Trend following
Trend following is an investment strategy that takes advantage of long-term moves that play out in various markets. The system aims to works 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. It is reactive, diversified, long-term and systematic by nature. 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 demands that you have a very strong self-discipline to follow the precise signals generated by the rules you wrote. It is a system made up of several parts. Involves a risk management component that uses three elements; the current market price, equity level in an account and current market volatility. Traders use an initial risk rule that determines their position size at the time of entry. This means they know exactly how much to buy or sell based on how much money they have in their account. Changes in price may lead to a gradual reduction or increase of your initial trade. On the other hand, adverse price movements may lead to an exit for your entire trade. Historically, Trend Following trader's average earnings per trade are significantly superior than the typical loss per trade. Their performance and trading styles are works of true discipline, exacting precision that result in huge profits.
These systems traders normally enter in the market after the trend properly establishes itself and for this reason, they miss the initial turning point, but this does not diminish their returns, as there are many false turning points called whiplash where the professional trader might get caught.
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.
A definition by Van K. Tharp
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.
Considerations
Price: One of the first rules of Trend Following is that price is the main concern. If a market is at 70 and goes to 68, 67, 63 - the market is in a down trend. Despite what every technical indicator might predict, if the trend is down, stay with the trend. 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 with 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 is not the timing of the trade or the indicator, but rather the desicion of how much to trade over the course of the trend.
Risk Control: Cut losses, cut losses, cut losses is the rule. This means that during periods of higher market volatility, your 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. Cutting losses is the way to stay in the game.
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 does not involve seasonals, point and figure, Market Profile, triangles or day trading.
Beyond the mere rules, the human element is core to the strategy. It takes discipline and emotional control to stick with the signals generated through the inevitable market ups and downs. Traders using this method expect ups and downs so they are planned for in advance.
Trend Followers
Trend following systems have enjoyed the success and growth over the years and it is mainly due to those traders and CTA’s who have had the most success with these systems. Famous trend followers include Bill Dunn, Ed Seykota, John W. Henry, Richard Dennis, and Richard Donchian
Many famous traders like Richard Dennis, Paul Rabar, and Jerry Parker say that following a market trend is their winning trading strategy. Its reactive and systematic nature helps them to get maximum benefit from the market trend.
Richard Dennis and Richard Donchian are the fathers of the trend following. Richard is one of the most successful futures speculators of all time. He started trading with an initial stock of just a few dollars and used the power of trend following systems and strategies to turn his initial investment into $200 million. During the 80s he 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 CTA rankings, they became known as the turtles
Original turtle Jerry Parker, one of the most successful of Richard’s students, believes that trend following with rules works. The small town boy from Lynchburg, uses a powerful trend following technique, is now the president and head trader of Chesapeake Capital an award winning CTA from Virginia.ref
Another popular trend follower, John W. Henry, who started with $16,000, has returned 20% annually on one of his programs. Witch helped him to buy the Boston Red Sox.
Conclusion
Trend Following answers these critical 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.
Further reading
Covel, Michael W. (2005). Trend Following. Financial Times Prentice Hall. ISBN 0131345508.