From the June 01, 2009 issue of Futures Magazine • Subscribe!

Trend following realized

In addition to the work of Edwards, Magee, Livermore and the others mentioned in last month’s article, the 1930s and 40s saw several other advances relating to the theory and evidence for trend following. One of the more interesting studies came from the Cowles Commission for Economic Research (now the Cowles Foundation at Yale University) in 1937. Written by Alfred Cowles III and Herbert E. Jones, this study investigated the probabilities of sequences of rises and falls in stock market prices over several time horizons, ranging from 20 minutes to seven months. Its conclusion was that, yes, there was a tendency for the market to continue in the same direction as the period before. In short, there was serial correlation. At least from one period to the next, there was trendiness, and some justification for the use of trading methodologies that we might today call trend following. The study concluded: “This evidence of structure in stock prices suggests alluring possibilities in the way of forecasting. In fact, many professional speculators, including in particular exponents of the so-called Dow Theory widely publicized by popular financial journals, have adopted systems based in the main on the principle that it is advantageous to swim with the tide.”

Also worthy of note was a 1949 article in Fortune, “Fashions in Forecasting,” by Alfred Winslow Jones, who was credited with creating the first hedge fund. In the article, Jones analyzes many of the then-current stock forecasting techniques, such as Mansfield Mills’ buying and selling curves, Dow Theory, and other methods with trend following characteristics. His explanation of trend following revolves around acceptance of “the undoubted fact of momentum in psychological trends.” The process he describes sounds something like George Soros’ reflexivity:

“Thus a movement of the stock market once under way generates unrealistic optimism or pessimism, so that the trend of prices then carries through and beyond some point of central value. After that, turned by profit takers or bargain hunters, with the basic forces of supply and demand altered, the market pendulum starts back and passes again through and beyond a point of reasonable value, wherever it may be.

Therefore, the chances are worth considering that once a trend has reversed itself to some measured extent (as determined by the Dow Theory, or by the penetration of a moving average or trendline), the new trend will continue far enough to make it worth following.”

It is notable that Jones uses the exact terms “trend followers” and “trend-following” in his article. But the meaning of the words perhaps differs from our usage today. For example, when he states that “what [Mills] and Lowry have are still trend-following tools, with all their advantages and limitations,” he seems to mean something more like “trend-lagging,” such as when a moving average turns higher after a trend has already begun. In other words, trend following was not yet a fully formed concept.

The individual who finally made the connection was William Dunnigan, a trader, technical analyst, and writer who ran a business cycle forecasting company in Palo Alto, Calif., in the 1950s. Dunnigan had many books and other publications to his credit, beginning with the very academic “Forecasting the Monthly Movement of Stock Prices” in 1930, and following with a more technically oriented mimeographed publication called “Trading With the Trend” in 1934. His major works, however, came out in the early and mid 50s.

Dunnigan is perhaps best known today for his “thrust” methodologies and “one-way” system; but his overall market perceptions were broad and deep. He had a knack for verbal innovation, including the invention of terms such as “trap forecasting” and “continuous forecasting,” used to distinguish between those trades designed to capture quick profits (“catching the market in a trap”) and those with an indefinite duration whose exit levels were determined on a day-to-day basis, depending on market action.

Starting with these perceptions, the transition to “trend following” is not an arduous one, for if a market is “trapped” into a directional commitment at the point of, say, a breakout (i.e., it generates a “signal”), then “continuous forecasting” takes over until the next “trap” (to liquidate or perhaps reverse) is signaled. But if that is the model, then is the forecasting part of the formulation really necessary? Is not the process rather one of monitoring the market for the occurrence of the next “trap,” and then, when it occurs, acting upon it? In his 1954 work “New Blueprints for Gains in Stocks and Grains,” that is what Dunnigan concluded, giving us some of our earliest articulated insights into the philosophy behind trend following:

“We think that forecasting should be thought of in the light of measuring the direction of today’s trend and then turning to the Law of Inertia (momentum) for assurance that probabilities favor the continuation of that trend for an unknown period of time into the future. This is trend following, and it does not require us to don the garment of the mystic and look into the crystal balls of the future.”

He describes it as a freeing exercise unburdening traders from the pressures of prognostication.

“We will merely chart our course and steer our ship in the direction of the prevailing wind. When the economic weather changes, we will change our course with it and will not try to forecast the future time or place at which the wind will change.”

Many of today’s trend followers take this approach. John Henry has stated that his approach is much simpler than those attempting to pick tops and bottoms.

Dunnigan today remains a very underrated trading researcher, although he was highly, if not widely, regarded in his day, even by academic economists. Elmer Clark Bratt, for example, refers to Dunnigan’s “trading with the trend” in his Business Cycles and Forecasting, one of the premier economics textbooks of his day: “What has been called “trading with the trend” [by Dunnigan] appears to be the only important forecasting principle which can be derived.”

Next in line among the pioneers of trend following was the much better known Richard Donchian, whose article “Trend-Following Methods in Commodity Price Analysis” appeared in the Commodity Yearbook of 1957. Donchian’s article was written in a confident, matter-of-fact manner suggesting that he had a long, intimate knowledge of the principles about which he wrote, particularly the use of moving averages and “swing trading,” both developed in the article as examples of trend following methodology. Like Dunnigan, Donchian discussed more than just the trading systems themselves; he also discussed the philosophy behind them. The comments he made about trend following still hold true:

“Every good trend-following method should automatically limit the loss on any position, long or short, without limiting the gain. Whenever a trend, once established, reverses quickly, there is always a point, not far above or below the extreme reached prior to the reversal, at which evidence of a trend in the opposite direction is given. At that point any position held in the direction of the original trend should be reversed – or at least closed out – at a limited loss. Profits are not limited because whenever a trend, once established, continues in a sustained fashion without giving any evidence of trend reversal, the trend-following principle requires that a market position be maintained as long as the trend continues.”

Donchian did much more than write about trend following. He was also a broker, analyst and trader, who most significantly was the founder of the first publicly managed futures fund, the moving average-based Futures, Inc., in 1948. Starting in 1960, he began writing a weekly commodity “Trend Timing” letter, based on one of his better-known trend following systems, the 5- 20-period moving average method, thereby creating a documented decades-long performance record for his trading methodology. Further, Donchian was an innovator in advancing the concept of trading many markets at the same time in a portfolio: “When I first got into commodities, no one was interested in a diversified approach. There were cocoa men, cotton men, grain men … they were worlds apart. I was almost the first one who decided to look at all commodities together. Nobody before had looked at the whole picture and had taken a diversified position with the idea of cutting losses short and going with a trend.”


With Dunnigan and Donchian we come to a close insofar as philosophy is concerned. Others have added ideas over the years, but the insights and principles articulated by these two pioneers still stand. They were the architects of modern trend following theory.

But theory is one thing, and practice another. Donchian’s early efforts notwithstanding, it took several years beyond the 1950s for trend following to be practiced on a widespread, public scale. An additional spark was required.

As it turns out, the markets themselves were that spark. Excellent trends, particularly in the grains in the 1950s and 60s, followed by the breathtaking commodity moves of the 1970s and 80s, gave trend following its pragmatic birth — for who could look on charts such as “Jump on this bandwagon” (page 49) and not think what if?

But ironically, the 1970s were also the heyday of efficient market theory. The weight of orthodoxy stood against the notion that a mechanical trading system could beat the markets. It took independence and insight for traders to consider that a trending market might be less risky than a vacillating one, and to conclude that holding on in the face of what seemed to be outrageous prices might be the soundest decision of all. The temptation to take profits must have been great.

Yet, there were traders of this period who met these challenges and seized the opportunities afforded. Many of today’s best-known trend followers and CTAs trace their origin to this era. Richard Dennis and Bill Eckhardt come to mind, as do John Henry, Keith Campbell, Bill Dunn, and Malcolm Wiener. Many others have come after (see “Trending higher,” above).

Moving to the present, trend following has generally come to be viewed as a legitimate (though there are many detractors) trading methodology capable of achieving solid, if sometimes volatile, returns. It has been declared dead on several occasions over the past 25 years, but had one of its best years in 2008. It will be fascinating to see how it performs in the years ahead.

Stig Ostgaard is an original Turtle trader who has been following trends since the 1980s. He is now a researcher and trader with Last Atlantis Capital Management LLC.

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