Trend Following Methods

Trend Following Methods

Trend following is a trading strategy based on the belief that asset prices tend to move in trends for extended periods. Instead of attempting to predict when trends will *begin* or *end*, trend followers aim to identify and capitalize on existing trends, riding them until conclusive evidence suggests they have reversed. This article provides a comprehensive introduction to trend following methods, covering their core principles, various techniques, risk management, and common pitfalls, geared towards beginners in the world of trading.

Core Principles of Trend Following

At its heart, trend following embodies a few key principles:

Objectivity: Trend following relies heavily on objective rules and indicators, minimizing emotional decision-making. Traders strive to react to price action rather than anticipate future movements based on subjective opinions. Technical analysis plays a crucial role here.
Discipline: Adhering to a predefined trading plan is paramount. This includes entry and exit rules, position sizing, and risk management protocols. Impulsive actions, driven by fear or greed, are the enemy of successful trend following.
Patience: Trends don't materialize instantly. Trend followers understand that periods of consolidation and whipsaw price action are inevitable. Patience is required to wait for legitimate trends to develop and to avoid premature entry.
Acceptance of Losses: Not every trade will be a winner. Losses are an inherent part of trading, and trend following systems are designed to accept small, frequent losses in exchange for larger, less frequent gains. Proper risk management is vital to survive these losing periods.
Trend Identification: The ability to accurately identify a trend is the foundation of any trend following strategy. This involves using various technical indicators and price action analysis techniques.

Identifying Trends

Several tools and techniques are used to identify trends:

Moving Averages (MA): Perhaps the most common trend-following indicator. Moving averages smooth out price data to reveal the underlying trend. Common periods include 50-day, 100-day, and 200-day MAs. A rising MA suggests an uptrend, while a falling MA suggests a downtrend. Investopedia - Moving Average
Trendlines: Simple yet effective. Trendlines are drawn along successive highs (in a downtrend) or lows (in an uptrend). A break of a trendline often signals a potential trend reversal. StockCharts - Trendlines
Relative Strength Index (RSI): While primarily an oscillator, RSI can confirm trends. RSI values above 50 generally indicate an uptrend, while values below 50 suggest a downtrend. Investopedia - RSI
Moving Average Convergence Divergence (MACD): A popular momentum indicator that can identify trends and potential trend reversals. A bullish MACD crossover (MACD line crossing above the signal line) suggests an uptrend, while a bearish crossover suggests a downtrend. Investopedia - MACD
Average Directional Index (ADX): Measures the strength of a trend. ADX values above 25 generally indicate a strong trend, while values below 20 suggest a weak or ranging market. Investopedia - ADX
Ichimoku Cloud: A comprehensive indicator that provides support and resistance levels, trend direction, and momentum signals. Investopedia - Ichimoku Cloud
Price Action Analysis: Observing candlestick patterns, chart formations (e.g., head and shoulders, double tops/bottoms), and overall price behavior to identify trends. Price Action - BabyPips
Donchian Channels: These channels display the highest high and lowest low over a specified period, highlighting potential breakouts and trend direction. TradingView - Donchian Channels

Trend Following Strategies

Numerous trend following strategies exist, each with its own nuances. Here are a few common examples:

Moving Average Crossover: This simple strategy involves buying when a shorter-period moving average crosses above a longer-period moving average (bullish signal) and selling when the shorter-period MA crosses below the longer-period MA (bearish signal). For example, a 50-day MA crossing above a 200-day MA. Fidelity - Moving Average Crossover
Breakout Strategy: This strategy involves buying when the price breaks above a resistance level or selling when the price breaks below a support level. The assumption is that a breakout signals the start of a new trend. Investopedia - Breakout
Channel Breakout Strategy: Similar to a standard breakout, but uses Donchian Channels or other channel indicators to define support and resistance. A breakout outside the channel suggests a continuation of the trend.
Dual Moving Average System: Uses two moving averages. Trades are taken only when both moving averages are trending in the same direction, providing stronger confirmation.
Parabolic SAR (Stop and Reverse): This indicator places dots above or below the price, acting as a trailing stop-loss and potential reversal signal. Investopedia - Parabolic SAR
Turtle Trading System: A famous trend following system popularized by Richard Dennis and William Eckhardt. It involves using a combination of breakout strategies and position sizing based on volatility. Van Tharp - Turtle Trading System
Trend Following with ATR (Average True Range): ATR measures price volatility. It can be used to set dynamic stop-loss levels and to filter out false breakouts. Investopedia - Average True Range
Three Moving Average Strategy: Uses three moving averages of different periods to confirm trend direction and generate entry/exit signals.
High/Low Breakout with Volume Confirmation: Combining price breakouts with volume analysis to confirm the strength of the trend. Higher volume during a breakout suggests greater conviction.
Fibonacci Retracement and Trendlines: Using Fibonacci retracement levels in conjunction with trendlines to identify potential entry points during pullbacks within a trend. Investopedia - Fibonacci Retracement

Risk Management in Trend Following

Effective risk management is crucial for the long-term success of any trend following strategy. Key considerations include:

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 capital on any single trade. Position Sizing - BabyPips
Stop-Loss Orders: Essential for limiting potential losses. Stop-loss orders automatically close a trade when the price reaches a predetermined level. Common stop-loss placement strategies include:

   * Fixed Percentage Stop-Loss:  Placing the stop-loss a fixed percentage below the entry price (for long positions) or above the entry price (for short positions).
   * Volatility-Based Stop-Loss:  Using ATR or other volatility measures to set the stop-loss level, adjusting it based on market conditions.
   * Swing Low/High Stop-Loss:  Placing the stop-loss below a recent swing low (for long positions) or above a recent swing high (for short positions).

Trailing Stop-Loss: Adjusting the stop-loss level as the price moves in your favor, locking in profits and protecting against potential reversals.
Diversification: Spreading your capital across multiple assets and markets to reduce overall risk. Don't put all your eggs in one basket.
Risk-Reward Ratio: Aim for a favorable risk-reward ratio, meaning that the potential profit of a trade should be at least twice as large as the potential loss. A 2:1 or 3:1 risk-reward ratio is often considered desirable.
Capital Preservation: The primary goal of risk management is to protect your capital. Avoid over-leveraging and taking unnecessary risks.

Common Pitfalls in Trend Following

Whipsaws: Periods of choppy price action that can trigger false signals and lead to losing trades. Using filters (e.g., ADX, volume analysis) can help avoid whipsaws.
Over-Optimization: Adjusting a strategy's parameters to fit historical data too closely, resulting in poor performance on live markets. "Curve fitting" is a serious risk.
Emotional Trading: Letting fear or greed influence your trading decisions, deviating from your predefined plan.
Ignoring Risk Management: Failing to implement proper risk management protocols, leading to potentially catastrophic losses.
Chasing Trends: Entering a trade late in a trend, after the majority of the profit has already been made.
Underestimating Drawdowns: Trend following systems inevitably experience periods of drawdown (losses). Being unprepared for these drawdowns can lead to panic selling.
False Breakouts: Price temporarily breaking through a support or resistance level before reversing direction. Volume confirmation can help identify genuine breakouts.
Trend Identification Errors: Mistaking random price fluctuations for legitimate trends. Confirming the trend with multiple indicators is essential.
Lack of Patience: Exiting a trade prematurely, before the trend has fully run its course.
Ignoring Market Context: Not considering broader economic and geopolitical factors that could influence market trends. Fundamental analysis can complement technical analysis.

Advanced Trend Following Techniques

Multi-Timeframe Analysis: Analyzing trends on multiple timeframes to gain a more comprehensive understanding of market direction.
Intermarket Analysis: Analyzing the relationships between different markets (e.g., stocks, bonds, commodities) to identify potential trends.
Algorithmic Trading: Automating trend following strategies using computer programs.
Machine Learning: Using machine learning algorithms to identify and predict trends.

Resources for Further Learning

Investopedia: Investopedia - A comprehensive resource for financial education.
Babypips: Babypips - A popular website for learning about forex trading.
StockCharts.com: StockCharts.com - A website providing technical analysis tools and education.
TradingView: TradingView - A charting platform with a social networking component.
Books by Michael Covel: Covel is a leading expert on trend following. Trend Following - Michael Covel

Trend following is a powerful trading strategy that, when implemented correctly, can generate significant profits. However, it requires discipline, patience, and a solid understanding of risk management. By mastering the principles and techniques outlined in this article, beginners can lay a strong foundation for success in the world of trend following. Remember to continuously learn and adapt your strategies to changing market conditions. Trading psychology is also a vital component for success.

Start Trading Now

Sign up at IQ Option (Minimum deposit $10) Open an account at Pocket Option (Minimum deposit $5)

Join Our Community

Subscribe to our Telegram channel @strategybin to receive: ✓ Daily trading signals ✓ Exclusive strategy analysis ✓ Market trend alerts ✓ Educational materials for beginners