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Trend following: How to make the trend your friend

10:37, 6 June 2022

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Trend following: How to make the trend your friend Photo: create jobs 51 / Shutterstock.com

Trend is your friend. The saying is attributed to Jesse Livemore, an American trader and the subject of Edwin Lefevre’s 1923 book Reminiscences of a Stock Operator. 

Livemore was notable for pioneering the trend following strategy still widely used by traders. In this trend following guide we take a look at the strategy’s history, key concepts and technical indicators. 

What is the trend following strategy?

Trend following is a strategy employed by some traders to attempt to profit from trends in the market. The basic idea is to buy assets that are rising in price and sell them when they start to fall, following the trend. 

A major tenet of trend following is that markets move in trends in a manner that repeats over time and across asset classes. The idea is not to ‘predict’ when a new trend will happen, but to use price action signals and technical indicators to show that a new trend has already begun.

Stock trend following is a system to trade trends in the equity markets, forex trend following is any strategy that follows trends in the foreign currency markets and commodity trend following does the same for commodities such as gold and Brent crude. 

The main benefit of trend following is that it could help you capture big price moves in the market. This is because you are essentially riding the wave of the trend. 

The downside of trend following is that you could also get caught in false moves. It is important to use trend following strategies with caution and use a stop loss.

Turtle trading experiment

Trend following as a strategy has been around for decades but really gained notoriety from the so-called Turtle trading experiment.

In the early 1980s, two Wall Street traders, Richard Dennis and William Eckhardt, developed a system for trading commodities that they called the "turtle system." 

They believed that anyone could be taught to trade successfully, so they recruited a group of novices and trained them in their method. This group became known as the "turtle traders." They were incredibly successful, and their turtle trading system became the subject of much interest on Wall Street.

The turtle trading strategy is a trend following system that uses moving averages to enter and exit trades, utilising two moving averages, one short-term and one long-term, to generate trading signals. 

When the short-term moving average crosses above the long-term moving average, it signals a buy, and when the short-term moving average crosses below the long-term moving average, it signals a sell. 

The strategy has since been adapted many times and is more broadly known as a moving average crossover strategy.

Different types of trends

There are a number of fundamental, sector and market trends that investors could use in their trading decisions. 

Fundamental trends include economic growth, inflation and interest rates. Sector trends can be just as important, and can be specific to the industry in which a company operates. 

For example, a company that operates in the retail sector could be affected by trends in consumer spending. There are market trends that account for rising levels of activity and participation in financial markets.

Trend followers tend to discount all other types of trend and focus purely on price trends, often incorporating price volatility as a factor for entry and exit decisions.

There are four main types of trends in trend following: secular, primary, secondary and intermediate. Each one has its own characteristics and can be used to identify different kinds of market movement.

Primary, secondary and minor trends on FTSE 100 chart
 

  • Secular trends

Secular trends are long-term trends that last for years or even decades. They are usually caused by structural changes in the economy or changes in demographic trends. 

  • Primary trends

Primary trends are shorter-term trends that last for months or a few years. They are usually caused by changes in the business cycle or by political or economic events.

  • Secondary trends

Secondary trends are shorter-term trends that last for weeks or a few months. They are usually caused by changes in investor sentiment or by technical factors. 

  • Intermediate trends 

Intermediate trends are shorter-term trends that last for days or a few weeks. They are usually caused by changes in the supply and demand for a particular asset or by changes in the level of volatility in the market.

  • Minor trends

Minor trends are very short-term trends that last for only a few days, and are the bread and butter of day traders and swing traders. They are usually caused by news events or changes in the level of trading activity in the market.

Different types of trends

What are trend following indicators?

Trend direction is one of the key pieces of information traders need for successful trend following. 

There are various technical indicators that can help you identify the direction of the trend such as the price action itself, trendlines and moving averages. As a rule these cannot be used in non-trending sideways markets.

Price action

The purest form of trend following is tracking the movement and direction of the price itself.

The strategy looks for a series of higher lows in an uptrend and lower highs in a downtrend. These are considered to be confirmation of the trend.

Once a higher low or lower high is formed, the trader can cover their position and look to enter a trade in the direction of the new and opposite trend. 

Tracking series of higher lows or lower highs on FTSE 100 chart

Trendlines

A trend line is simply a line that connects the highs or lows of the price of a stock or security  over a period of time. Oftentimes a trendline will connect the same highs and lows used when trading price action. 

When the price bounces off the trendline, it offers a potential trading signal to enter during the correction phase of a trend. When a trendline breaks, it is a signal the trend might have ended or will soon end.

Trendline example on FTSE 100 chart

Moving averages

Another type of trend trading technique is to use moving averages. 

A moving average is an average of the past X periods of closing prices. The most common are the 50-day moving average and the 200-day moving average. 

Some traders will use the relative position of these moving averages to determine the trend. If the 50-day moving average is above the 200-day moving average, then the trend is up. If the 50-day moving average is below the 200-day moving average, then the trend is down.

50-day and 200-day moving averages on FTSE 100 chart

The bottom line

The key principle of the trend following strategy is to be patient and to wait for the trend to develop before opening a position. 

It could also be important to have a solid risk management plan in place so that you can protect your capital if the trend does not move in your favour.

Note that markets are volatile, and you should always conduct your own diligence before trading. Keep in mind that past performance is not a guarantee for future returns. And never trade money you cannot afford to lose. 

FAQs

Does trend following still work?

By its very nature, a trend following trading strategy depends on markets trending. Periods of sideways churn will tend to be when trend following strategies do not work. Periods with a few strong trends are when they tend to work if you buy or sell at the right time. Keep in mind that past performance is not a guarantee for future returns. And never trade money you cannot afford to lose.

Is trend following profitable?

Trend following could be profitable, as any form of trading if you time your trades correctly. Equally, all forms of trading can result in losses. There are hedge funds and commodity trading advisors that have been in business for decades, making money with a trend following strategy. However, like all trading strategies it must be undertaken with caution. You should look to incorporate other important aspects of trading, like money management. Note that markets are volatile. You should always conduct your own diligence before trading. And never trade money you cannot afford to lose.

How to create a trend following strategy

A trend following system can be built manually or with the help of automated trading. Whichever approach is taken, the most important thing is to identify the key factors that will indicate whether a new trend is emerging. Once you have identified these factors, you can then create a system that will help you to follow the trend, including risk management, entry and exit orders.

What is the difference between momentum and trend following?

The difference is really one of speed of price change versus price direction. Momentum investors aim to buy stocks or securities that are experiencing a sharp rise in price, which tends to be a short-term strategy. While trend following investors aim to buy stocks and securities that are trending up over a period of time, which is a more medium-to long-term strategy, although it can be applied to shorter time frames.

The difference between trading assets and CFDs
The main difference between CFD trading and trading assets, such as commodities and stocks, is that you don’t own the underlying asset when you trade on a CFD.
You can still benefit if the market moves in your favour, or make a loss if it moves against you. However, with traditional trading you enter a contract to exchange the legal ownership of the individual shares or the commodities for money, and you own this until you sell it again.
CFDs are leveraged products, which means that you only need to deposit a percentage of the full value of the CFD trade in order to open a position. But with traditional trading, you buy the assets for the full amount. In the UK, there is no stamp duty on CFD trading, but there is when you buy stocks, for example.
CFDs attract overnight costs to hold the trades (unless you use 1-1 leverage), which makes them more suited to short-term trading opportunities. Stocks and commodities are more normally bought and held for longer. You might also pay a broker commission or fees when buying and selling assets direct and you’d need somewhere to store them safely.
Capital Com is an execution-only service provider. The material provided on this website is for information purposes only and should not be understood as an investment advice. Any opinion that may be provided on this page does not constitute a recommendation by Capital Com or its agents. We do not make any representations or warranty on the accuracy or completeness of the information that is provided on this page. If you rely on the information on this page then you do so entirely on your own risk.

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