Trend following is one of the most popular and enduring styles of trading. Many believe that it’s the best strategy for consistently making money in the markets, yet some traders know little about how or why it works so well.
Why is this? Maybe it’s because they find it hard to believe that an approach as straightforward as trend following can make money. In fact, it does. Witness the long-term success of traders like Richard Dennis, John Henry and Bill Dunn.
One of the cardinal rules of trading is to trade with a trend, not against it. Knowing the direction of a trend can be just as important as avoiding a bad trade. Chris Koval, senior commodity broker with Archer Financial Services, says, “Which is the easier way to get aboard a moving train? Do you try to run alongside it and jump on, or do you stand in front of it?”
Van K. Tharp defines the trend following trading approach in his book, “Trade Your Way to Financial Freedom”:
“The first part of the term 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, you will not be able to sell at higher prices. The second part of the term is “following.” We use this word because trend followers wait for the trend to shift first, then they “follow” it.”
For his book, “Trend Following: How Great Traders Make Millions in Up or Down Markets,” Michael Covel studied several traders who use this approach. In his research, he discovered that they share a number of common characteristics. They are all highly disciplined, patient, objective, they accept the truth, exercise restraint and stay in the present. They’re also able to shake off the markets’ inevitable setbacks and upsets. Nothing surprising here, right? These are the qualities that every good trader should have.
Perhaps what might give them an edge is their ability to create, and stick to, their game plan. They approach their trading like science. They are statistical thinkers and they base their decisions on a single piece of information — price. Price is objective data that can be compared and contrasted, even if a trader knows nothing about the underlying market.
Trend followers base their trading strategies on a statistically validated, objective set of trading rules. These trading systems take the emotion and subjectivity out of trading decisions, which in turn enforces discipline. Their systems tell them when they should enter or exit a trend, and how to manage position sizes while they’re in the market.
Because price is a lagging indicator, trend followers usually aren’t able to enter at the exact bottom of a trend or exit at the exact top. It doesn’t matter though, because they wait for the right market conditions. They don’t force a market. Once they’re in, they ride trends as far as they can, instead of taking profits as soon as they make them. Cutting losses and letting profits run is the trend follower’s mantra.
Technical analysis is one tool trend followers incorporate into their trading systems. There are two types of technical analysis, 1) the predictive approach that’s based on the ability to read charts and use indicators to divine the market direction, and 2) the reactive approach that doesn’t forecast, but instead simply reacts to the market’s movements whenever they occur. Trend followers use the latter approach.
Markets trend upward, downward or sideways, and once a trend establishes, irrespective of its direction, it typically continues in that direction until something happens to reverse it. Support and resistance are levels based on prices where bulls and bears buy and sell respectively with equal aggression. Support is the floor and resistance is the ceiling.
Chart patterns are bounded by support and resistance. Trend lines show support and resistance lines on an angle.
Trending markets take periodic rests. These are points of congestion or consolidation. After these rest periods, a trend either continues in the same direction or reverses. Examples of price continuation patterns are rectangles, triangles, pennants, flags and cups and saucers.
Reversal patterns can take the shape of head-and-shoulders, M tops and W bottoms, rounded tops and bottoms, and yes, rectangles and triangles. Rectangles and triangles can go either way. You typically have to wait to see.
There are many indicators to choose from. These are some of the most popular.