Trend following

From Wikipedia, the free encyclopedia

Generally, trend following is the imitation of what is the current fashion (also called trend).

In finance, trend following is an investment strategy that tries to take advantage of long-term moves that seem to 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. 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.

Contents

[edit] Definition

This trading method 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.

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

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. 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 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 or demand factors.

Trend Following answers the questions:

  • How and when to enter the market.
  • How many contracts or shares to trade at any time.
  • How much money to risk on each trade.
  • How to exit the trade if it becomes unprofitable.
  • How to exit the trade if it becomes profitable.

[edit] Trend followers

Trend following systems have enjoyed popularity over the years - well-known trend followers include Bill Dunn, Ed Seykota, John W. Henry, Richard Dennis, and Richard Donchian.

Many traders like original Turtles Paul Rabar and Jerry Parker say that following a market trend is their winning trading strategy.

Dennis and Donchian are the fathers of the trend following. During the 1980s Richard 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 Covel, Michael (2007). The Complete TurtleTrader. ISBN 0061241709. .

[edit] Notes and references

  1. ^ Tharp, Van K. (1998). Trade Your Way to Financial Freedom. 83: McGraw-Hill. ISBN 0-07-064762-3. 

[edit] Further reading

  • Brown, Kedrick (2006). Trend Trading: Timing Market Tides. John Wiley & Sons, Inc.. ISBN 0-471-98021-8. 
  • Covel, Michael W. (2005). Trend Following. Financial Times Prentice Hall. ISBN 0-13-134550-8. 
  • Covel, Michael W. (2007). Trend Following. HarperCollins. ISBN 0978-0-06-124170-3. 
  • Faith, Curtis M. (2007). Way of the Turtle:The Secret Methods that Turned Ordinary People into Legendary Traders. McGraw-Hill. ISBN 0-07-148664-X. 

[edit] See also

Techniques

Related phenomena