What Is Trend Following?

Updated: Jun 10, 2021

How to successfully take advantage of a trend in the stock market.

Trend following is sticking to your guns to the one-way move in the market. That one-way direction can be up or down.

Trends are generally formed when a swarm of traders and investors bet in one direction. Behind the price trend is also an underlying fundamental trend that feeds the price trend.

At some point, the trend becomes a consensus, and excesses are built in the price. At that point, the traders and investors get exhausted and the directional moves get smaller and smaller. (The MACD indicator is a great tool to identify such change)

Then comes the reversal as everyone rushes to take profits.

Generally, the bigger the move in one direction, the more violent is the reversal.

Trend following is one of the most widely followed trading strategies as it is rewarding and can be implemented on any trading instrument including stocks, futures, commodities, and forex.

How is trend following done?

In trend following, traders follow a process to identify, ride and exit a trend. Not all trades are successful, therefore, traders also have a stop loss that is set while initiating the trade.

Trend traders can use indicators like moving averages and RSI or simply rely on chart patterns to identify a new trend.

As traders practice and see enough cycles, they also develop the necessary skillset to correctly identify a trend in the making.

As trends are generally formed over short and mid-term time horizons, the holding period in trend trading can range from a few days to a few months. Some longer-term trends can also last over years, but those are generally pursued by long-term investors.

While riding the trend, traders profit the most from riding their winners for the duration. A trend trader wouldn’t want to sell prematurely and miss a big part of the move, while still ensuring not to overstay the welcome and lose all the gains as the trend reverses.

Therefore, different trend traders will have different exit strategies. Traders exit while the price is still moving in the trade direction or sell into the weakness after the trend has reversed. Some traders also apply a mix of the two exit strategies.

As a best practice in any form of trading, trend traders will have a pre-determined stop loss level, which is generally a point where the trend is deemed to be failed.