Trend following

From Wikipedia, the free encyclopedia

Trend following is an investment strategy that takes advantage of long-term moves that play out in various markets. The system aims to work on the market trend mechanism and take benefit from both sides of the market enjoying the profits from the ups and downs of the stock market. Traders who use this approach can use current market price calculation, moving averages and channel breakouts to determine the general direction of the market and to generate trade signals. This approach is reactive, diversified, long-term, and systematic by nature. Traders who subscribe to a trend following strategy do not aim to forecast or predict markets or price levels; they simply jump on the trend and ride it.

1 Definition
2 Considerations
3 Trend Followers
4 Conclusion
5 Notes and references
6 Further reading
7 See also
8 External links

[edit] Definition

This trading method demands a very strong self-discipline to follow the precise signals generated by the traders rules. It involves a risk management component that uses three elements; the current market price, equity level in an account and current market volatility. 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. Changes in price may lead to a gradual reduction or increase of the initial trade. On the other hand, adverse price movements may lead to an exit for the entire trade. Historically, a trend following trader's average earnings per trade is significantly superior than the typical loss per trade. Their performance and trading styles are the results of discipline, exacting precision that result in huge profits.

These systems traders normally enter in the market after the trend properly establishes itself and for this reason, they miss the initial turning point, but this does not diminish their returns, as there are many false turning points called whipsaw trades where the professional trader might get caught.

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 Van K. Tharp, in the book Trade Your Way to Financial Freedom^[1]

“

Let's break down the term Trend Following into its components. The first part is "trend". Every trader needs a trend to make money. If you think about it, no matter what the technique, if there is not a trend after you buy, then you will not be able to sell at higher prices..."Following" is the next part of the term. We use this word because trend followers always wait for the trend to shift first, then "follow" it.

”

[edit] Considerations

Price: One of the first rules of Trend Following is that price is the main concern. If a market is at 70 and goes to 68, 67, 63 - the market is in a down trend. Despite what every technical indicator might predict, if the trend is down, stay with the trend. Traders may use other indicators showing where price will go next or what it should 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 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, cut losses, cut losses, is the rule. This means that during periods of higher market volatility, your 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. Cutting losses is the way to stay in the game.

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 or demand factors. Trend Following does not involve seasonals, point and figure, Market Profile, triangles or day trading.

Beyond the mere four elements, the human element is core to the strategy. It takes discipline and emotional control to stick with the signals generated through the inevitable market ups and downs. Traders using this method expect ups and downs so they are planned for in advance.

[edit] Trend Followers

Trend following systems have enjoyed the success and growth over the years and it is mainly due to those traders and CTA’s who have had the most success with these methods. Famous trend followers include Bill Dunn, Ed Seykota, John W. Henry, Richard Dennis, and Richard Donchian

Many famous traders like original Turtles Paul Rabar and Jerry Parker say that following a market trend is their winning trading strategy. Its reactive and systematic nature helps them to get maximum benefit from the market trend.

Richard Dennis and Richard Donchian are the fathers of the trend following. Richard is one of the most successful futures speculators of all time. He started trading with an initial stock of just a few dollars and used the power of trend following systems and strategies to turn his initial investment into $200 million. During the 1980s he made a bet with partner William Eckhardt that he could train non-traders this technique; he won the bet and these people rank in the top 10 CTA rankings, they became known as the turtles

Original turtle Jerry Parker, one of the most successful of Richard’s students, believes that trend following with rules works. The small town boy from Lynchburg, VA, uses a powerful trend following technique, and is now the founder, chief executive officer and chairman of Chesapeake Capital Corp., an award-winning CTA from Virginia's western Henrico County which manages $1.6 billion.^[2]

John W. Henry, who started with $16,000, has returned 20% annually on one of his programs, which helped him to buy the Boston Red Sox.