Why Does Trend Following Trading Work?

Why Does Trend Following Trading Work?

Trend Following

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The more effective a strategy, the more likely other traders will discover it and use it. At first, this may be fine, but over time, if enough people begin using the strategy, it may impact the strategy’s effectiveness by impacting the trend itself. You are no longer ahead of the trend; you’re in the same position as everyone else, which erodes or even eliminates your ability to make a profit. This is only a small sample of the traders who have gone on to make their fortunes through trend following, but it does highlight the timeless aspect of this trading strategy and its potential to provide lucrative returns. Information on the Trend Following™ network of sites may not be copied, reprinted, or redistributed without written permission from Michael Covel and or Trend Following . The purpose of this website is to encourage the free exchange of ideas across investments, risk, economics, psychology, human behavior, entrepreneurship and innovation. The entire contents of this website are based upon the opinions of Michael Covel, unless otherwise noted.

  • Thus, to make their programs truly robust many CTAs use 25 years of data.
  • The fact is, it rarely pays to focus your efforts on any one market, in any asset class.
  • But many investors don’t know enough about unfamiliar investments to make wise choices.
  • The relative performance of trend-followed equity strategies to buy and hold equity strategies on a rolling 5-year basis will test the will of any investor.
  • They trade everything from currencies, agriculture, metals, bonds, energy, and indices just to mention a few so this is a strategy worth checking out.
  • The worst drawdown in this period for the S&P 500 was a 36% decline from .
  • If you spend too much time looking at minor variations of entry rules you risk missing the important parts.

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Using return data collected from as far back as 1223, a representative trend-following system can be built for a period spanning roughly 800 years. The chart below shows a 100-day moving average acting as support (i.e., the price bounces off of it). However, since the price is more volatile than the moving average, this method is prone to more false signals, as the chart above shows. When the price crosses above a moving average, it can also be used as a buy signal, and when the price crosses below a moving average, it can be used as a sell signal. Trend traders will also watch for chart patterns, such as flags or triangles, which indicate the potential continuation of a trend.

Trend Following

Nathan is a Portfolio Manager at Newfound Research, a quantitative asset manager offering a suite of separately managed accounts and mutual funds. At Newfound, Nathan is responsible for investment research, strategy development, and supporting the portfolio management team. Nathan holds a Master of Science in Computational Finance from Carnegie Mellon University and graduated summa cum laude from Case Western Reserve University with a Bachelor of Science in Chemical Engineering and a minor in Mathematics. During normal market environments and even in prolonged equity-market drawdown periods like 2008, trend following outperformed the option-based strategy. Earning the full return on the underlying equity is generally beneficial. For this analysis, we will use the S&P 500 index for equity returns, the 1-year LIBOR rate as the risk-free rate, and options data on the S&P 500 .

Making a rules that says ‘Trade these parameters for Corn’ is a bad idea. Making rules that adapt to market characteristics could make sense. The simple rules presented here are good enough to replicate the performance of many large name trend following hedge funds with high precision and correlation. In my book I detail several ways this can be further enhanced and improved upon.

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Trend following has proven that markets are simply driven by humans and human nature never changes. This means with trend following a trader can identify recurring patterns that appear over and over with slight variations.

Compare, for example, one-year forward returns based on one-year trailing results for the Russell 1000 Growth versus the Russell 2000 Value. We took the Fama-French data and looked at how the simple trend following rule would have performed. In Figure 1 below, we compare the returns of a buy-and-hold strategy to a trend-following strategy for both small-cap value and large-cap growth back to the beginning of the Fama-French data in 1926. Many investors still focus on fundamental investment strategies because they are looking for the “edge” employed by Warren Buffett. While fundamental analysis has been extremely successful, it has attracted tremendous competition that has made it somewhat commoditized.

Will Trend

They show highly similar results simply because they attempt to achieve the same thing. Just make sure you do that after you have tried the basic strategy.

Trend Following

With so many potential trades, how can a trader possibly decide when a trend is occurring and make a profitable trade accordingly? A trader could attempt to watch the market and guess what will happen next or go with a “gut feeling,” but this is challenging. For example, maybe a stock’s price has increased steadily over the last two weeks. And this is a relatively simple scenario – a stock trending upwards. Once you begin working in more complex strategies with multiple durations and rules, it can become even more complicated.

Some of those pieces won’t do well in a rip-roaring bull market. The ever thoughtful pseudonymous blogger, Jesse Livermore, wrote a piece a few years ago that provided a comprehensive backtest of trend-following across a number of countries and markets. If you plan on using this type of strategy to avoid a calamity like 2008, you also have to accept the whipsaws that have you jumping in and out of the markets in times where we don’t experience a monster of a drawdown. In contrast, look at the chart in Figure 4 below for small value. We observed that small value earns such high returns coming out of high volatility periods that trend following destroys your returns in the 2000–03 period.

When paired together, they can provide greater diversification to a portfolio and historically have been additive to portfolio performance. Extreme market trends can appear from out of nowhere moving either up or down.

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A trader uses indicators to spot a trend and decide when to enter a position, but this is not the only time when traders must rely on indicators. Traders also use indicators to help them decide when to exit a position. Trend following centers on identifying trends with indicators and managing risk with strict position sizing rules. Every trend following strategy has its unique indicators to identify trends of various duration. These indicators can help the trader decide when to enter a position and when to exit a position. Let’s look at why trend followers use these indicators and how they help them make these decisions.

If you think about growth as a momentum bet and a market-sentiment bet, it makes sense that trend following would work on growth indices. In contrast, value is perceived as a mean-reversion bet, and the times to own the most value generally are the times it’s done the worst, as we’ve seen.

Trend Following

The relative strength index is a momentum indicator that measures the magnitude of recent price changes to evaluate overbought or oversold conditions in the price of a stock. Swing high is a technical analysis term that refers to price or indicator peak. Swing highs are analyzed to show trend direction and strength. The following Alibaba Group chart shows several examples of how trends can be analyzed, as well as some examples of potential trades using chart patterns and the trend. Traders use both price action and other technical tools to determine the trend direction and when it may be shifting.

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Nevertheless, details are applicable to a variety of strategies. It is my hope that a broader perspective will encourage investors to ask more pragmatic questions, ultimately improving their manager selection process. Many of the larger CTAs are, due to their size, more concentrated in only the most liquid markets (i.e. overly weighted towards developed bond, FX and equity markets with far less exposure to many commodity areas). The benefits of diversification are far less than one typically would expect from the strategy. Smaller CTAs are able to have proportionally higher allocations to smaller futures markets, particularly across the commodity complex at a scale that is sufficient to ‘move the needle’ from a P&L perspective. Government intervention has prevented the normal functioning of markets, dampened volatility and typical trend formation behaviour. Activism as well as increased market regulation by monetary authorities has had a direct impact on asset prices .

We provide the clear, unbiased advice you need to succeed on your terms. InstitutionsWe’re proud to provide financial guidance to a wide range of nonprofit organizations, helping them support and expand their important missions. Gyrations are replaced by a more clearly defined trend-like advance ending with a speculative fluff. Another interesting observation noted by Quest Partners and others is the asymmetry between profitable long and short trades. Over the last 25 years, particularly for the managers with larger AUM’s, long trades have been more profitable than short trades.

Trend Trading: The 4 Most Common Indicators

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You could also mention a decent brokerage that you are using. You might also want to look at regular position rebalacing logic. That’s a key important point that I left out of the book to avoid the added complexity. Exit on three average true range moves against the position from its peak reading. No intraday stops are used, so a close beyond three ATR units are needed for a stop to be triggered the following day. For the core strategy on this website I use a desired daily impact of 20 basis points. Introducing systematic rules and principles took my trading profitability and Sharpe ratio to the next level.

Trend trading is a method of trading designed to take advantage of uptrends where the price tends to make new highs or downtrends where the price tends to make new lows. At Buckingham Strategic Wealth®, we’re committed to always acting in our clients’ best interests. It’s not just a promise, it’s a legal, fiduciary responsibility. Click on the covers to learn more and order the books our national thought leaders have written in recent years. Buckingham prides itself on producing a wealth of non-biased financial information on a regular basis. See these articles from our blog and from our thought leaders around the nation.

Regardless of the period used to create the moving average, how the moving average data can be used to find trends remain relatively similar. While technical indicators are critical to a trend following strategy, it’s also important to note that alone they will not lead to a successful trading career. Traders must understand risk management, trading psychology, and periodically check to ensure their trading strategy is still sound.

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