Saturday, April 05, 2014

A summary of what trend following can't do (and what it can)

A good trend following approach will include the following factors:
  • What market are you looking to buy or sell (what markets are in your trading portfolio?);
  • When do you buy and sell a position (what are your entry rules?);
  • How much to buy or sell (what are you risk per trade levels and your overall account risk levels?);
  • When to exit a losing position (where is your initial stop placed?); and
  • When to exit a winning position (what are your exit rules?)
These are the basic parameters of any trend following system, and are set at the discretion of the trader.

Like any approach to trading, trend following has its own strengths and weaknesses. There are things such an approach can or cannot do. In my opinion, the strengths far outweigh those weaknesses.

Trend following cannot do any of the points listed below:
  • Get you in a long trade at the bottom of a price move;
  • Get you in a short trade at the top of a price move;
  • Get you out of a long trade at the top of a price move;
  • Get you out of a short trade at the bottom of a price move;
  • Give you a high win percentage on your trades;
  • Deal with 'V' shaped reversals in the market.
If you disagree with any of the above, or believe that you can consistently do what a trend following system can't do, then you are looking at the wrong site.

What it CAN do is this:
  • Give you clear, unambiguous signals of where to enter and exit a trade;
  • Limit your losses when a trade goes against you;
  • Allows your profits to run when a trade goes in your favour;
  • Allows the size of your winners to be larger than the size of your losers;
  • Allows you to focus on the sole metric that can physically make you a profit - price;
  • Allows you to deal with small retracements against you, and keep you in the trade;
  • Allows you to avoid or ignore opinions, economic forecasts, hot tips or hunches;
  • Only gives an exit signal when the trend has run its course.
If you agree with these points, then you are in the right place.

Trend followers will never appear in the top calling brigade. We also don't try to catch falling knives. There has to be some strength in a market for the trader to go long, or some price weakness for the trader to go short.

Trend following is based on odds, probabilities, risk and reward. It seeks to limit the downside and not restrict the upside. This can only be done if the focus is on price.

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