Trend following is one of the oldest approach to trading the markets. It has been adopted by famous speculators from the likes of Jesse Livermore(1920s), Richard Donchian(1960s) and Richard Dennis(1980s).
Now in modern day finance it’s still used by the biggest hedge funds in the world like Man AHL, Dunn Capital and Chesapeake Capital. And some of these funds have 20 year track record averaging 20% a year!
So what do trend followers do that makes them so profitable?
Trend followers do not know when there will be a trend and will not try to predict one, we simply follow prices. We remain long as price goes up and short as price comes down.With that said, we never short at the highs or long at the low because we simply do not know where is the turning point, we don’t predict remember?
Low Winning %
Trend followers typically win about 30% of the time. Yes we lose more than half the time. The reason being we are willing to let our profits run as much as possible, at the expense of a lower winning ratio. Once we catch a trend, it will easily pay for our small losses and provide a good return.
No Profit Targets
No profit targets?! Yes. Because trend followers ride the trend till it ends. By having profit targets we are limiting what the markets give us. It makes sense to limit your losses but to limit your profit sounds foolish, why would we want that? In a sense trend following is similar to going long a call option. We have limited downside but unlimited upside.
However by having no profit targets it doesn’t mean we have no exit strategy. We will trail out stops accordingly and let the market eventually take us out. The market decides when we get out of the trade, not us.
Trade All Markets
At any point in time, trend followers do not know which markets will start to trend. This is why we trade all markets to increase the probability of capturing a trend be it in the indices, bonds, agriculture, energy, currencies etc. We trade them all.
If we limit ourselves to only a handful of markets, we will not be able to exploit the trends in the rest of the markets. And what if the markets we selected are not trending? A double whammy for us. This is why we trade all markets to reduce the possibility of missing a trend.
Buy High and Sell Low
You read it right, buy high and sell low. Trend followers buy markets which are rising and sell markets which are falling. In anticipation that the trend will continue once in motion.
Even if an instrument has doubled over the last 3 months, trend followers will still look to long. Thus breakout strategy is something that trend followers execute most of the time. What’s high can go higher and what’s low can go lower.
I hope I have shed some light what trend following is all about. By now you would realize that trend following is vastly different from most trading strategies out there, and contradict most school of thought.
This should come as no surprise as 95% of traders fail to make money consistently over time. In order to be the 5% you have to think different from the rest, and you can begin by learning how to build a trend following trading system.
So, what do you think of trend following?