Every trader needs a trend to make money. If you think about it, no matter what the technique, if there is no trend after you buy, then you will not be able to sell at higher prices.
Trend following trading is completely different that what most investors are accustomed to which is a buy and hold strategy. Trend followers wait for a trend to begin before they enter the market and once the trend has shown signs of deterioration trend followers are exiting the market. Trend trading takes discipline and emotional control to stick with the strategy through the inevitable market ups and downs. It seeks to capture the majority of a market trend, up or down, for profit even if that means experiencing uncomfortable market volatility.
One of the great trend followers or our time, John Henry explains this best:
“There is an overwhelming desire to act in the face of adverse market moves. Usually it is termed ‘avoiding volatility’ with the assumption that volatility is bad. However, I found avoiding volatility really inhibits the ability to stay with the long-term trend. The desire to have close stops to preserve open trade equity has tremendous costs over decades. Long-term systems do not avoid volatility, they patiently sit through it. This reduces the occurrence of being forced out of a position that is in the middle of a long-term major move.”
Trend trading is best seen as reactive and systematic by nature. It does not forecast or predict markets.
“I don’t believe that I am the only person who cannot predict future prices. No one can consistently predict anything, especially investors. Prices, not investors, predict the future. Despite this, investors hope or believe that they can predict the future, or someone else can. A lot of them look to you to predict what the next macroeconomic cycle will be. We rely on the fact that other investors are convinced that they can predict the future, and I believe that’s where our profits come from. I believe it’s that simple.” John Henry
Trend Following always involves a plan. It requires that you have strong self-discipline to follow precise rules (no guessing or wild emotions). It involves a risk management system that uses current market price, the equity level in your account and current market volatility. Trend traders use an initial risk rule that determines your position size at the time of entry. This means you know exactly how much to buy or sell based on how much money you have. Changes in price may lead to a gradual reduction or increase of your initial trade. On the other hand, adverse price movements may lead to an exit for your entire trade. Historically, a trend trader’s average profit per trade is significantly higher than the average loss per trade.
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Top Reasons for Trend Following Investing
Profit in Up and Down Markets:
Trend following doesn’t swear an allegiance to a bull or bear market. It follows trends to the end. No matter how ridiculous trends might appear early and no matter how insanely extended they might appear at the end, follow trends. Why? Because they always go further than anyone expects. Ignore momentum at your peril.
No More Buy and Hold, Analysts or News:
Trend following decision-making doesn’t involve discretion, guesses, ‘gut’ feels or hunches. It’s not day trading or buy and hold (hope). It doesn’t involve passive indexing, in and out trading or fundamental analysis. No more 24-hour news cycles, daily turbulence or sensational hype. No black boxes or magic formulas either. Hope is the most addictive drug. Let go of the Holy Grails. The good news? Complete beginners can learn trend following.
Trends exist everywhere, always coming and always going. Whether fashion, business or whatever, we all want to find trends and ride them as far as they can go. Markets are no different: they trend up and they trend down. That said, no one can predict a market trend, you can only react to them. Trend following never anticipates the beginning or end of a trend. It only acts when the trend changes. However, there is no need to figure out ‘why’ a market is trending — just follow it. You don’t need to understand electricity to use it.
The Big Money of Letting Profits Run:
Trend following aims to compound absolute returns. It doesn’t shoot for ‘average.’ Do you really want to be exactly like your neighbor? The goal is to make the big returns, not generate passbook savings returns. Trend following also has the unique ability to lie and wait for ‘targets of opportunity.’ This means ‘outlier’ events (read: unpredictable surprises like the 2008 market crash) can make you huge money.
No Traditional Diversification:
Trend following is not restricted to any single market or instrument. A focus on ‘price action’ allows trend following to be applied to an exceptionally large variety of markets. Price is the one thing that all markets have in common. That means a system for treasury bonds will work on the Euro too. And if you switch it over to coffee, something totally different than treasury bonds, it still works. Trend following is robust. But don’t expect the ‘tape’ to lecture you. You have to trust your buy and sell signals and follow all rules.
No Government Reliance:
Forget Social Security, bailouts, stimulus plans and roads to nowhere. Those won’t help you to make money, but they might help you to lose money. When the Fed takes the ‘training wheels’ off the economy will you be ready to mint cash or will you just sit there and take it again? If your portfolio is grounded in sound principles you can win, but the government has nothing to do with sound anything.
Takes Advantage of Mass Psychology:
Markets, which are always changing, are only our subjective expectations reflected objectively. Interestingly, people’s reactions to change always remain the same (i.e., they bet wrong as a group). Trend following takes advantage of ‘panicky sheep’ behavior to make money. How? Strict discipline minimizes behavioral biases. It solves our eagerness to realize gains and reluctance to crystallize losses. Let’s face it too many people believe what pleases them and social conformity means that even if the group is wrong, we go along. Most behaviors are simply driven by the impulsive moment of now. They aren’t purposeful, thought-out choices. Trend following wins because of that.
Scientific Approach to Trading:
Trend following doesn’t require a belief, but rather it relies on unwavering principles proven over decades. It has a defined edge just like the MIT card counting team that beat Vegas casinos (read: mathematical game theory from the movie ‘A Beautiful Mind’). Be the casino and not the hapless player. How? Trend following uses hard rules rooted in numbers (think process not outcome). And remember, frequency of correctness does not matter, the magnitude of correctness matters. ‘Winning percentage’ means zilch. How much time will trend following take? No staring at the screen drinking ‘Red Bulls’. Once you are setup, minutes a day is all you need when you approach trading like an engineer.
Strong Historical Performance in Crisis Periods:
Trend following prepares for the worst at all times. It is adaptable to differing climates and environments performing best during periods of rising volatility and uncertainty. Guess what? The unknown will happen again. Are you ready? You have to be able to ride the bucking bronco while also riding the storm out. That said, the day you have to do something, you are screwed. Trend following, like a lion waiting to strike wounded prey, is very patient.
Risk Management is Top Priority:
Trend following always has defined exit protocols to control ‘injury’ to your account. Stop losses and proper leverage usage are standard practice. Trend following also has low to negative correlations with most other investment opportunities. It eliminates exposure to groupthink and toxic assets. Eliminating exposure is a winning move whereas hedging can actually increase your exposure. Trend following is the best protection for when bubbles pop and everyone starts running for cover.