Trend Following 101

In its most basic form, trend following is the idea of profiting by buying securities that are in uptrends, selling securities that are in downtrends, and avoiding anything stuck in a range. The single most important element to trend following is price analysis.

The trend follower’s mantra is as follows: Let profits run and cut losses early.

Sounds simple right? Don’t let the semantics fool you, though, trend following is not easy by any measure.

When executed correctly, trend following can net handsome returns in bull markets and protect capital (if not profit) during bear markets. Consider a century of historical evidence on trend following from AQR Capital Management.

The key takeaways from the above, and the rest of the study, are as follows:

• A trend-following approach does an excellent job of protecting capital during major market downturns, and even netting a profit; the reason being that a bear market develops gradually, giving trend followers an opportunity to reposition.

• Performance has been remarkably consistent over an extensive time horizon period.

• The trend-following strategy has proven diversification benefits for investors’ portfolios.

As is the case with any other investment strategy done right over time, trend following can reap you great rewards.

The reason that trend following is so difficult to master is in large part due to the fact that investors must overcome the very same long-standing behavioral biases that ultimately propel the trends from which they aim to profit. In essence, failing to recognize and escape from your own psychological tendencies is likely to be your biggest barrier to success here.

Learn more about How to Battle Your Own Investing Biases.

While often mistaken as being identical to one another, there are a number of core differences that separate trend following from moment trading:

• Trend following is reactive; momentum trading is predictive.

• Trend following avoids range-bound securities, whereas momentum (swing) traders might go after these.

• Trend following focuses on absolute price changes; momentum trading is more concerned with relative price changes.

• Trend following tends to work best over a long-term horizon; momentum trading, and most notably swing trading, tends to work better over shorter time frames, relatively speaking.

Ultimately, the key difference is that trend following is inherently backward-looking, whereas momentum strategies are forward-looking.

Each has its advantages/drawbacks depending on the market environment and your objective, so picking one as being “better” than the other would be foolish.

A successful trend-following strategy boils down to two things: first and foremost is price, and second is money management.

When it comes to price analysis, this means:

• Position Selection: Stick to strong and developing trends; avoid looking at support/resistance levels when formulating an opinion on the trend at hand.

• Timing: Don’t overstress about the “perfect entry"; if you catch the right trend, your gains will more than make up for it.

• Exit Strategy: Take profits when the long-term trend changes; don’t get caught up with profit targets and resistance levels.

Useful considerations to keep in mind from a money management perspective are:

• Position Size: Adjust your trade size based on the environment; the more volatile the environment, the smaller your position.

• Position Risk: Plan ahead how much you want to lose at worst and set your stop-loss accordingly.

While they aren’t at the core of this strategy by any means, technical indicators do play a key role in a well-rounded trading strategy. With that being said, some technical indicators to consider as you build out your trend-following plan may include:

• Moving Averages.

• Average Directional Index (ADX).

• Anything else that’s not predictive; avoid oscillator indicators.

Currently, there are no ETFs that employ a trend-following approach.

Alternatively, investors can develop a trend-following strategy of their own and apply it to the investable ETF universe. A great starting point for compiling your watch list is the ETF Trading Cheat Sheet. The ETFdb Screener offers an even broader starting point.

As with any investment strategy or trading system, trending following requires discipline, a solid toolkit, lots of planning, and careful execution for success. Don’t be quick to lump the trend-following strategy into the same bucket as momentum trading like most do. Instead, take the time to read about historical studies on trend following so you may uncover its nuances and then determine if it is appropriate for you.

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