Trend following is one of the most popular and enduring styles of trading. Many believe that it’s the best strategy for consistently making money in the markets, yet some traders know little about how or why it works so well.
Why is this? Maybe it’s because they find it hard to believe that an approach as straightforward as trend following can make money. In fact, it does. Witness the long-term success of traders like Richard Dennis, John Henry and Bill Dunn.
One of the cardinal rules of trading is to trade with a trend, not against it. Knowing the direction of a trend can be just as important as avoiding a bad trade. Chris Koval, senior commodity broker with Archer Financial Services, says, “Which is the easier way to get aboard a moving train? Do you try to run alongside it and jump on, or do you stand in front of it?”
Van K. Tharp defines the trend following trading approach in his book, “Trade Your Way to Financial Freedom”:
“The first part of the term is “trend.” Every trader needs a trend to make money. If you think about it, no matter what the technique, if there is not a trend after you buy, you will not be able to sell at higher prices. The second part of the term is “following.” We use this word because trend followers wait for the trend to shift first, then they “follow” it.”
For his book, “Trend Following: How Great Traders Make Millions in Up or Down Markets,” Michael Covel studied several traders who use this approach. In his research, he discovered that they share a number of common characteristics. They are all highly disciplined, patient, objective, they accept the truth, exercise restraint and stay in the present. They’re also able to shake off the markets’ inevitable setbacks and upsets. Nothing surprising here, right? These are the qualities that every good trader should have.
Perhaps what might give them an edge is their ability to create, and stick to, their game plan. They approach their trading like science. They are statistical thinkers and they base their decisions on a single piece of information — price. Price is objective data that can be compared and contrasted, even if a trader knows nothing about the underlying market.
Trend followers base their trading strategies on a statistically validated, objective set of trading rules. These trading systems take the emotion and subjectivity out of trading decisions, which in turn enforces discipline. Their systems tell them when they should enter or exit a trend, and how to manage position sizes while they’re in the market.
Because price is a lagging indicator, trend followers usually aren’t able to enter at the exact bottom of a trend or exit at the exact top. It doesn’t matter though, because they wait for the right market conditions. They don’t force a market. Once they’re in, they ride trends as far as they can, instead of taking profits as soon as they make them. Cutting losses and letting profits run is the trend follower’s mantra.
Technical analysis is one tool trend followers incorporate into their trading systems. There are two types of technical analysis, 1) the predictive approach that’s based on the ability to read charts and use indicators to divine the market direction, and 2) the reactive approach that doesn’t forecast, but instead simply reacts to the market’s movements whenever they occur. Trend followers use the latter approach.
Markets trend upward, downward or sideways, and once a trend establishes, irrespective of its direction, it typically continues in that direction until something happens to reverse it. Support and resistance are levels based on prices where bulls and bears buy and sell respectively with equal aggression. Support is the floor and resistance is the ceiling.
Chart patterns are bounded by support and resistance. Trend lines show support and resistance lines on an angle.
Trending markets take periodic rests. These are points of congestion or consolidation. After these rest periods, a trend either continues in the same direction or reverses. Examples of price continuation patterns are rectangles, triangles, pennants, flags and cups and saucers.
Reversal patterns can take the shape of head-and-shoulders, M tops and W bottoms, rounded tops and bottoms, and yes, rectangles and triangles. Rectangles and triangles can go either way. You typically have to wait to see.
There are many indicators to choose from. These are some of the most popular.
One of the most basic and easy to understand technical indicators is the moving average. It is used to emphasize the direction of a trend. It takes the prices for a specific number of periods, sums them and then divides them by the number of periods. Each day, the oldest price drops off and a new one is added. Because prices constantly change, the moving average moves with each new input.
While the most commonly used timeframes are 10-, 20-, 40- and 50-day averages, you can choose any period you wish. The longer the time span, the less sensitive the moving average will be to daily price changes.
There are three main types of moving averages: simple, weighted and exponential. The last two place more emphasis on recent prices. Whichever type you choose, you end up with a single smoothed line that when laid over a price chart, gives you a picture of the trend (see “Spotting trends,” above).
As long as prices remain above the average, there is strength in the market. If prices cross below the average, the market no longer expects prices to continue to move higher.
Moving Average Convergence Divergence (MACD) is an indicator that can help you decide when you might want to get in on a potential trend. MACD uses three moving averages. Two of them are based on the number of price periods used and a third is an average of the difference between the two moving averages. These indicators are turned into a momentum oscillator (a measure of how much prices have changed over a given time period) by subtracting the longer moving average from the shorter moving average. The resulting plot forms a trigger line that oscillates above and below zero, without any upper or lower limits.
When the line is above zero, the market may be considered to be in an uptrend. Below the line, a downtrend may be at hand. The zero line also can act as an area of support and resistance (see “Finding trends early,” page 45).
Traders watch how the MACD’s movements compare with price movements. When prices make a high and then another high, while MACD makes a high and a lower high, they are diverging. The two are going in different directions. Divergence can signal underlying weakness in the market.
Average Directional Movement Index (ADX) measures the strength of a trend, whether it is up or down. This indicator has two directional movement indicators, one for upward movement (+DMI) and the other for downward movement (-DMI). ADX represents the average difference between the two DMIs.
Rising values suggest that the trend’s strength is increasing. An ADX value crossing above 25 is in a strong trend. As long as price is trending, ADX should remain above 25.
ADX is an objective measure of trend strength. This can help traders know when to let profits run.
THE END OF THE TREND
Relative Strength Index (RSI) measures the velocity of price movements by comparing the magnitude of recent gains to recent losses to determine overbought and oversold conditions.
RSI ranges from 0-100. A market is considered to be overbought if the RSI approaches the 70 level, meaning that it may be getting overvalued and is a good candidate for a pullback. Jeff Friedman, senior market strategist with Lind-Waldock, says, “This number isn’t written in stone, because some believe that in a bull market 80 is a better level to indicate an overbought price, since prices often trade at higher valuations during bull markets. Likewise, if the RSI approaches 30, it’s usually an indication that the market may be getting oversold and may become undervalued. But some traders adjust to 20 in a
The shorter the number of days used, the more volatile the RSI, and the more often it can hit extremes. A longer-term RSI fluctuates a lot less.
Many markets will remain overbought or oversold for extended periods of time, so RSI is best used as a complement to other tools and not a stand-alone indicator.
Bollinger Bands measure market volatility. The bands are lines plotted two standard deviations from a simple moving average, typically a 20-day, although other time frames can be used. The bands adjust themselves to the market conditions. When the markets become more volatile, the bands widen and when they become less volatile, the bands contract. A tightening of the bands is often seen as an early indication that volatility is about to increase sharply.
This is one of the most popular technical analysis techniques. The closer the prices move to the upper band, the more overbought the market is and the closer the prices move to the lower band, the more oversold it is.
There are other indicators you may wish to try or may already favor. You can learn more about them by picking up any text on technical analysis. Whichever indicators you choose, remember that they are just one piece of the puzzle; your trading discipline is what will underpin your success.
Laura Oatney is a freelance writer with more than 20 years of industry experience. She can be contacted at firstname.lastname@example.org.