TREND FOLLOWING TRADING

Let’s face it: nobody likes being uncomfortable.  But sometimes you have to be willing to experience a certain amount of discomfort in order to reap the greatest reward.  Trend-following trading is based on this principle. 

Let’s face it: nobody likes being uncomfortable. But sometimes you have to be willing to experience a certain amount of discomfort in order to reap the greatest reward. Trend-following trading is based on this principle.
A trend-following system is rooted in the idea that it’s best to buy a futures market when the price is on an uptrend, and sell the futures when its price is on a downtrend. Trend-following trading doesn’t look at predictions or forecasts – it’s not concerned with what the market may do. It’s reactive by nature. It’s only concerned with what the market is actually doing. And the only thing that can tell you what the market is actually doing is price. Actual, current futures price carries the most weight in a trend-following system. If it is rising in one general direction, with higher swing lows and higher swing highs, then there is an uptrend. If it is falling in one general direction, with lower swing lows and lower swing highs, then there is a downtrend. It’s that simple.

Or is it? 

Here is the tricky thing about a trend-following system: a downtrend isn’t the same as a temporary low.  Because of the natural volatility of the market, a trend-following trader will need to fight the urge to sell at certain times.  He or she will need discipline and resolve to withstand the discomfort and anxiety brought on by market movements.  It will be necessary to “wait out” certain low periods to ride the trend to its greatest profit.  Not many people find this easy.  Trend-following trading requires a strict application of price data to determine whether a trend is happening, and when to ride it and for how long.  Identifying the direction of a trend, and knowing when to exit the market, therefore becomes critical. 

Trend traders who use a trading system usually enter the system after a trend has been established.  If the trend is an uptrend, they take what is called a long position, which is based on the belief that the trend will continue.  If they are entering during a downtrend, then they take what is called a short position.  In order to assess their initial risk, or the amount that they are going to buy or sell to enter the market, traders look for certain trade signals.  These are determined by certain indicators that help trend traders analyze price data.  After all, trend traders need to look to some past data in order to come to conclusions about what is happening in the present.

These indicators include the following:

  • Moving Averages
  • Momentum Indicators
  • Trendlines

A moving average is a way of averaging out futures daily prices over a set number of days.  By eliminating a futures price’s hourly fluctuations, and focusing just on the average daily price over a certain timeframe, a trader is better able to identify a larger trend at work.  A moving average may also determine when a trader should enter or exit the market.  Typically a trader will enter a long position when a short-term moving average crosses above a long-term moving average, or he or she will enter a short position when a long-term moving average crosses below a short-term moving average, like with the Dual Moving Average Crossover Trading System

If a trend has already been established, a momentum indicator can be used to determine when to buy and sell.  The relative strength index, or RSI, looks at the degree of recent price changes in a futures to conclude whether a certain futures is oversold or undersold.  The RSI is an oscillator that shows price momentum on a graph.  If momentum rises above a certain place, then analysts usually conclude that a futures is becoming oversold and a correction is due.  If momentum falls below a certain spot, analysts then conclude that a futures may be undervalued.  These are points at which traders can then enter, or exit, a market with some assurance that the timing is right. 

A trendline is a visual representation of price direction charted on a graph.  It may be drawn along swing lows in an uptrend or swing highs in a downtrend.  It shows a possible place that a price may return to, whether high or low.  The set time period varies, but the purpose is the same: to show in stark, uncertain terms a downtrend or an uptrend in futures price. 

Throughout it all, trend traders must reconcile themselves with a core truth: that loss is a part of life.  Any futures trading system using a trend-following strategy will involve a certain amount of loss, but according to trend-following theorist Michael Covel, a trend trader’s average profit per trade is significantly higher than their average loss per trade.  And keep in mind the words of John Henry, one of the most famous trend traders of all time (and the owner of the Boston Red Sox): “Long-term systems do not avoid volatility.  They patiently sit through it.”

Are you patient enough to be a trend trader?  There’s only one way to find out….