This article on trend following strategies is the opinion of Optimus Futures.
- Trend following is one of the simplest and (at times) most effective strategies to follow.
- It’s also one of the hardest and most misunderstood approaches, despite its potential simplicity.
- Many traders following a trend following strategy are often confused as they don’t adequately understand the nature of the trend itself.
What Is A Trend Following Strategy And How Does It Work
We’ve all heard the maxim “the trend is your friend,” and for good reason. There’s an entire group of traders and money managers who swear by the so-called “trend-following” approach. But before we get into that, let’s first take a deeper look into the principles of trend following.
To better understand how trend following works, it is important to understand a few basic ideas:
- Price is either trending–upward or downward–or it’s moving sideways or in a range-bound direction.
- You can always identify trends when looking back, but you can never tell whether the current price action is going to continue the trend, reverse the trend, or stall in a sideways motion.
- There are multiple trends within a trend, depending on your time frame.
- Trends in different time frames can contradict one another (i.e., the uptrend in the 5-minute chart, the downtrend in the 1-hour chart, the uptrend in the daily chart, downtrend on the weekly chart, and sideways on the monthly chart).
- You can’t predict a trend but you can follow a potential trend by using identification criteria backed by a solid risk management strategy in case your trend bias doesn’t pan out.
- Trend following performance can exhibit a low win rate, but as long as the profit factor is significantly higher, you can still come out with favorable returns.
The concept behind trend following is pretty simple: you trade in the direction of the trend based on your trend-identification rules. You try to exit your position(s) when the price is no longer trending. You try your best not to experience too many drawdowns due to being “whipsawed.” And finally, you aim to capture a larger return in a single trend that hopefully will dwarf your smaller yet frequent losses.
That’s the concept behind a trend-following strategy. The hard part is finding rules that work consistently enough for you to achieve everything we just mentioned.
What Are the Most Common Trend Following Rules and Approaches?
The simplest trend-following rule is this:
- An uptrend is a series of higher highs and higher lows
- A downtrend consists of lower lows and lower highs
- When a swing low is violated in an uptrend, it might indicate a correction within an uptrend, the end of a trending cycle (potentially going sideways), or a trend reversal toward the downside
- When a swing high is violated in a downtrend, it might indicate a bear rally within a downtrend, the end of a trending cycle (potentially going sideways), or a trend reversal toward the upside
As far as approaches are concerned, there are so many that it would be impossible to discuss even half of them. But the more common tools for identifying, analyzing, and trading trends are as follows:
Simply connecting the lows in an uptrend or the highs in a downtrend can get you started in visualizing trends. You may end up drawing many trend lines, and this will show you exactly what we mentioned above–that there can be many trends within a trend. Some trends may appear stronger than others, and trend strength is a necessary yet separate component to trend directionality.
If you’re new to trend following, then drawing simple trend lines is a start. There’s much more to it, as you’re about to see for yourself.
The premise of trend cycles is at the foundation of every trend-following approach. A look at a price chart shows that price moves in cycles, alternating between uptrends and downtrends with range periods in between.
The screenshot below illustrates how price moves in waves and thereby makes new swing highs and lows. Trend-following traders, or swing traders, use this way of natural price behavior and incorporate those principles in their trading decisions. They typically look for a fresh swing point and then follow price behavior on its way to making a new swing in the opposite direction.
This approach of trend-following and swing trading sounds simple, but it certainly isn’t easy. Trend following traders have to identify reliable swing points that lead to a strong enough trend wave; trend following trading strategies can make use of a variety of different technical analysis concepts, trading tools and indicators.
Multi Timeframe Analysis
Multiple timeframe analysis should be at the core of every trading strategy. Before you start your trading day, move up one or two timeframes and see where you are in the overall picture. Most amateur traders get so caught in the day-to-day price action on their lower execution timeframes, that they completely lose feeling for the overall price scenario.
To increase your odds and to identify trades that lead to smoother development, only trade into the direction of the higher timeframe.
Another tip that can keep you out of trades that violate the higher timeframe view is that every time that you are about to enter a trade, move up to your higher time frame to confirm your trade direction. It can get hectic during the day and it’s easy to lose focus when making trade decisions with money on the line; stepping back for just a few moments can help you gain clarity again.
Technical Analysis Filters
Trend following traders can choose from a variety of technical analysis concepts and indicators to make trading decisions. Mostly, indicators have the purpose to act as a filter and provide a framework in which trading decisions can be made in a reliable and more objective way.
For trend traders especially, indicators are usually not only used to make actual entry decisions but only to determine trend direction and identify the trend phase price is currently in.
Three Most Popular Tools for Trend Following Strategies:
Moving Average Direction
Moving averages are one of the oldest and most commonly used tools in technical analysis. And even market wizard Marty Schwartz said about moving averages:
The 10-day exponential moving average (EMA) is my favorite indicator to determine the major trend. I call this “red light, green light” because it is imperative in trading to remain on the correct side of a moving average to give yourself the best probability of success. When you are trading above the 10 day, you have the green light, the market is in positive mode and you should be thinking about buying. Conversely, trading below the average is a red light. The market is in a negative mode and you should be thinking about selling.” – Marty Schwartz
The screenshot below uses both the 10 EMA and a slower 21 SMA. During trending phases, the moving averages can help traders identify the direction of trends and stay in trends until clear signals of momentum shifting – price crossing the moving average – are given. The length of the moving average determines how sensitive it reacts to price changes.
Bollinger Bands are somewhat similar to moving averages, but the outer Bands can tell you a lot about trends and trend direction.
When the price is trending and the price keeps trending close to the outer Bands, it signals trend strength. As long as the price moves close to the outer Bands, the trend is still intact. It’s rare to see an immediate reversal when the price is moving close to the outer Bands. This knowledge can help trend following traders remain confident during their trades.
Stochastic can help traders identify trend cycles because of its oscillating nature. The screenshot below shows the same 4H Gold chart with a multi-timeframe Stochastic at the bottom. Keep in mind that Stochastic should only help you get a sense of direction. It should not be used to generate trade entries.
The screenshot shows nicely how the Stochastic cycles can help differentiate between bullish and bearish phases and serve as an additional filter.
Directional Filters Are The Core Of Trend-following Approaches
The difficulty of trend-following trading is, surprisingly, determining trends and the direction of trends. By using technical tools and indicators, traders can improve their analytical process and remove a lot of subjectivity from their trading. The top-down approach is important and can often make a big difference in a trend trading approach.
Can You Combine Trend Rules and Indicators?
The answer is yes…absolutely! That’s what system developers do: mix and match rules to create new approaches and refine them once a “thesis” has been developed.
The trick is not in the rules but in the robustness of the performance. If you tweak the rules, how well can it consistently perform across time? How many markets might it be applied to in a manner that can yield positive results? What time frames might work best with the new rules? These are all things you have to consider when testing system alterations. Failing to do so may yield disastrous outcomes.
Given all of the system developers creating and perhaps selling their systems or methodologies, someone should have come up with the “best” set of indicators, right? Yes and no.
Which is the Best Trend Indicator?
A long-term trend indicator, say, one that says to buy once the 50-Week moving average crosses over the 200-Week moving average will do very little for a day-trader or swing trader. An Opening Range Breakout trend system will do nothing for a longer-term investor.
What does this tell you? The “best” trend indicator is situational. The best indicator (or set of indicators) is the one that helps you reliably identify a given trend in the simple, fastest, and most efficient manner relative to your timeframe, risk tolerance, and capital.
This sounds like an easy answer, but it’s not. For example…
A Seemingly Perfect Approach…Ruined
Remember the Turtle Traders back in the 1980s? The founders, Richard Dennis and William Eckhardt interviewed a wide and eclectic mix of people to join their trading team,
Dennis and Eckhardt financed their team’s trades.
The system they created worked, at least in the years surrounding their reign in the pits.
Think about it: all the capital to trade one of the “best” approaches. Yet not everybody qualified to join the Turtles. What happened? The reason why not every trader applying for the job made it was not a lack of capital or a lack of an effective approach–it had everything to do with personality and risk tolerance (even though they weren’t risking their own money).
This tells you two things: if there is a “best” trend indicator out there, it has to do two things: first, it has to work; second, it has to suit your trading style. Take either criteria out of the equation and you have a losing approach.
What are the Best Markets for Trend Following Strategies?
This is a great question because it exemplifies almost perfectly the WRONG way to view trend following. How so?
The concept of “trend” is not a function of any given market.
Trend is a function of price over a period of time.
Trend is the dominance of directional clarity and consistency.
Trend is the absence of conflicting price disruption.
Trend is therefore “anti-noise,” yet…
Noise is a “relative” concept relative not to markets but, again…time (and time frame).
Is Trend Contingent on Liquidity?
Lumber isn’t as liquid as the ES. Yet, here it is.
Oat futures are far from liquid. Do you see a trend?
This is not to say that you should trade any of these markets. The examples are there to demonstrate that there can be trends in virtually any market.
You just have to choose the ones that you can trade, according to your capital, risk tolerance, and methodology.
What Do New Traders Get Wrong About Trend Following Strategies?
In short, just about EVERYTHING. Here are a few ideas to think about when trying your hand at trend following:
- Trend following can yield more losses than wins, but the wins (if you have a good system) can more than compensate for the losses.
- There is more than one trend within a trend–beginners often get confused.
- Trend exhaustion–when a trend is likely to “bend”–can be anticipated but not predicted. It can also be the most dangerous part of a trend if you’re not prepared for it.
- Trend following concepts–even the best ones–are easy to understand, but hard to “stomach.”
- There is no way to determine if a current trend exists–you can only see a trend that existed, and there’s no guarantee that it’ll continue.
- Trend following rules can’t predict–they can only guide trades based on principles.
- The trend can seem noisy and noise can seem trendy, but time distinguishes one from the other.
- One of the most famous trend followers, Ed Seykota, was famous for saying “trend does not exist.” Figure that one out for yourself, because there’s truth to it.
- There’s a “trend” and separately, there’s your “perception” of a trend. The two may not be the same. Yet you must follow your rules, assuming that your rules yield greater positive than negative payoffs.
Trend following–as a system–isn’t easy. But, if done right, it can be powerful.
Can There Be Such a Thing as Trend Following Trading Signals?
Ever heard of a “fund of funds”? Let’s assume that a fund is already diversified. How might you diversify it further? Add another fund that has a different focus. The same goes with trading signals.
It’s called “system diversification.” Imagine subscribing to various “signals” that focus on different market angles–day trading, swing trading, different markets, different time frames, trend following, mean reversions, etc.
If you can backtest and combine the results of each strategy and come up with a favorable combination, then you’re “trend following” the expectations of a given set of systems.
Is it possible? Yes, but it’s complicated and onerous. Can it work? Hedge funds and system developers employ this approach more often than most people realize. But again, it’s a lot of work.
The Bottom Line
The trend is your friend until it ends, they say. Don’t take that statement at face value. The trend is your friend only if you fully understand the “potential” trend you’re anticipating. If you don’t understand the nuances of your trend, and the context surrounding it, then you may eventually end up “following” something, but certainly, not the trend that you think is there.
Disclaimer: There is a substantial risk of loss in futures trading. Past performance is not indicative of future results.