Trend following is an investment strategy 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 mechanism and take benefit from both sides of the market, enjoying the profits from the ups and downs of the stock or futures markets. 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 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.
Contents |
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 component that uses three elements: number of shares held, the current market price, 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 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, 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. | ” |
Trend following strategy answers the questions:
A trader would identify a security to trade (currencies/commodities/financials) and would come up with a preliminary strategy, such as[3]:
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, 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).
Techniques:
Related phenomena:
|
||||||||||||||||||||||||||||||||||||