Trend following, often referred to as trend trading, is a systematic trading style that aims to profit from market trends. It is based on the principle of buying when an asset's price rises over a period of time and going short when it falls over a period of time, making it an ideal strategy for those who prefer a systematic approach to trading.
Historically, some of the most successful traders have been trend followers. Jesse Livermore, often regarded as the father of trend following, was a prime example. In his time, he amassed a fortune equivalent to $1.5 billion in today's dollars, solely through his own trading.
Ed Seykota, another prominent trend follower, turned a modest $5,000 into $15 million over his career, achieving an impressive +60% net return over three decades. Michael Marcos, a successful trend-following trader who learned from Seykota, turned $30,000 into $80 million.
More recently, David Harding, a very successful trend following trader, founded Winton Group in 1997, a hedge fund that managed $20 billion as of September 2020, and he himself has a net worth of $1.3 billion.
Trend following identifies trends using indicators and manages risk with strict position sizing rules. Each trend following strategy uses unique indicators to identify trends of various durations.
Which indicators best fit a trade depend a lot on the personality of the asset being traded. For my own purposes, I experiment quite a bit with backtesting. In doing so, I'm able to ascertain which patterns of behavior may be most conducive towards a continuation of the underlying price trend as well as attempting to identify that trend reliably and as early as possible.
Such indicators for systematic trend trading can aid traders in deciding when to enter and exit a position. For instance, moving averages, one of the most popular and straightforward technical indicators, average the price of a security over a period and help in identifying trends by smoothing out price data.
Another common strategy involves crossovers, where two different moving averages or the security price and a moving average signal buy or sell opportunities.
As we progress to more complex strategies, Donchian channel expansion, high or low relative strength, Bollinger band breakouts and other indicators can also help traders to map out the mechanics of possible trend following strategies.
Effective risk management is crucial in trend following. Position sizing and risk management strategies significantly impact the performance of a trading system. For instance, traders should not risk more than 2% of their capital in one trade, with most opting for only 1%.
The trade risk is determined by the distance between the purchase price and the stop loss, and positions can be weighted based on the volatility of individual instruments or the entire portfolio's movement.
Futures trading offers several advantages for trend following. These include leverage, which allows traders to gain significant market exposure with little capital (use caution); high liquidity, ensuring easy entry and exit; diversity in market access; simplicity in short selling; low trading costs relative to the market exposure gained; and absence of time decay, a common concern with options trading.
There are also potential tax advantages, such as preferable capital gains treatment and a lack of K-1 schedules as futures provide direct rather than proxied access to the underlying instruments, such as commodities.
While trend following has proven successful over many decades, it requires awareness of the current market regime and the personality of the asset being traded. Strategies should be thoroughly backtested and periodically updated to adapt to evolving market patterns.
The key to success in trend following lies in recognizing that market patterns and trends are not static and require flexibility from the trader and their systematic approach. Adapting and evolving as the markets do.
Trend following emphasizes a disciplined, systematic approach to trading, focusing on data and strategy over emotion and excitement. This method may not provide the adrenaline rush of more speculative trading styles but offers the potential for consistent, uncorrelated returns that can diversify risk, especially when trading across various asset classes and markets.
It underscores the philosophy that successful trading should be a methodical, even boring process, and excessive excitement often signals a deviation from sound trading principles.