Trading the downside - remaining faithful to the process

The last couple of months have been very positive as profitable downtrends have appeared in a number of stocks, both at home and abroad. Fortunately, I have been able to profit from some of these (while suffering small losses in a few others!), and while some which developed into downtrends have now triggered their exit signals, prices in others have remained in a downtrend.

This has potentially meant I may have been able to profit from the downwards move while those who trade longer-term trends have had to suffer an erosion of open profits, or even suffering losses, from a pullback or retracement within the context of a prevailing longer-term uptrend.

An example in trade management - the trailing stop

When trading using a clearly defined set of rules, it can easily become frustrating for an inexperienced trader to get stopped out of a position, only for price to then reverse and start moving back in the direction of your trade.

Some see that as a weakness of their method. Yet I, and many other traders who religiously follow their rules (be they automated or not), see that as a strength. 

20 truths about trend following

People are often attracted towards adopting a trend following because of its robustness and longevity, together with the returns it can generate.

This is no 'get rich quick' scheme - the basic concept has been proven to work over many decades, in up and down markets, and some of the most successful traders and Market Wizards have used it.

That said, it demands a lot from you. If you are considering adopting a trend following approach, here are some basic truths that you need to understand and accept:

Thoughts on what price action to focus on, timeframes and parameters

I've talked in the past here about how the indices are constructed, and given an argument as to why you may want to avoid following them 'parrot fashion'. It generated some interesting comments from readers, so it is worth a read.

Remember that, if you trade individual stocks, you are trading just that, and not the stock market as a whole. This point may well be anathema to a lot of people who trade using a 'top down theory' of analysis, and that's fine. I am simply putting forward a different point of view or belief.

Not 'jumping off' the ride, and letting trades play themselves out

A trend follower never takes positions based on predictions or opinions about what may happen. Trend following is reactionary, and based on what price is doing - therefore price has to show some strength before you look to go long, or some weakness before you look to go short.

Just as importantly, trend followers never try and predict potential turning points in a market. There is a process where price can look to change trend from one direction to another - this can happen very quickly, or in some cases take several months! Generally speaking though, this takes time, and a single day's movement does not constitute a change of trend.

It is for this reason that trend followers never get out of an existing position at the extreme of the move. There is always a process of 'giving back' some of the open profits before an exit signal is triggered, and/or a change of trend is signalled.

Trend following and the ‘V’ shaped reversal

Occasionally when utilising a trend following method you have to deal with a ‘V’ shaped reversal. This is where, after moving strongly in your favour, price decides to sharply reverse direction, before your trailing stop has had chance to 'lock in' the bulk of those gains.

This type of price reversal can be the bane of a trend follower. I know my own basic approach struggles with them.

Marty Schwartz and the sunspot theory

Every so often you come across a post from a trader talking about a specific stock along the lines of "Is there a reason NOT to own XYZ plc?"

Whenever I see a question like that, it immediately sets off alarm bells, which more often than not are confirmed when you go and look at a price chart of the stock in question.

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.

Trend following - the Marmite way to trade

Trend following is like Marmite - you either love it or hate it. Who on earth would trade in such a manner? Surely you need to know whether something is overbought or oversold, what the underlying fundamentals or earnings are, or...

Hang on a minute.