How well does trend following work: advantages and disadvantages of trend following


This is Part 2 of the Ultimate Guide to Trend Following. In Part 1, we explained everything you need to know about the basics of trend following.

  1. The essence of trend following
  2. What is a trend
  3. How to define a trend
  4. What is trend following, and how do trend followers profit
  5. How trend following treats probability differently than other trading strategies
  6. What isn’t trend following
  7. What to do: principles and beliefs behind trend following
  8. What not to do: things to be careful of when building a trend following system
  9. Why many people don’t like trend following (even though it’s so profitable)

In Part 2 we’re going to examine:

  1. Trend following’s advantages
  2. Trend following’s disadvantages
  3. The Truth: how well trend following works in different markets

No strategy works equally well in all markets. Some trading strategies (such as trend following) work better in some markets and worse in other markets. Using data and backtests, we can see how well different strategies work in different markets.
But more importantly, we need to understand WHY some strategies work better in some markets and worse in other markets. That’s why we also examine the advantages and disadvantages of various trading strategies like trend following.

Trend following’s advantages

Trend following’s advantages are clear. As you would expect, these advantages are the opposite of trend following’s disadvantages.
Remember: no strategy has 100% advantages or 100% disadvantages. Every strategy has pros and cons. No strategy works equally well in all market environments.
Trend following works well when there are clear and persistent trends
As the name suggests, trend following works best when there are clear “trends” in the market. It doesn’t work well when the market is very choppy.
Trend following strategies will keep you in the trend when the market is going up a lot or down a lot.
Here is a chart of the S&P 500. This is a simple trend following strategy, whereby you buy when the S&P breaks out above its 200 day moving average and sell when the S&P breaks down below its 200 day moving average.

In this chart, the benefits of trend following are evident. This strategy keeps you in the majority of this trend, letting you capture almost all the profits.

  1. You buy when the S&P breaks out above its 200 day moving average.
  2. You don’t sell when the stock market is going up because you think “the stock market has gone up too much, a pullback is overdue”.
  3. Instead, you hold your long S&P position because the uptrend has not reversed.
  4. You hold your long position all the way until the S&P breaks down below its 200 day moving average. This is the first sign that the uptrend may be reversing, so the trend follower sells and locks in a massive profit.

Other strategies such as contrarian swing trading strategies will try to pick a top, sell too early, and then watch the market soar, leaving you on the sidelines while everyone else is making money.

Guaranteed to avoid major crashes when you use price only
Trend following strategies that only use price data are GUARANTEED to avoid major market crashes.
No other strategy can guarantee that you will avoid a major market crash that wipes out all your capital.
Why? Because by definition, all major crashes occur when the market has broken down below main moving averages. I.e. all major crashes occur when the market is no longer in an uptrend, and is now in a downtrend. So if the market is telling you that it is no longer in an uptrend, and then you sidestep the potential downtrend, you are guaranteed to be spared of any single devastating loss.
Here is an example with silver in 2013.

Many traders were bullish on silver in early-2013 for a variety of reasons. Many other traders were bearish on silver in early-2013. Reasons from both the bull camps and bear camps were equally plausible.
But the only way one would have definitely avoided the crash was by selling (going short, or at least not going long) because silver was below its 200 day moving average.
Here is a chart with Bitcoin.

In early-2018, many traders were extremely bullish on Bitcoin. But it didn’t matter. Once Bitcoin broke down below its 50 day moving average, trend followers would have gotten out of Bitcoin, thereby sidestepping most of the crash.
Trend followers don’t need to know “why” these crashes happen. Lots of traders create complicated theories to explain “why the market will crash” or “why the market won’t crash”. The only traders who can sidestep every major crash without missing out on major rallies are trend followers who only use price.
The price does not lie.

  1. A price that’s crashing is a market that’s crashing.
  2. A price that’s rallying is a market that’s rallying.

There’s no point in arguing with the market.
There is no guessing
A lot of traders and investors spend a lot of time “guessing” where the market will go next. Many of these people are world renown, and they come up with many elaborate theories to explain why they think the market will go up or down.
Many investors and traders follow these gurus thinking “this person is smart, he knows what he’s talking about” or “this person is a VP at Goldman Sachs, he must know what he’s talking about” or “this person uses a lot of financial jargon that sounds smart, he must be right”
But what if I told you that most of these experts’ opinions and market outlook are no better than random guessing?
That’s right.
The average professional in the finance industry can’t even beat buy and hold, which even a monkey can do.
Just because these experts know how to say things that sound smart, doesn’t mean that the things they say are actually smart.
Here are several famous examples.
Over the past decade or so, world famous and Nobel prize-winning economist Robert Shiller has repeatedly said that “the stock market could crash”. Despite constantly appearing on CNBC and being cited by financial media, these predictions have been worse than a coin toss.
Don’t forget that this man won the Nobel economics prize. In the markets, IQ doesn’t matter. Just because someone can say something that sounds smart, doesn’t mean that it’s the right thing to do.
2011: Shiller says to be wary of the stock market

2013: Shiller says to be wary of the stock market

2014: Shiller says to be wary of the stock market

2017: Shiller says to be wary of the stock market

How have his predictions played out over time?

What about other famous investors and traders?
The same thing. Most of their “analysis” and predictions are no better than a coin toss, when you add up the successful predictions and the failed predictions.
For example, strategist Tom Lee (a regular feature on CNBC) was busy telling everyone in late-2017 why Bitcoin could go to $100,000.

And of course, Tom Lee was very, very wrong.
Bitcoin crashed in 2018.

The point is not to pick on these “experts”. The point is to recognize that anyone’s “smart sounding analysis” is just that – “smart sounding”. Just because something sounds smart, doesn’t mean it’s right.
Traders shouldn’t care about what “sounds smart”. Traders should only care about what works and what makes money.
The only way to know for sure that the stock market wouldn’t crash from 2009-2018 was the fact that for most of this 10 year period, the stock market was in an uptrend.

The only way to know for sure that Bitcoin wouldn’t soar in 2018 (as Tom Lee predicted) was the fact that Bitcoin was in a downtrend in 2018 (e.g. broke below moving averages).

Trend followers don’t need to waste time on “guessing” where the market will go next and coming up with elaborate “analysis”. Instead, they save that time and dedicate it to building better trend following strategies.
Trend following strategies have no “guessing” involved. The rules that determine BUY and SELL signals are crystal clear and capable of being backtested.
No vague terms
Trend following does not waste time on vague terms and subjective trading strategies. These include the popular tactics:

  1. Use support/resistance to become a better trader.
  2. Use chart patterns to spot reversals in the market.

These are all vague terms

  1. “Support” and “resistance” are vague terms. There is no objective and repeatable way to define “support” and “resistance”, because 10 people will come up with 10 definitions.
  2. Chart patterns are also vague terms.

Here’s an example.
In the first 2 charts, I’m going to draw support and resistance.


If I were a trading guru, I could give you a 30 minute lesson on how you too can draw support and resistance lines, just like me. Then the students would OOOHHHH and AHHHH as if they discovered the “secret to trading that the pros aren’t telling you”.
Do you want to know the real “secret”?
I drew these support and resistances by closing my eyes.
That’s right. These support and resistances, as “smart” and “sophisticated” as they seem, were drawn completely randomly.
A lot of trading experts who use vague terms such as “support and resistance” draw multiple trend lines.

  1. As the market goes down, the gurus say “if the market doesn’t bottom at $10, it’ll go to $9. If it doesn’t bottom at $9, it’ll go to $8. If it doesn’t bottom at $8, it’ll go to $7” (well no duh Sherlock, this is how numbers work)
  2. As the market goes up, the gurus say “if the market doesn’t top at $20, the next target is $21. If the market doesn’t top at $21, the next resistance is $22. If the market doesn’t top at $22, the next resistance is $23”.

While this may sound “smart”, it is stating the obvious. When you draw enough lines on a chart, one of them will always eventually “work successfully” as support or resistance. That’s like saying “if I toss a coin 10 times, I’ll eventually be right”.
Here’s an example.
As the S&P 500 was falling in late-2018, the trading experts were busy drawing their vague support and resistance trendlines. How do they define “support”?

According to traditional technical analysis, “support” = price areas in which the market bottomed in the past

There are 2 problems with this vague definition.

  1. What counts as a “bottom”?
  2. When the market moves around enough, EVERY price was once a “bottom in the past”


As you can see, what counts as “support and resistance” is very vague. Moreover, most “support and resistance” is not much more useful than tossing a coin.
The same problem applies to chart patterns. Technical analysts have invented a dizzying array of chart patterns, some of which they claim to “predict” trend reversals and others that they claim to “predict” trend continuations

  1. Wedge patterns
  2. Flag patterns
  3. Triangle patterns
  4. Cup and handle patterns
  5. Vomiting camel patterns (this last one is for laughs)

Once again, these patterns are extremely vague. No 2 traders define a chart pattern the same way. There is no objective way to define “what works” and what “doesn’t work” with chart patterns.
Traders who rely on chart patterns need to rely on faith: faith that chart patterns work, and faith that what has worked for them throughout their career will keep working. There is no way to objectively backtest how well chart patterns work over the long term.
It’s not that “support and resistance”, chart patterns, and other vague trading strategies don’t work. They do work, 50% of the time – just like tossing a coin works 50% of the time. But do they work better than random guessing? No.
Not extremely complicated and capable of being backtested
Standard trend following is not very complicated, partially because there is no “guessing” involved. You don’t need to

  1. Guess what “looks” like a head and shoulders pattern
  2. Guess what “looks like” a consolidation pattern
  3. Guess what “looks like” a reversal pattern

Trend following is based on standard, quantifiable technical indicators that are easily backtestable.
By being able to backtest these indicators, you can easily know what works and what’s just voodoo. A lot of things that sound complicated and “smart” are actually not much more useful than flipping a coin.
With trend following, you can create a complete, end-to-end trading strategy. Many other trading strategies focus on finding “trade setups”, and don’t tell you what to do the other 80% of the time when there is no “trade setup”.
This is especially problematic in the stock market, because the stock market will often go up even though it doesn’t have an “ideal setup”. If you sit on the sidelines while the stock market is going up because “there’s no ideal risk:reward trade setup right now”, you will miss out on a lot of the market’s gains.
You need to have a complete end-to-end trading system because you have a benchmark to beat. Your goal isn’t to “be a profitable trader”. You can do nothing all day, buy and hold for 30 years, and still be “profitable”. Even a monkey can do that. As a trader, your job is to beat buy and hold.
Here’s an example.
A lot of traders try to learn how to identify “profitable trade setups”.
Trade Setup XYZ yields an average profit of 0.2%, and there are 10 of these trades a year. You learn about Trade Setup XYZ, and think “holy cow I found a profitable trade setup!” But that doesn’t matter, because this isn’t a complete system. This trade setup yields 2% a year, far worse than buy and hold.
What happens when 99% of the time this trade setup doesn’t exist? What do you do then? Do you go looking for other 1-time trade setups? The other 99% of the time you’re waiting for this trade setup, you’re not making any money while the market is leaving you behind in the dust.
You need an end-to-end system that tells you what to do all the time!
Unemotional
Traders who try to predict the market with discretionary trading strategies are inevitably prone to dealing with their emotions. This is why many experienced discretionary traders spend a lot of time on “managing their trader psychology” and “controlling their emotions”.
This is not an issue for trend followers, especially quantitative trend followers. Trend followers don’t need to control their emotions.

  1. They develop a solid, rules based trading strategy.
  2. They backtest and stress test the strategy under different market environments to make sure that it is robust
  3. They stick to their proven strategy.
  4. They don’t let their emotions determine their position size, entry and exit positions, etc. The only thing that determines their position size and trades is their strategy.

Discretionary trading without a solid rules-based strategy is dangerous. The human mind has many fight-or-flight tendencies that result in poor decision making. Emotions can wreak havoc.
For example:
A trader who’s losing money on a position might cut his position at the bottom of the market, even though he should hold onto his position because the market will likely rebound. Why? Because he can’t stand the pain of losing money and is afraid of the small probability that the market will fall even more. He lets his fears get the best of him.
This is the mentality of a lot of traders and investors in 2008-2009. Here’s a chart of the S&P 500.

Once they sold….
….the market soared

Trend following’s disadvantages

Trend following works poorly when the market is choppy and there are no clear and persistent trends
Trend followers need to cut a lot of losses when the market swings back and forth in a choppy range. 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 by selling at a lower price.
  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 by buying back their short positions at a higher price.

Each of these individual losses on individual trades are small on their own. But when the market is choppy for a long time, there will be many small losses that add up over time and result in a big loss.
Here’s an example. The stock market was very choppy in 2015. Let’s use a moving average cross over as an example.

  1. Trend followers buy when the S&P 500’s 50 day moving average crosses above its 200 day moving average.
  2. Trend followers sell when the S&P 500’s 50 day moving average crosses below its 200 day moving average.

Moving average crossovers occur very infrequently when the market is trending strongly, upwards or downwards.

But moving average crossovers happen more often when the market is very choppy.

This is problematic.

  1. The market goes down. The faster moving average (e.g. 50 dma) crosses below the slower moving average (e.g. 200 dma). Hence the trend follower sells at a low price.
  2. The market goes up. The faster moving average (e.g. 50 dma) crosses above the slower moving average (e.g. 200 dma). Hence the trend follower buys at a higher price.
  3. The market goes down. The faster moving average (e.g. 50 dma) crosses below the slower moving average (e.g. 200 dma). Hence the trend follower sells at a low price.
  4. The market goes up. The faster moving average (e.g. 50 dma) crosses above the slower moving average (e.g. 200 dma). Hence the trend follower buys at a higher price.

As you can see, this leads to a bunch of small losses that add up. Each time the trend follower buys at a higher price and sells at a lower price, he loses a little bit of money. Each loss isn’t small. But with multiple small losses, the losses do add up.

The Truth: how well trend trading works in different markets

How well does trend trading work in different markets? As we mentioned, no trading strategy works equally well in all markets.
Here are some simple backtests

  1. S&P 500
  2. Gold
  3. Oil
  4. Currencies
  5. Bitcoin

We’re going to try 3 sets of moving averages:

  1. 200 day moving average
  2. 50 day moving average
  3. 20 day moving average

Trend trading for the S&P 500
The strategy is simple

Go long the market when it is above its moving average
Go to cash when it is below its moving average

Going long the S&P when it is above its 200 dma and cash when it is below its 200 dma yields an average of 7.19% a year, from 1950 – present

Going long the S&P when it is above its 200 dma and cash when it is below its 50 dma yields an average of 6.05% a year, from 1950 – present

*It’s interesting to see how this strategy has worked poorly over the past 20 years. The market’s price action has changed. Clearly it has gotten choppier around the 50 dma.
Going long the S&P when it is above its 200 dma and cash when it is below its 20 dma yields an average of 6.12% a year, from 1950 – present

*Once again, it’s interesting to see how the market’s price action has changed over the past 20 years. The short term has become more choppy.
Trend trading for gold
The strategy is simple

Go long the market when it is above its moving average
Go to short when it is below its moving average

Going long gold when it is above its 200 dma and short when it is below its 200 dma yields an average of 7.77% a year, from 1970 – present

Going long gold when it is above its 50 dma and short when it is below its 50 dma yields an average of 5.23% a year, from 1970 – present

Going long gold when it is above its 20 dma and short when it is below its 20 dma yields an average of 6.13% a year, from 1970 – present

Trend trading for crude oil
The strategy is simple

Go long the market when it is above its moving average
Go to short when it is below its moving average

Going long oil when it is above its 200 dma and short when it is below its 200 dma yields an average of 5.19% a year, from 1983 – present

Going long oil when it is above its 50 dma and short when it is below its 50 dma yields an average of 0.6% a year, from 1983 – present

Going long oil when it is above its 20 dma and short when it is below its 20 dma yields an average of -4.16% a year, from 1983 – present

Trend trading for currencies (U.S. Dollar Index)
The strategy is simple

Go long the market when it is above its moving average
Go to short when it is below its moving average

Going long the USD when it is above its 200 dma and short when it is below its 200 dma yields an average of 2.85% a year, from 1973 – present
*Real returns would be higher, because all currency traders trade with leverage.

Going long the USD when it is above its 50 dma and short when it is below its 50 dma yields an average of 3.4% a year, from 1973 – present
*Real returns would be higher, because all currency traders trade with leverage.

Going long the USD when it is above its 20 dma and short when it is below its 20 dma yields an average of 0.68% a year, from 1973 – present
*Real returns would be higher, because all currency traders trade with leverage.

Trend trading for Bitcoin
The strategy is simple

Go long the market when it is above its moving average
Go to short when it is below its moving average

Going long Bitcoin when it is above its 200 dma and short when it is below its 200 dma yields an average of 213% a year, from 2011 – present
*This return is extremely unreliable. It stems from the fact that Bitcoin cost less than $1 when it first began.

Going long Bitcoin when it is above its 50 dma and short when it is below its 50 dma yields an average of 272% a year, from 2010 – present
*This return is extremely unreliable. It stems from the fact that Bitcoin cost less than $1 when it first began.

Going long Bitcoin when it is above its 20 dma and short when it is below its 20 dma yields an average of 296% a year, from 2010 – present
*This return is extremely unreliable. It stems from the fact that Bitcoin cost less than $1 when it first began.

Bottom line for advantages and disadvantages of trend following

Trend following works well in a lot of markets. However:

  1. It works better in markets that spend more time trending
  2. It works more poorly in markets that spend more times swinging sideways.

You can see that no strategy works equally well in all markets. Moreover, you can see that every strategy goes through periods of underperformance and outperformance.
No strategy yields the same consistent X% year after year after year. It is simply impossible.
In fact, the quickest way to know that a guru is scaming you is if he says “using my strategy, you too can make a consistent X% every single year” (that’s actually how they caught Bernie Madoff). I cannot tell you how many of these I-will-teach-you-to-be-rich gurus preach “you too can make 2% a week using my strategy” while driving behind a Lamborghini with some “hot girlfriend” who is probably just a paid actress. (We’ve all seen the Youtube ads)
There are strategies that do well in the long run. We share these in our Membership Program. However, none of our strategies deliver a consistent X%, year after year.
For example, if a strategy yields an average of 15% a year (without leverage),

  1. Some years it will yield 35%
  2. Some years it will yield -5%
  3. Some years it will yield 21%
  4. Some years it will yield 8%

And lastly, you can see that short term trend following strategies tend to deteriorate more easily than long term trend following strategies
This is true of any trading strategy – not just trend following strategies.
Why?

Because all trading strategies based on technical analysis rely on price action
If price action changes, the effectiveness of a trading strategy changes
Short term price action changes more often and more easily than long term price action
Hence, short term trading strategies deteriorate more easily than long term trading strategies

For example, trend following strategies work better if the market’s price action is less choppy. If the market’s price action over the next 30 years is choppier than the market’s price action was over the past 30 years, then the trading strategy’s returns would deteriorate.
Trading strategies that pick tops and bottoms (e.g. swing trading, chart patterns, contrarian trading) work better if the market’s price action is choppy. If the market’s price action over the next 30 years is less choppy than the market’s price action was over the past 30 years, then the trading strategy’s returns would deteriorate.
This is why we repeatedly emphasize that for stock market traders, focus on medium-long term trading strategies instead of short term trading strategies. It is extremely easy for short term trading strategies to deteriorate over time.

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