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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.

How rewarding can be trend following

Markets remain in trend (up or down) most of the time. Therefore, trend followers generally have ample opportunities to trade.

The real juice of the move in any asset class is concentrated in the time when it is trending. In strongly trending markets, some disciplined trend traders end up multiplying their trading capital in extremely short periods.

For example, in the chart below, the NASDAQ 100 saw a decisive change in trend when the index crossed its 50DMA. The trend lasted for 6 months and delivered a 30%+ move. Though the return may look unattractive to many, one must consider that this was the return in the index. Many individual stocks jumped multiple times in this period after they witnessed a change a trend.

The importance of rules in trend following

Successful trend traders develop their rules and stick to them at all times. These rules can be as simple as how to use indicators or can be extremely complex that use mathematical formulas to eke out alpha from trend following.

Rules help traders identify buy points, set stop losses, ride winners, and exit the trades profitably.

For example, a trader might have the rule to enter the position only when the stock is coming out of consolidation and not enter when the trend is midway through.

Similarly, for the exit, the trader might have a rule to close the position in strength when the price is too extended from a moving average or sell in weakness when the stock price goes below a short-term moving average.

Apart from the rules that are specific to strategy, traders also have rules for money and risk management. For example, a successful trend follower might have a rule to allocate a maximum of 25% of her trading account in one trade.

These rules are formed after a tremendous amount of trial and error. Good traders know themselves very well and form the rules and systems based on their psychology and comfort. The rules save traders from a lot of trading blunders and keep away the emotions from trading. Best traders are the ones who are extremely unemotional about trading and have solid trading discipline.

How to start as a trend follower?

If you have decided to embark upon trend following to create wealth, you must start by reading and observing how trends were formed in the past. You will have to go through hundreds of charts and stories that led to trends to get a good historical view.

With history, you would understand that how trends were formed, how powerful they were, and how they reversed. Therefore, if you are starting to trade when the trend is midway or at its end, you will be cautious. Conversely, if you are at the beginning of a new trend, you could be aggressive to make the most of it.

Most new traders enter midway or late in the trend when it is already known to the average Joe. That helps them make some easy money initially, which makes them throw caution out of the window. Once the reversal strikes, it takes their earnings and their capital too.

General advice would be to start small, test waters, perfect your strategy, build the rules and discipline. Once your system makes consistent profits on small capital, up your game and add more money to your trading account or take leverage.

If you missed the recent trend, it’s not the end of the world. The next one will appear. Use the periods of lull to build more knowledge and sharpen your skills. You just need to make sure that you are prepared when the next trend finally blossoms.

See my Trend Following video here for more free knowledge!

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