What is trend following: its advantages and disadvantages


Trend following is a trading strategy that was made famous in the 1970s. Many of the greatest traders in the 1970s were trend followers – among them were famous traders such as Paul Tudor Jones. Many of these traders were featured in Market Wizards by Jack D. Schwager. In this post we are going to look at:

  1. What is trend following.
  2. What are its advantages and disadvantages.
  3. How we can improve on trend following’s disadvantages.

What is trend following

Trend following is a trading strategy that can be used for all markets. It is based on technical analysis (trend following is not a fundamental analysis strategy).
Trend followers:

  1. Buy an asset when the market is ALREADY going up because they believe that the market will go up even more (i.e. its current trend will continue).
  2. Sell an asset when the market is already going down because they believe that the market will go down even more (i.e. its current trend will continue).

Trend following is based on the following assumptions:

  1. If the market is falling, I don’t know when it will stop following.
  2. But if the market is falling and then reverses, I can get in early on the new uptrend because I can reasonably guess that the market will continue to rise.
  3. If the market is rising, I don’t know when it will stop rising.
  4. But if the market is rising and then reverses, I can get in early on the new downtrend because I can reasonably guess that the market will continue to fall.

Trend followers don’t know about fundamentals. They can’t use fundamentals to take a contrarian point of view on the market. All they can do is use price action to extrapolate the current trend into the future.
Trend followers also use a very simple stop loss strategy.

  1. If the trend continues to favor the trend follower’s direction, then the trend follower will hold the position.
  2. If the trend starts to go against the trend follower’s direction, then the trend follower will close the position.

Trend following can be used for the short term, medium term, and long term. It is most popular among short term and medium term traders.
There are 2 types of trend followers: systematic trend followers and discretionary trend followers:
Systematic Trend Followers
Systematic trend followers use quantitative indicators such as moving averages and MACD to get in and out of the market. An example of a systematic trend following strategy is:

  1. Buy when the market rises above its 50 daily moving average. Trend followers believe that the market is stuck in an “uptrend” as long as it remains above its 50sma.
  2. Sell when the market falls below its 50 daily moving average. Trend followers believe that the market is stuck in a “downtrend” as long as it remains below its 50sma.

Here’s an example.

Discretionary Trend Followers
Discretionary trend followers use “breakout” and “breakdown” chart patterns to buy and sell.

  1. They buy when they think that the market has “broken out” from a resistance trendline or resistance pattern.
  2. They sell when they think that the market has “broken down” from a support trendline or support pattern.

Here are some examples.


Systematic trend following strategies are generally better than discretionary trend following strategies. You don’t know if a discretionary trend following strategy works or not because you can’t backtest it. You can backtest a systematic trend following strategy to see how well it works.

The problem with trend following

Trend following’s advantages and disadvantages are obvious:

  1. Trend following works well when there are clear and persistent trends.
  2. Trend following works poorly when the market is choppy and there are no clear trends. This results in a lot of small losses from being stopped out of a position. It could lead to “death by a thousand cuts”.

When trend following works well.
For example, trend following worked very well in the stock market in 2017. That’s because the stock market’s trend was very strong: the market went upwards nonstop. Trend followers rode the market all the way up and did not miss out on the rally, unlike contrarian traders who got out way too early just because the market was “overbought”.
Here’s an example of a simple trend following strategy: buy when the market breaks above its 100sma, sell when the market breaks below its 100sma.

As you can see, a simple trend following strategy would have kept you in most of the market’s uptrend throughout 2017.
When trend following doesn’t work well.
Trend followers need to cut a lot of losses when the market swings back and forth. This is when the market’s trend is unclear.

  1. The market goes up, so trend followers BUY. It’s a false breakout, so the market comes back down and trend followers are forced to cut their losses.
  2. The market goes down, so trend followers SELL. It’s a false breakdown, so the market comes back up and trend followers are forced to cut their losses.

These losses on their own are small. But when the market is choppy for a long time, these losses will add up and result in a big loss.
Here’s an example. The stock market was very choppy in 2015. Trend followers would have made a lot of BUY and SELL trades, many of which would have resulted in small losses from being stopped out of a position.
Here’s an example of a simple trend following strategy: buy when the market breaks above its 100sma, sell when the market breaks below its 100sma.

As you can see, trend followers would have been whipsawed by a lot of false breakouts and breakdowns. This would have resulted in a lot of small losses.

How to improve on trend following’s disadvantages

Trend following’s big disadvantage is that false breakouts and breakdowns lead to a lot of small losses. The key to improving a trend following strategy is to decrease the % of false breakouts and breakdown trades that you make.
You need to know whether the market is in a strongly trending phase or in a sideways phase.
*Trend followers were wildly successful in the commodities markets in the 1970s. Commodities experienced big bull and bear markets in the 1970s, which resulted in strong uptrends and strong downtrends.
Some traders say that you should wait a little longer before chasing the market. They think that this will cut down on the risk of a false breakout/breakdown. For example:

  1. Normal trend followers would buy if the market breaks above its 50sma. Some traders improve on this strategy by waiting for the market to break above its 50sma for 3 consecutive days before going long.
  2. Normal trend followers would sell if the market breaks below its 50sma. Some traders improve on this strategy by waiting for the market to break below its 50sma for 3 consecutive days before going short.

I’ve done the backtesting for these improvements, and the reality is that this doesn’t help. Waiting a few more days does not decrease the probability that this is a false breakout/breakdown.
In addition, waiting for a few more days after a breakout/breakdown usually means that you’ll get in and out of the market at a worse price.

Improve on trend following by adding fundamentals

This is a point that I continue to advocate: strategies that combine technical analysis with fundamental analysis are better than strategies that are solely dependent on technical analysis.
Trend following is a technical strategy. It depends on price-based indicators and charts. But if you combine trend following with fundamental indicators, the strategy will become much more effective. You will get fewer false signals.
The stock market
A simple trend following strategy is “buy when the S&P 500 is above its 200sma, sell when the S&P falls below its 200sma”.
Here’s the problem with this simple strategy on its own: the stock market frequently breaks down below its 200sma during a bull market, only for the market to reverse back up above this moving average a few days or weeks later.

But if you overlap fundamentals with this strategy, you will get a lot fewer false signals. For example, your new trend following + fundamental strategy can be:

  1. Buy when the S&P 500 is above its 200sma.
  2. Only sell when the S&P 500 falls below its 200sma AND the U.S. economy is deteriorating.

CAN SLIM
William O’Neill’s CAN SLIM is a reasonably good strategy for trading individual stocks. This is essentially a trend following + fundamentals strategy. CAN SLIM traders buy stocks that:

  1. Are breaking out (trend following), and…
  2. Have strong earnings growth (strong fundamentals).

These strong fundamentals lower the probability that a breakout will turn into a false breakout.

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