Trend following

Trend following or trend trading is a trading strategy according to which one should buy an asset
when its price trend goes up, and sell when its trend goes down, expecting price movements to
continue.[1]

There are a number of different techniques, calculations and time-frames that may be used to determine
the general direction of the market to generate a trade signal (forex signals), including the current
market price calculation, moving averages and channel breakouts. Traders who employ this strategy do
not aim to forecast or predict specific price levels; they simply jump on the trend and ride it. Due to the
different techniques and time frames employed by trend followers to identify trends, trend followers as a
group are not always strongly correlated to one another.

Trend following is used by commodity trading advisors (CTAs) as the predominant strategy of technical
traders. Research done by Galen Burghardt has shown that between 2000-2009 there was a very high
correlation (.97) between trend following CTAs and the broader CTA index.[2]

Contents
Definition
Considerations
Example
See also
Notes and references
Further reading

Definition
Trend following is an investment or trading strategy which tries to take advantage of long, medium or
short-term moves that seem to play out in various markets. Traders who employ a trend following
strategy do not aim to forecast or predict specific price levels; they simply jump on the trend (when they
perceived that a trend has established with their own peculiar reasons or rules) and ride it. These traders
normally enter in the market after the trend "properly" establishes itself, betting that the trend will
persist for a long time, and for this reason they forego the initial turning point profit. A market "trend" is
a tendency of a financial market price to move in a particular direction over time. If there is a turn
contrary to the trend, they exit and wait until the turn establishes itself as a trend in the opposite
direction. In case their rules signal an exit, the traders exit but re-enter when the trend re-establishes.

Cutting Loss. Exit market when market turn against them to minimize losses, and "let the profits run",
when the market trend goes as expected until the market exhausted and reverses to book profit.

This trading or "betting with positive edge" method involves a risk management component that uses
three elements: number of shares or futures held, the current market price, 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 an increase of the initial trade. On the other hand, adverse price movements may
lead to an exit from the entire trade.

In the words of Tom Basso, in the book Trade Your Way to Financial Freedom[3]

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.

The key reasons for trending markets are a number of behavioral biases that cause market participants
to over-react:

Herding: After markets have trended, some traders jump on the bandwagon, and thus prolonging the
herding effect and trends.

Confirmation Bias: People tend to look for information that confirm their views and beliefs. This can
lead investors to buy assets that have recently made money, and sell assets that have declined, causing
trends to continue.

Risk Management: Some risk-management models will sell in down markets as, for example, some risk
budgets have been breached, and buy in up markets as new risk budgets have been unlocked, causing
trends to persist.

"Don't fight the tape" is a term that means do not bet or trade against the trend in the financial markets,
i.e., if the broad market is moving up, do not bet on a downward move. The term "tape" refers to the
ticker tape used to transmit the price of stocks.[4][5] It is analogous to the trader's maxim, "The trend is
your friend."

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 and demand factors.
Diversification: Research published by hedge fund manager Andreas Clenow shows that cross
asset diversification is an essential part of professional trend following.[6]

Example
A trader would identify a security to trade (currencies/commodities/financials) and would come up with
a preliminary strategy, such as:[7]

Commodity: soybean oil

Trading approach: long and short alternately.
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%.
Conventional wisdom on stop losses set the risk per trade anywhere between 1%-5% of capital for a
single trade; this risk varies from one trader to another.

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 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 on stocks, which are more likely to be mean reverting
(which favors swing traders).

In addition to quiet low volatility markets, where trend following strategies perform well, trend trading is
also very effective in high volatility markets (market crash). Trend traders "short" the market and benefit
from the downside market trend.

See also
Mean reversion (finance)

Techniques:

Electronic trading
Algorithmic trading
Day trading
Stock market cycles

Related phenomena:

Chart pattern
Business Cycle
Information cascade
Noise trader
Keynesian beauty contest
Herd behavior
Notes and references
1. Trend Trading (https://www.investopedia.com/terms/t/trendtrading.asp). Investopedia
2. Dr. Galen Burghardt (December 13, 2010). "Measuring the impact of trend following in the CTA
space" (http://www.opalesque.tv/hedge-fund-videos/Galen_Burghardt/1). Opalesque TV.
3. Tharp, Van K. (1998). Trade Your Way to Financial Freedom. 83: McGraw-Hill. ISBN 978-0-07-
064762-6.
4. Barron's finance & investment handbook by John Downes, Jordan Elliot Goodman 2003 ISBN 0-
7641-5554-7 page 353
5. Wall Street words by David Logan Scott 2003 ISBN 0-618-17651-9 page 113
6. Clenow, Andreas F. (2012). Following the Trend: Diversified Managed Futures Trading. Wiley &
Sons. p. 300. ISBN 978-1118410851.
7. 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.

Further reading
Christensen, Hugh (2012). "Forecasting High-Frequency Futures Returns Using Online Langevin
Dynamics". IEEE Journal of Selected Topics in Signal Processing. 6 (4): 366–380.
doi:10.1109/JSTSP.2012.2191532 (https://doi.org/10.1109%2FJSTSP.2012.2191532).
Brown, Kedrick (2006). Trend Trading: Timing Market Tides. John Wiley & Sons, Inc. ISBN 978-0-
471-98021-6.
Covel, Michael W. (2007). Trend Following: How Great Traders Make Millions in Up or Down
Markets, New Expanded Edition (https://archive.org/details/trendfollowingho00cove_0). Financial
Times Prentice Hall (March 19, 2007). ISBN 978-0-13-613718-4.
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 978-0-13-702018-8.
Covel, Michael W. (2007). The Complete TurtleTrader: The Legend, the Lessons, the Results. Collins
(October 9, 2007). ISBN 978-0-06-124170-3.
Covel, Michael W. (2009). The Complete TurtleTrader: How 23 Novice Investors Became Overnight
Millionaires. Collins Business (February 24, 2009). ISBN 978-0-06-124171-0.
Faith, Curtis M. (2007). Way of the Turtle:The Secret Methods that Turned Ordinary People into
Legendary Traders. McGraw-Hill. ISBN 978-0-07-148664-4.
Markman, John D. (2003). Swing Trading: Power Strategies to Cut Risk and Boost Profits. ISBN 978-
0-471-20678-1.
Seykota, Ed (August 2006). "How to determine the trend" (http://www.seykota.com/tribe/TSP/Trends/
index.htm). FAQ. Retrieved 2006-08-21.
Tate, Christopher (March 2001). The Art of Trading. ISBN 978-1-876627-63-8.
Nilsson, Linus (November 2015). "Trend Following - Expected Returns". SSRN 2689861 (https://ssr
n.com/abstract=2689861).

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