Optimization:** Optimizing a strategy too closely to historical data can lead to poor performance in live trading. Overfitting is a common problem.
• **Emotional Trading:** Fear and greed can lead to impulsive decisions, undermining a disciplined trend following approach.
• **Ignoring Fundamentals:** Focusing solely on technical analysis and ignoring fundamental factors can be risky. [13]
• **Cost of Carry:** In some markets (e.g., futures), there are costs associated with holding a position (carry costs) that can erode profits.

Combining Trend Following with Other Strategies

Trend following doesn’t have to be used in isolation. It can be effectively combined with other strategies.

• **Trend Following + Mean Reversion:** Use trend following to identify the overall direction of the market and then apply mean reversion strategies within that trend.
• **Trend Following + Fundamental Analysis:** Use fundamental analysis to identify markets with strong underlying trends and then use trend following techniques to capitalize on those trends.
• **Trend Following + Sentiment Analysis:** Use sentiment analysis to gauge investor behavior and confirm the strength of a trend. [14]

Resources for Further Learning

• **Investopedia:** [15]
• **BabyPips:** [16]
• **StockCharts.com:** [17]
• **TradingView:** [18]
• **Books:** "Trade Like a Turtle" by Michael Covel, "Following the Trend" by Andreas Clenow.
• **Websites dedicated to technical analysis:** [19] and [20]
• **Blogs and forums:** Search for "trend following blog" or "trading forum" to find communities of traders sharing ideas and strategies.
• **Explore various trading indicators:** [21] to enhance your trend identification skills.

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