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Trend Following

Updated on April 25, 2024
Article byAswathi Jayachandran
Reviewed byDheeraj Vaidya, CFA, FRM

What Is Trend Following?

Trend Following are investment strategies that focus on profiting from market trends by applying rules-based trading systems to various markets. This strategy aims to identify potential opportunities and capitalize on trends by purchasing assets at rising prices and selling them at declining prices.

What Is Trend Following

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Followers of trends try to keep the market moving forward as long as they make big profits. Rather than trying to time or predict market reversals, traders track extended periods of market activity because they think these trends can present valuable trading opportunities. This, in turn, helps them manage risks and make informed decisions.

Key Takeaways

  • Trend following refer to investment strategies that capitalize on market trends by buying assets at rising prices and selling them at declining prices, using rules-based trading systems.
  • Traders can use patterns, moving average method, trendlines, pivot points, and the STOCHASTIC indicator to track trends.
  • It offers a systematic trading approach, profit opportunities, and risk management, but requires self-control and patience, and may not accurately predict future price movements.
  • Bond and equity portfolios can benefit from these strategies due to their combination of long and short positions, exposure to international markets, and systematic investment approach.

Trend Following Trading Explained

Trend following in financial markets is a trading technique that aims to enable individuals and entities to profit from the potential long-term direction of financial market movement. These algorithms or trading systems determine when price trends start and stop and size positions by the trend’s strength and the associated risks of the market. 

This technique trades both long (making money on rising markets) and short (making money on falling markets) positions. Since trends in specific markets can be deceptive, these systems must be consistently applied to a wide range of markets. The technique provides diversification and a more consistent return profile by simultaneously tracking movements in different markets.

They are an excellent choice to follow in typical bond and equity portfolios for three main reasons. These strategies consist of both long and short positions, provide exposure to international bond and stock markets, and are a systematic approach to investing. They offer long and short positions in market uptrends and downtrends, providing exposure to global currencies, stock markets, bonds, commodities, and more. 

The methods give exposure to international bonds, stock markets, currencies, and commodities. Moreover, they are systematic and dynamically update portfolios in response to market price changes, making them advantageous for investors who find it difficult to forecast market behavior.

Strategies

Some of these strategies used by investors are:

#1-Patterns

This type of trading uses chart patterns and price action concepts to connect trending phases. Chart patterns are often found during corrective trend phases, where the ongoing trend is pausing. Breakouts from chart patterns often signal a trend continuation. A downtrend (bearish trend) is identified when the price moves lower. The traders following these strategies should avoid sideways corrections and wait for a close below support levels before trading.

#2-Moving Average Method

The moving average method is a powerful trading tool for trending markets, as it accurately describes the trend. Indicators are 100% objective, providing a valuable tool for new and inexperienced traders. Trend-follower traders seek signals when the price moves back into the channel and then trade the rejection away from it.

#3-Trendlines

Trading tools known as trendlines connect high and low points in an uptrend or downtrend to identify market patterns. Three touchpoints are needed for it to be valid. Trend followers or traders hold off on making bullish trades until they see indications of support. Trendlines are useful in a multi-timeframe approach, identifying trendlines on higher timeframes and looking for chart patterns and rejection signals on lower timeframes. Traders can maximize their profits by waiting for price pullbacks instead of chasing the trend. This enables them to purchase a trending market at a discount.

#4-Pivot Points

Pivot points are important price components these trading systems use to understand the market environment. The central pivot point in charts provides the average price of yesterday’s price action, confirming a trending market. During the uptrend, the price moves above the pivot point, and each subsequent pivot point is higher than the one before it. The first indication that the previous downturn may end is a sustained price move above the pivot point.

#5-Stochastic Indicator

One popular indicator for trading overbought and oversold signals is the stochastic indicator, which is a pure momentum indicator. A high stochastic indicates a strongly moving market, so it would be incorrect to go against it.

Examples

Let us look at a few examples to understand the concept better.

Examples #1

Suppose Daisy, an investor, chooses the companies for her portfolio by using trend following. She chooses to invest in healthcare-related firms with strong price momentum after spotting an upward trend in the industry. Daisy wants to profit from future gains as long as the trend continues, so she follows it. This approach aligns with her long-term goal of achieving capital appreciation by capitalizing on favorable market trends.

Example #2

A paper authored by Brian Hurst, Lasse Heje Pedersen, and Yao Hua Ooi has published data about trends following investing. The paper suggests that the practice, especially the time series momentum, was a century old. The research was done using data from markets on four major asset classes, a few bond markets and currency pairs, including equity indices. It found out that the returns were mostly based on future prices and that the markets have exhibited significant trends over the century.

Advantages And Disadvantages

Some of the advantages and disadvantages of following trends are given as follows.

Advantages

  • It has the potential for identifying important market movements and making big profits.
  • The trading method gives traders a systematic and controlled approach to trading.
  • It uses stop-loss orders and risk management strategies to assist in managing risks.
  • It can be used with various asset classes, such as currencies, equities, and commodities.
  • The strategy gives traders awareness about opportunities to profit from positive and negative market moves.

Disadvantages

  • Not every transaction will be lucrative because trend reversals and misleading signals can happen.
  • It involves having the self-control and patience to follow the plan through times of erratic price changes or market turbulence.
  • Investors could overestimate their risk-taking ability to keep up with the trends.
  • The technique is based on past price data; it may not always be able to predict future price movements with accuracy.

Trend Following vs Swing Trading

The differences between both the concepts are given as follows:

PointsTrend followingSwing trading
ConceptIt is observing the patterns in the long term to trade.  Swing trading is trading the daily fluctuations in equities, commodities, and currencies.  
PurposeCapturing and riding longer-term market trends is the main goal of tracking trends.Capturing brief price fluctuations within a longer trend is the main goal of swing trading.  
DurationObserving patterns possibly entails keeping a position for weeks or months at a time.  Positions are usually held for a few days to a few weeks while swing trading.  
Number of tradesTrend-followers frequently trade less because they anticipate large gains.Since they anticipate quick profits, swing traders place more deals during that time

Frequently Asked Questions (FAQs)

1. Does trend following work on stocks?

Trend following on stocks can be an effective approach in stock trading because it focuses on capturing and profiting from price trends. However, the success of this strategy on stocks is influenced by various factors, including market conditions, the accuracy of trend identification, and the utilization of effective risk management techniques.

2. Does trend following still work?

Yes, trend following still works. However, the answer usually seems a bit perceptive. Many investors believe that the era of trend following is over. However, many others suggest that these strategies are still in effect.

3. What are trend following indicators?

These indicators are valuable technical tools utilized to identify and confirm trends in price movements. These indicators include moving averages, MACD (Moving Average Convergence Divergence), ADX (Average Directional Index), and Parabolic SAR (Stop and Reverse). They assist traders in recognizing and validating trends, aiding in the decision-making process.

This article has been a guide to what is Trend Following. Here, we explain its strategies, examples, advantages, disadvantages, and differences with swing trading. You may also find some useful articles here –

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