Trend following trading is an investment approach that at first, seems too simple to work. After all, investing in stocks should be difficult. You analyze company balance sheets and industry fundamentals, calculate a fair value of the stock, and analyze stock chart patterns. Or do you? According to the basic premise of trend following, most of this analysis is unnecessary. Instead, just buy what is going up and hold until it stops going up. Does that sound too good to be true? There might be a little more to it than that, but this trading approach has merit and is worth investigating, especially if you have not been satisfied with your investment results.
History of Trend Following Trading
Trend following trading, though not yet well known, has been around for a while. According to Lawrence Clark, the famous trader David Ricardo made a tidy sum buying and selling bonds and stocks around 1800 using a strategy that he called “Cut short your losses and let your profits run on." This expression captures one of the central tenants of trend following trading.
More recently, this type of trading approach has received more attention after Michael Covel wrote several books about the turtle traders, a group of unknowns with little trading experience who were taught trend following strategies and then went on to become highly successful traders.
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As the name implies, the first step in the strategy is find the trend. Trends exist in any type of market. They can be up (rising prices) or down (falling prices). Most traders use some sort of system to identify them, based on a technical analysis of the chart patterns. Just noticing that a stock is going up is not enough to call it a trend. You need to quantify the trend using rules. Your rules might look like this:
- Are both the 200 and 50 day moving averages of the stock price sloping up?
- Have these moving averages been sloping up for longer than one month?
- Is the stock showing higher highs and higher lows (in a stair-step pattern)?
Different traders create their own rules to help them spot trends.
Using Stop Losses
Once you identify that the stock is in a positive trend, it is a buy candidate. But before you buy, you create an exit strategy in case you are wrong, also known as a stop loss. If the stock falls below a certain price after you buy, you sell to limit your loss. Usually you place the limit price just below a previous low point of the stock over the past several weeks or months. If the stock price falls below that level, you will take a small loss and move on.
If the most logical spot for a stop price is well below the current price (more than 15% below), most traders decline to take that trade. They want to have only small losses when they are wrong.
After you decide on where to place your stop loss, you buy and hold until the trend ceases. You set up rules for identifying when that happens, just like your rules for identifying the trend.
As you can see, the idea is simple. The complexity is in the execution – in the rules you use to spot trends and trend changes.
Trend Following is Not Momentum Investing
Some investors confuse trend following with momentum investing. Momentum investing is mostly a short-term trading strategy in which you look for stocks that are in the news and are moving strongly upwards (or downwards) and you buy (or short) the stock, hoping for quick profits. Trend following works on longer time frames and unlike momentum investing, the popularity of the stock is not important as long as the trend is established. In fact, trend following often works well for off the radar stocks that have not yet been discovered. Stocks that are attractive to momentum investors tend to be stocks that are already discovered by the masses and whose upward trends might be mature (and thus subject to reversal).
Theory Behind the Strategy
The premise behind trend following trading is that the markets are not predictable. You can never have enough information, no matter how much research you do, to predict market prices. Markets are simply too complex. Market prices are determined partly by sentiment, which is prone to wild swings and depends on the collective psychology of people, which is impossible to predict or even quantify. Therefore, the best you can do is follow the markets, detect the trends, preferably shortly after they start, and then hop on board. The best trends can last for a long time. If you get in early on a trend, the money you make on that one position can more than make up for many small losing positions.
Some investors don’t like trend following because it does not consider stock valuations or fundamentals. Value investors like to buy a stock when their analysis of the fundamentals indicate that the stock is undervalued. Trend following traders don’t care about valuations because, again, valuation is subjective and based on sentiment, which is not predictable. For them, only price matters.
Does it Work?
Whether this method works is difficult to answer. Most people don’t make their trading results public. However, one study that looked at trend following over the past 100 years found that it produced strong results. This study also found that the strategy provided some protection in bear markets, which are periods of falling stock prices.
Like most trading strategies, in the end, whether it can work for you depends on how well you set up your rules and whether you have the discipline to follow them consistently.
For me, the advantage of the system is that it protects you somewhat from large losses, if you sell when the trend changes. In investing, avoid losses is just as important, if not more so, then making gains.