Monday, April 06, 2015

Trend following - an overview

Trend following is a reactionary approach to trading the markets. We will wait for price to tip its hand (by moving to new highs or lows) before we enter a trade.

By doing this, we never get in a new position (or out of an existing one) at the exact top or bottom of a price move. We never look to buy low to sell high - we look to buy high and sell even higher (or short low and sell out even lower).

Studies have shown that, while markets do spend a great deal of time not trending, once a trend does start to develop, they have a tendency to persist. What nobody knows, however, is how long these trending phases will last, and to what magnitude.

From a psychological point of view, this is great. In this way, we are not tied to any opinions or predictions, which could act as 'anchors' in our thinking - we simply follow price and its movements.

Trend followers are frequently wrong. A typical win rate is between 30% - 40%. But, when we are right, the average size of the winning trades are multiples bigger than the average size of those losing trades. This gives us our positive expectancy. Trend followers are very impatient with losing trades, but extremely patient with their winners - they avoid cutting short any winning trades. That would have been akin to going short crude oil at $90 several months ago, and selling out at $85. They will let those trades play themselves out until they get an exit signal.

You never know which trade will develop one of these major trends, but you have to be able to ride those price moves as is it they which will cover all the small losses taken, and power your equity to new highs.

Risk management is an inherent element of a trend following approach. Given that most of our trades are losers, it has to be, otherwise we would go broke. A solid trend following approach with good risk control will lead you to taking on an emotional indifference towards each trade. If you lose, you only suffer a small reduction in your equity.

However, if a pronounced trend does develop, there will be lots of traders who will incur repeated losses trying to get in at the supposed extreme of such a move. Like those who were trying to pick the bottom of the 2008/early 2009 downtrend. Like those who didn't believe the moves in stocks in the dot.com bubble in 1999/2000. Like those who believed the drop in crude oil over the last few months was overdone. Or in thousands of other examples, in different markets or stocks over the years.

Of course, in all those cases mentioned above, price did finally reverse its direction. But a trend following approach will always get you on the right side of a major move at some point. Your entry and exit parameters will determine how early or late you get into and out of such a move. More importantly, with a trend following approach you should never get caught on the opposite side of such of a move. For that piece of security, and the potential of catching some of those big moves, trend followers are more than happy to miss out on trying to catch turning points.

It is no surprise that most trend following CTA's have done well the last few months. One only has to look at the charts of crude oil and EUR/USD, for example, to know the source of these profits.

Has it taken some great amount of research or intellect to generate those profits? Of course not. All they have done is follow price and its movements, and executed their trading plan.

For an individual trader, this approach can work too. Implementing a set of rules to identify entries and exits is only one part. Good risk control is essential, as is developing the right mindset so that you can follow the rules, and act at the appropriate time.

Trend following will not suit everybody, in the same way that day trading or scalping would suit others. But the potential rewards are there waiting for you, providing you are patient, disciplined and committed.

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