Trend following - what is this?
Trend following has been used over a number of decades by some of the most successful traders in history. In its purest form, the price of a stock or instrument, and its movements, is the sole metric that requires analysis. As a result, the basic method is very simple and easy to understand, whether you are new to the trading game, or an experienced market participant.
Trend following historically has been applied to commodities, foreign exchange, stock indices, interest rates and other futures contracts. In principle, however, this can be applied to anything which has a fluctuating price.
Trend following can be a method to participate in the markets either via a fully automated or systematic approach, or by being a 'rules-based discretionary' trader. I am the latter and have used the approach successfully to trade individual stocks for a number of years.
Ok, so how do you define what is a trend?
A basic definition is as follows:
"A fluctuation between two price points over a period of time. To identify a trend, comparison is made between the current price and a historic price level - the distance in time between these price points determines whether this a shorter-term or longer-term trend.
If the current reading is above the historical reading, we have an uptrend. If lower, we have a downtrend. Traders often look at a series of highs and lows attained over a period of time to determine the trend. A series of higher highs and higher lows signify an uptrend, while a downtrend is identified by a pattern of lower highs and lower lows."
There are a number of different ways where you can define a trend and attempt to make money - some of which are shown below:
Perhaps the most popular and simplest method of identifying a trend is by using a moving average, such as shown in this chart.
For longer-term trends, the 200 day moving average is a commonly used indicator. For intermediate-length trends, the 50 day is often used. For short-term trends, the 10 day can be used, such as by famed Market Wizard Marty Schwartz.
Basically, if price moves above the moving average, then it is signalling an uptrend is in place. If price falls below the moving average, then a downtrend is in place.
Here is a daily chart of the FTSE100 index with a 200 day moving average:
And here is the same chart with a 10 day moving average. You can see how the moving average, being calculated over a much shorter period of time, is far more responsive to price moves. This can allow you to profit from shorter-term trends, but can lead to suffering losses when price is 'whipsawing' around and not generating a trend:
Often you will see traders use two moving averages of different lengths together, and look for the shorter-term average to 'cross over' the longer-term average, to denote a change of trend. Here is a chart of US stock Tesla Motors with the 20 and 50 week moving averages. In this example, you can clearly see the major uptrend from spring 2013 to the end of 2014, and the subsequent lack of a clear trend since:
Guppy Multiple Moving Averages
An interesting variation of using moving average was developed by the Australian trader, Daryl Guppy, who used a series of moving averages of different period lengths to help determine what 'traders' and 'investors' would do - and when.
Here is a weekly chart of the GBP/EUR. The series of moving averages at the bottom help to highlight that a long-term downtrend has been in place since the start of 2016.
I first came across this concept when reading the classic 'Technical Analysis of Stock Trends' by Edwards and Magee.
Here is a daily chart of US Crude Oil with some trend lines drawn on. When price breaks through the trend line, then that can indicate a potential change of trend. Trend lines can be subjective in how you draw them, and are prone to failure, particularly in volatile or 'non-trending' market phases (just as the other methods can be too). You need to remember that there is no 'Holy Grail' that will allow you to identify all the changes in trend on your chosen timeframe.
Price channels are often referred to as 'Donchian Channels' after Richard Donchian, who helped popularise this method, as well as trend following in general.
The channels act as a clear guide to show when prices are making new highs or lows using a look back period over a set number of days. People vary the parameters depending on whether they are looking to profit from a short-term, or longer-term trend.
How can you use this information?
Trend following can be applied either in a fully automated, systematic fashion, or on a rules-based discretionary method. The basic method lends itself to either of these approaches as it aims to use clearly defined entry, stop and exit parameters.
It is important to remember that, when a signal of a potential new trend is given, you never know whether the trend will develop over time as anticipated. All you can do is spot a potential entry point into a new trend set up, and see what happens.
Trends frequently do not act as intended, and therefore you should use good risk management of your funds, together with following the exit signals you use, to protect your trading capital.
Historically, the most successful trend followers have achieved their results even though they make a profit on less than half of their trades. They profit in overall terms by keeping losses small, and letting profits run so that, occasionally, they end up with a profit that will cover a number of small losses, and leave some residual profit left over.
How can I find out more?
My e-book is a great introduction as to how I have traded using a price channel approach, with scans to help me identify potential stocks to trade. Combined with good risk control, this has allowed me to achieve decent profits over a number of years.
This site is focused on a simple goal - to show how YOU can trade the markets successfully in a systematic, unemotional manner.
What are the benefits of trend following
- It will, without fail, put you on the right side of the major uptrends and downtrends in the markets;
- It is based upon similar methods used by some of the biggest and most successful traders in the world;
- It can be used to speculate on stocks, commodities, foreign exchange or other financial instruments;
- It focuses on the single metric which determines whether you make a profit or a loss - price.
There are some things that to trend following can't do - read this post for more.
On this blog you will find the answers on how you can:
- Maximise your profits, while keeping your risk to a minimum at all times;
- Learn the importance of a conservative approach to risk;
- Develop the necessary mindset to be successful in the markets.
What's more, if you sign up to our mentoring programme, you get complete support for 12 months in helping you develop your own trend following approach.
"Let me guide you on your trading journey, and show you how to profit from price trends" - Trader Steve. Trader, coach and mentor.