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Trend following

Trend following

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Trend following is an investment strategy
Investment strategy
In finance, an investment strategy is a set of rules, behaviors or procedures, designed to guide an investor's selection of an investment portfolio...

 that tries to take advantage of long-term moves that seem to play out in various markets. The strategy aims to work on the market trend
Market trends
A market trend is a putative tendency of a financial market to move in a particular direction over time. These trends are classified as secular for long time frames, primary for medium time frames, and secondary for short time frames...

 mechanism and take benefit from both sides of the market
Financial instruments
A financial instrument is a tradable asset of any kind, either cash; evidence of an ownership interest in an entity; or a contractual right to receive, or deliver, cash or another financial instrument....

, enjoying the profits from the ups and downs of the stock or futures markets. Traders
Trader (finance)
A trader is someone in finance who buys and sells financial instruments such as stocks, bonds, commodities and derivatives. A broker who simply fills buy or sell orders is not a trader, as they are merely executing instructions given to them. According to the Wall Street Journal in 2004, a managing...

 who use this approach can use current market price calculation, moving averages
Moving average (technical analysis)
In statistics, a moving average, also called rolling average, rolling mean or running average, is a type of finite impulse response filter used to analyze a set of data points by creating a series of averages of different subsets of the full data set.Given a series of numbers and a fixed subset...

 and channel breakouts to determine the general direction of the market and to generate trade signals. Traders who employ a trend following strategy do not aim to forecast or predict specific price levels; they simply jump on the trend and ride it.

Trend following is most commonly associated with Commodity Trading Advisors as the predominant strategy of technical traders. Dr. Galen Burghardt, an adjunct professor at the University of Chicago's Booth School of Business, researched the relative impact of trend following funds in the CTA business. By tracking a subset of trend following CTAs and comparing that subset them with a broader CTA index (from the period 2000-2009), Dr. Burghardt measured a correlation of .97 between the two groups, showing how large the impact of trend following is in the CTA business.

Definition


Trend following is a betting strategy that tries to take advantage of long-term moves that seem to play out in various markets. Traders who employ a trend following strategy do not aim to forecast or predict specific price levels; they simply jump on the trend (when they perceived that a trend has established with their own peculiar reasons or rules) and ride it.
These traders normally enter in the market after the trend "properly" establishes itself, betting that the trend will persist for a long time,and, for this reason, they ignore the initial turning point profit.
A market "trend" is a tendency of a financial market price to move in a particular direction over time.
If there is a turn contrary to the trend, they exit and wait until the turn establishes itself as a trend in the opposite direction. In case their rules signals an exit, the trader exits but re-enters when the trend re-establishes.

Cutting Loss.
Exit market when market turn against them to minimize losses, and "let the profits run", when the market trend goes as expected until the market exhausted and reverses to book profit.

This trading or "betting with positive edge" method involves a risk management
Money management
Money management is the process of managing money which includes investment, budgeting, banking and taxes. It is also called investment management....

 component that uses three elements: number of shares held, the current market price, and current market volatility
Volatility (finance)
In finance, volatility is a measure for variation of price of a financial instrument over time. Historic volatility is derived from time series of past market prices...

. An initial risk rule determines position size at time of entry. Exactly how much to buy or sell is based on the size of the trading account and the volatility of the issue. Changes in price may lead to a gradual reduction or an increase of the initial trade. On the other hand, adverse price movements may lead to an exit for the entire trade.

These traders normally enter in the market after the trend properly establishes itself, and, for this reason, they ignore the initial turning point profit.

If there is a turn contrary to the trend, these systems signal a pre-programmed exit or wait until the turn establishes itself as a trend in the opposite direction. In case the system signals an exit, the trader re-enters when the trend re-establishes.

In the words of Tom Basso
Tom Basso
Thomas F. Basso was a stock and commodities trader who was president and founder of Trendstat Capital Management. He is the author of two books, Panic-Proof Investing and the self-published The frustrated investor...

, in the book Trade Your Way to Financial Freedom

Considerations

  • Price: One of the first rules of trend following is that price is the main concern. Traders may use other indicators showing where price may go next or what it should be but as a general rule these should be disregarded. A trader need only be worried about what the market is doing, not what the market might do. The current price and only the price tells you what the market is doing.

  • Money management: Another decisive factor of trend following is not the timing of the trade or the indicator, but rather the decision of how much to trade over the course of the trend.

  • Risk control: Cut losses is the rule. This means that during periods of higher market volatility, the trading size is reduced. During losing periods, positions are reduced and trade size is cut back. The main objective is to preserve capital until more positive price trends reappear.

  • Rules: Trend following should be systematic. Price and time are pivotal at all times. This technique is not based on an analysis of fundamental supply and demand
    Supply and demand
    Supply and demand is an economic model of price determination in a market. It concludes that in a competitive market, the unit price for a particular good will vary until it settles at a point where the quantity demanded by consumers will equal the quantity supplied by producers , resulting in an...

     factors.

Q&As


Trend following strategy answers the questions:
  • What Market Do You Buy or Sell at Any Time?
  • How Much of a Market Do You Buy or Sell at Any Time?
  • When Do You Buy or Sell a Market?
  • When Do You Get Out of a Losing Position?
  • When Do You Get Out of a Winning Position?

Example


A trader would identify a security to trade (currencies/commodities/financials) and would come up with a preliminary strategy, such as:
  • Commodity: soybean oil
  • Trading approach: long
    Long (finance)
    In finance, a long position in a security, such as a stock or a bond, or equivalently to be long in a security, means the holder of the position owns the security and will profit if the price of the security goes up. Going long is the more conventional practice of investing and is contrasted with...

     and short alternatively.
  • Entrance: When the 50 period simple moving average (SMA) crosses over the 100 period SMA, go long when the market opens. The crossover suggests that the trend has recently turned up.
  • Exit: Exit long and go short the next day when 100 period SMA crosses over 50 period SMA. The crossover suggests that the trend has turned down.
  • Stop loss
    Stop loss
    Stop loss may refer to,* Stop loss order, stock or commodity market order to close a position if/when losses reach a threshold* Stop-loss policy, US military requirement for soldiers to remain in service beyond their normal discharge date...

    : Set a stop loss based on maximum loss acceptable. For example if the recent, say 10 day, Average True Range
    Average True Range
    Average True Range is a technical analysis volatility indicator originally developed by J. Welles Wilder, Jr. for commodities. The indicator does not provide an indication of price trend, simply the degree of price volatility....

     is 0.5% of current market price, stop loss could be set at 4x0.5% = 2%.


The trader would then backtest the strategy, using actual data and would evaluate the strategy. The simulator would generate estimated number of trades, the fraction of winning/losing trades, average profit/loss, average holding time, maximum drawdown
Drawdown (economics)
The Drawdown is the measure of the decline from a historical peak in some variable ....

, and the overall profit/loss. The trader can then experiment and refine the strategy. Care must be taken, however, to avoid over-optimization.

It is possible that a majority of the trades may be unprofitable, but by "cutting the losses" and "letting profits run", the overall strategy may be profitable. Trend trading is most effective for a market that is quiet (relative low volatility) and trending. For this reason, trend traders often focus on commodities, which show a stronger tendency to trend than on stocks, which are more likely to be mean reverting (which favors swing traders
Swing trading
Swing trading is commonly defined as a speculative activity in financial markets whereby instruments such as stocks, indexes, bonds, currencies, or commodities are repeatedly bought or sold at or near the end of up or down price swings caused by price volatility...

).

External links


See also

  • Don't fight the tape
    Don't fight the tape
    Don't fight the tape is a term used in finance. It means do not bet or trade against the trend in the financial markets, e.g. if the broad market is moving up, do not bet on a downward move. The term tape here refers to the ticker tape used to transmit the price of stocks....



Techniques:
  • Electronic trading
    Electronic trading
    Electronic trading, sometimes called etrading, is a method of trading securities , foreign exchange or financial derivatives electronically...

  • Algorithmic Trading Platforms
  • Day trading
    Day trading
    Day trading refers to the practice of buying and selling financial instruments within the same trading day such that all positions are usually closed before the market close for the trading day...

  • Stock market cycles
    Stock market cycles
    Stock market cycles are the long-term price patterns of the stock market.-Description:There are many types of business cycles including those that impact the stock market....



Related phenomena:
  • Chart pattern
  • Information cascade
  • Noise trader
    Noise trader
    A noise trader also known informally as idiot trader is described in the literature of financial research as a stock trader whose decisions to buy, sell, or hold are irrational and erratic...

  • Keynesian beauty contest
    Keynesian beauty contest
    A Keynesian beauty contest is a concept developed by John Maynard Keynes and introduced in Chapter 12 of his work, General Theory of Employment Interest and Money , to explain price fluctuations in equity markets.-Overview:...

  • Herd behavior
    Herd behavior
    Herd behavior describes how individuals in a group can act together without planned direction. The term pertains to the behavior of animals in herds, flocks and schools, and to human conduct during activities such as stock market bubbles and crashes, street demonstrations, sporting events,...