Trend following is a trading strategy employed by some of the world’s most successful traders and hedge funds.
It first became popular in the 1970s, and since then has made millionaires and billionaires in stocks, commodities, currencies, and other markets.
The beauty behind trend following?
It isn’t hard. It isn’t complicated. It isn’t voodoo.
Trend following can be easily proven via numbers to work. It is very profitable, if done the right way.
Don’t believe me? Here are some of the world’s wealthiest trend followers:
- Bruce Kovner: worth $5.3 billion
- John Henry: worth $2.1 billion (he bought the Boston Red Sox with his gains from trading)
- Richard Dennis: went from $1,600 to $200 million in the 1970s
- And many more
*Some of these profits are abnormal. Many of the wealthiest trend followers achieved great returns, but most of their personal wealth came from running other peoples’ money. Here’s an example.
Let’s assume you are worth $100 million, but you run a $5 billion hedge fund. You make 20% this year.
- On your own $100 million, you made $20 million.
- You made 20% on $5 billion = $1 billion. As a management fee, you take 20% of the profits. You made $200 million.
- You are now worth $320 million ($100 million + $20 million + $200 million)
This isn’t to degrade the performance of these legendary trend followers. I’m merely saying that by combining exceptional returns with managed money, these trend followers made far more money than they could have merely trading their own accounts.
You can read a lot of books and guides on trend following. But they’re all very similar, and many of them don’t tell you the secret to trend following: you can quantify it. There is no guessing involved.
Many trading gurus explain trend following via charts, showing you how it “works”. Truth is, nothing works 100% of the time. You can just as easily find cases in which trend following doesn’t work.
But with simple calculations, we can easily see how well trend following works overtime, as a complete trading strategy.
In Part 1 and Part 2 of the Ultimate Trend Following Guide, I will take you through everything you need to know about trend following. We include explanations and statistics. Many experts claim to have strategies that “work”, but can never seem to back up their claims with proof. We will show you the proof.
In this guide we will cover:
- The essence of trend following
- What is a trend
- How to define a trend
- What is trend following, and how do trend followers profit
- How trend following treats probability differently than other trading strategies
- What isn’t trend following
- What to do: principles and beliefs behind trend following
- What not to do: things to be careful of when building a trend following system
- Why many people don’t like trend following (even though it’s so profitable)
- Trend following’s advantages
- Trend following’s disadvantages
- The Truth: how well trend following works in different markets
For a video guide on everything you need to know about trend following, watch our Youtube video below
The essence of trend following
The essence of trend following is simple. It is evident in the word “trend”
Focus on the bigger picture
This means that trend followers don’t get lost in the small stuff. They focus on the forest and not on the trees. They don’t get lost on each and every movement in the market.
Instead, trend followers focus on the bigger picture and the overall direction of the market.
Here is an example of the “small picture”
See how it can be confusing?
Here is a bigger picture of that same small picture.
Do you see how it is more clear once you look at the bigger picture?
On a higher time frame, the small picture barely even registers as a blip. The big picture almost completely swamps the small picture.
This is the problem that many traders have. They are so focused on the small picture that they lose sight of the big picture. Trend following forces traders to focus on the big picture.
If you’re having trouble identifying the trend, step back from your screen. Look at the bigger picture.
- Is the left side of the chart higher than the right side of the chart? That is a “downtrend” (more on this later).
- Is the right side of the chart higher than the left side of the chart? That is an “uptrend” (more on this later).
As long as the market doesn’t go nowhere, there is a trend.
And that brings us to the definition of a “trend”
What is a trend
A “trend” is the general direction of the market. It means that once you step back and look at the bigger picture, what is the market doing overall?
There are 2 types of trends, and one type of non-trend:
- An uptrend
- A downtrend
- A choppy market
Here are some examples of each.
In an “uptrend”, the market is generally going upwards. This doesn’t mean that the market goes up every single day, or that it doesn’t go down for a few days. It means that AS A WHOLE, the market is going up.
Here is an example of an uptrend, on the S&P 500. We say that the market is “trending upwards”.
- “Uptrend” = noun
- “Trending upwards” = verb
As you can see, the market is generally going up, even though it may go down occasionally.
In an “downtrend”, the market is generally going downwards. This doesn’t mean that the market goes down every single day, or that it doesn’t go up for a few days. It means that AS A WHOLE, the market is going down.
Here is an example of a downtrend, on gold. We say that the market is “trending downwards”.
- “Downtrend” = noun
- “Trending downwards” = verb
- A sideways swinging market
- A choppy market
- A non-trending market
- Whipsaw(ing) market
These terms all mean the same thing.
The market is not trending. It is going nowhere.
Here is an example of the U.S. Dollar Index in 2015
As you can see, the U.S. Dollar is basically swinging in a sideways range. The market is very choppy (going up and down). It is not trending (the left side of the chart is not much different from the right side of the chart). This kind of market “whipsaws” trend followers. More on “whipsaws” later.
As you can see, these 3 states cover all the possible states for the market. The market can either go:
- Or Sideways
Similarly, trends can either go:
- Or Sideways
There is no other possibility.
There is a fourth term that you should know.
This is “countertrend”
Trend followers do not profit from countertrends. They watch out for countertrends.
What is a countertrend?
A countertrend is any movement that goes against the main trend.
Countrends only exist in “uptrends” and “downtrends”. They do not exist in “choppy markets”, because there is no main trend in the first place.
- If the market falls temporarily while it is in an uptrend, that “fall temporarily” is a countertrend.
- If the market rises temporarily while it is in a downtrend, that “rise temporarily” is a countertrend
Here’s a chart of the S&P 500 in 2013. This is an uptrend because the main trend is going up. The right side of the chart is higher than the left side of the chart. But there are multiple countertrend moves along the way.
What is a “trend reversal”? A “trend reversal” is different from a “countertrend”
A “trend reversal” is a change in the main trend. It is longlasting. On the other hand, countertrends are temporary.
There are 2 kinds of trend reversals
- An uptrend can change into a downtrend. This is a “downwards trend reversal”
- A downtrend can change into an uptrend. This is an “upwards trend reversal”
Here’s a downwards trend reversal. This is a gold chart from 2009-2015. Notice how gold reversed from an uptrend to a downtrend.
Here’s an upwards trend reversal. This is a S&P 500 chart from 2008-2009. Notice how the S&P reversed from a downtrend to an uptrend.
How is this different from a countertrend?
Countertrends are temporary. Trend reversals are long lasting.
Here are the same charts again.
Gold was in an uptrend from 2009-2011. There were multiple countertrend moves along the way. These countertrend moves were temporary.
These countertrend moves were very different from gold’s trend reversal that occurred in 2011. The trend reversal generated a new downtrend from 2011-2015. The downtrend was much more longlasting than previous countertrend moves.
Here are the same charts again.
The S&P was in a downtrend from 2007-2009. There were multiple countertrend moves along the way. These countertrend moves were temporary.
These countertrend moves were very different from the S&P’s trend reversal that occurred in 2009. The trend reversal generated a new uptrend after 2009 that lasted many years. The uptrend was much more longlasting than previous countertrend moves.
How do you differentiate between countertrend moves and trend reversals?
So how can you know in advance (without 20/20 hindsight) if a move in the market right now is just a countertrend move, or if it is the start of a true trend reversal?
Here’s a chart of the S&P 500 in 2019.
How do you know if the recent rally is just a countertrend move against a downtrend…
…or if it is the start of a trend reversal (new uptrend)?
A lot of trading gurus will teach you crazy complicated methods. The methods will sound very smart, their followers will OOHHHH and AHHHH.
But when you run the numbers, you will realize a simple truth.
NOTHING can differentiate a trend reversal from a countertrend move with 100% accuracy. Not unless you have the benefit of 20/20 hindsight.
And since no one can know the future with 100% accuracy, it is IMPOSSIBLE to consistently and accurately know with 100% certainty that a move in the market right now is a trend reversal or a countertrend.
But as I will show you later in this trend following guide, you don’t need 100% accuracy in order to be profitable as a trader. There is no such thing as a 100% guarantee in the markets, so stop looking for one.
How to define a “trend”
So now that you know what a trend is, how do you define a trend beyond the simplistic “is the market going up or down from the left side of the chart to the right side of the chart?
There are 2 main methods. One is quantitative, the other is discretionary
- Use moving averages (quantitative)
- Use “higher highs and higher lows” or “lower highs and lower lows” (discretionary)
Define a trend using moving averages
Remember the essence of trend following:
Focus on the bigger picture
How do you focus on the bigger picture, from a quantitative perspective? By using a moving average!
Here’s a non-trading example that we can all relate to.
Let’s assume that you are in school, and you receive various exam papers.
- Exam #1: you scored 85%
- Exam #1: you scored 72%
- Exam #1: you scored 73%
- Exam #1: you scored 81%
- Exam #1: you scored 69%
- Exam #1: you scored 86%
- Exam #1: you scored 82%
- Exam #1: you scored 81%
- Exam #1: you scored 84%
- Exam #1: you scored 85%
If you think about each exam on its own, it’s hard to know how well you’re doing overall. It’s easy to get lost in the trees by focusing on each exam paper on its own.
To focus on the forest, take an AVERAGE of your grades.
The difference between the financial markets and your exam grades is that the financial markets are constantly moving. There is a lot of historical data in the financial markets.
That’s why we take a moving average of the financial markets.
There are 3 most popular moving averages.
- 200 simple moving average (shortform 200 sma)
- 50 simple moving average (shortform 50 sma)
- 20 simple moving average (shortform 20 sma)
Can you use other moving averages? Of course! You can use any moving average you way. 21, 35, 59, 83, 135, 195, 294. 200, 50, and 20 are merely the most popular moving averages. They are popular simple because other people use them. (Similar to how a lot of people follow the Kardashians simply because other people follow the Kardashians).
A moving average that is longer (e.g. 200 simple moving average) is less responsive to each individual number. A single day’s price will have a very small impact on longer term moving averages like the 200 simple moving average.
Hence, a longer term simple moving average is going to “hug” the market less closely.
Here’s an example of the S&P 500 against its 200 simple moving average.
A moving average that is shorter (e.g. 50 simple moving average) is more responsive to each individual number. A single day’s price will have a bigger impact on shorter term moving averages like the 50 simple moving average.
Hence, a shorter term simple moving average is going to “hug” the market more closely.
Here’s an example of the S&P 500 against its 50 simple moving average.
Hence, a quantitative way to define “uptrend” vs. “downtrend” is simple
- When the moving average is going up, the market is in an “uptrend”
- When the moving average is going down, the moving average is in a “downtrend”.
This method is quantitative. All you need to do is calculate the market’s moving average.
Define a trend using “higher highs and higher lows” or “lower highs and lower lows”
Now let’s look at a discretionary way to define trends.
- When the market is making “higher highs and higher lows”, it is in an uptrend
- When the market is making “lower highs and lower lows”, it is in a downtrend
Here’s what “higher highs and higher lows” looks like. As you can see, the tops are getting higher and the bottoms are getting higher. The market is in an uptrend.
Here’s what “lower highs and lower lows” looks like. As you can see, the tops are getting lower and the bottoms are getting lower. The market is in a downtrend.
The problem with using “higher highs and higher lows” or “lower highs and lower lows” to define trends
What counts as a “higher high”?
What counts as a “lower lows”?
These counts are arbitrary and up to the discretion of each individual trader. For example, what you consider to be a “higher low” might not be considered by someone else as a “higher low”.
Here’s an example of an uptrend.
In May-July, the market “looks like” it made a lower low.
But was this really a “lower low”? It’s only a “lower low” if the current low is below the “previous low”.
What counts as a lower low? Is it this?
This is why we prefer the quantitative methods of defining trends (moving averages) instead of the discretionary way. Quantitative is clear. No matter what you do or how hard you try, discretionary will always be unclear.
The human eye tricks you into believing that things work, because you have the benefit of 20/20 hindsight.
In real time, without 20/20 hindsight, it’s really hard to know if the market is making “higher highs and higher lows” or “lower highs and lower lows”.
So for the remainder of this guide, we will use the quantitative method for defining trends: moving averages
Trends exist on all time frames.
Trends exist on all time frames:
If you can’t see a clear trend on 1 chart (e.g. daily chart), zoom out for the bigger picture. There may be a trend on a different time frame chart.
Remember: when your time frame is unclear, always jump to the higher time frame. E.g. if the intraday chart is unclear, jump to the daily chart. If the daily chart is unclear, jump to the weekly chart. And if the weekly chart is unclear, jump to the monthly chart.
Here is an hourly chart for Bitcoin. Notice the downtrend.
Here is a daily chart for Bitcoin. Notice the downtrend.
Here is a weekly chart for Bitcoin. Notice the previous uptrend and the current downtrend.
What is trend following, and how do trend followers profit?
You now know what trends are.
What is trend following? How do trend followers profit?
Trend following is a trading strategy whereby trend followers try to profit from the existence of trends.
It’s just that simple.
- Step 1: Find an existing trend that is in its infancy
- Step 2: Trade on the side of the trend
- Step 3: Close your position when the trend has already ended, but not before it’s too late
Trend followers are like bandwagoners. They try to find trends that are emerging, hop on the trend before everyone else spots the trend, and then make profits as the trend continues.
Here’s how trend followers profit on the long side.
Here’s how trend followers profit on the short side
As you can see, trend followers don’t try to buy at bottoms and sell at tops. They don’t try to predict tops and bottoms. Instead,
- They try to buy AFTER the bottom (but not too far after the bottom). Instead of trying to predict a bottom that may never come, they buy AFTER the bottom is probably already confirmed.
- They try to sell AFTER the top (but not too far from the top). Instead of trying to predict a top that may never come, they sell AFTER the top is probably already confirmed.
Because trend following is based on the belief that NO ONE can consistently and accurately predict each and every top and bottom.
Yes, lots of people have “successfully predicted the top/bottom”. You see this on financial media all the time.
Gurus XYZ goes on CNBC and says “you should listen to me because I predicted the stock market’s top in 2007”.
Yes, but these gurus also have made a lot of FAILED predictions.
Most of these gurus are no better than a coin toss: if they make 10 random predictions, a few of them will eventually become true. Not because they were a “genius” (as these gurus would like for you to believe), but because that’s just how numbers work. Even a broken clock is right twice a day.
This is the problem with trying to predict bottoms.
Scenario #1: someone tries to predict a bottom, and goes long.
If he is lucky…
If he is unlucky…
The unlucky scenario is an unfortunate case of “catching a falling knife”.
- If you manage to time it perfectly and catch the falling knife perfectly, you will make $$$.
- If you time it imperfectly, your hand will be cut.
The same problem occurs when people try to predict tops
Scenario #1: someone tries to predict a top, and sells or goes short.
If he is lucky…
If he is unlucky…
Common trend following strategies
There are several common trend following strategies that traders can use:
- Breakouts and breakdowns (moving averages)
- Moving average itself going up/down
- Multi-day sustained breakouts and breakdowns
- Moving average crossovers
Breakouts and breakdowns
- Trend followers buy when the market “breaks out” above a moving average.
- Trend followers sell when the market “breaks down” below a moving average
Here’s an example.
Oil breaks out above its 20 day simple moving average. The trend follower goes long. He holds his long position until oil breaks down below its 20 day simple moving average.
Here’s another example.
Oil breaks down below its 20 day simple moving average. The trend follower goes short. He holds his short position until oil breaks out above its 20 day simple moving average.
Moving Average itself going up/down
- Trend followers buy when the market’s moving average is going up
- Trend followers sell when the market’s moving average is going down
Here’s an example
The S&P 500’s 200 day simple moving average is going up. The trend follower goes long. He holds his long position until the S&P 500’s 200 day simple moving average starts to go down.
Here’s another example.
The S&P 500’s 50 day simple moving average is going down. The trend follower goes short. He holds his short position until the S&P 500’s 50 day simple moving average starts to go up.
Multi-day sustained breakouts and breakdowns
The problem with any trend following strategy are the FALSE signals. Here’s an example.
The S&P breaks out above its 50 dma. The trend follower goes long. But then the S&P falls below its 50 dma for 1 day. The trend follower sells, and then the market goes higher. The trend follower buys back into the market at a higher price, thereby missing out on some profits.
Many trend followers try to deal with this problem by instituting ways to reduce FALSE signals
- “Only sell when the market breaks below its moving average for 5 CONSECUTIVE days” (as if waiting for a CONSECUTIVE breakdown would give fewer false signals).
- “Only sell when the market breaks below its moving average by 3%
Many gurus will preach these tactics.
We’ve actually spent a lot of time running the numbers.
Sometimes these tactics help you, and sometimes these tactics hurt you. On balance – when you add up the times these tactics help you and the times these tactics hurt you – these do nothing to help you.
Here’s an example
“Only sell when the market breaks below its moving average for 5 CONSECUTIVE days” (as if waiting for a CONSECUTIVE breakdown would give fewer false signals).”
Examine the trade above again.
Using this rule would help you avoid this whipsaw missed opportunity.
Here’s a case in which this rule hurts you.
In this first chart, you sell because the S&P breaks down below its 50 dma for 1 day.
Here’s what would happen if you wait for a 5 day consecutive breakdown before selling.
As you can see, in this case, using this anti-whipsaw tactic hurts your returns. You sell at a worse price
This is a simple fact of trend following:
It is impossible to completely avoid whipsaws. When you try to avoid whipsaws, the amount that it benefits you will equal the amount that it hurts you. The end result is no different in terms of trading performance.
Moving average crossovers
- Trend followers buy when the market’s faster moving average crosses above its slower moving average
- Trend followers sell when the market’s slower moving average crosses below its faster moving average.
Which “slower moving average” and “faster moving average” should you use?
The most common ones for moving average crossovers are the 50 day moving average and the 200 day moving average.
- Trend followers buy when the market’s 50 dma crosses above its 200 dma
- Trend followers sell when the market’s 50 dma crosses below its 200 dma
*Of lesser popularity are the 20 dma (faster moving average) and the 50 dma (slower moving average)
Here’s an example
The S&P’s 50 dma crosses above its 200 dma. The trend follower goes long. He holds his long position until the S&P’s 50 dma crosses below its 200 dma.
Here’s another example
Oil’s 50 dma crosses below its 200 dma. The trend follower goes short. He holds his short position until oil’s 50 dma crosses above its 200 dma
How trend following treats probability differently than other trading strategies
We’ve now covered the basics of trend following. But as you can see, trend following isn’t always profitable. Trend following has a lot of trades that result in losses.
Here’s a simple example.
Let’s assume that Trend Follower XYZ wants to go long the S&P 500. Hence, he buys whenever the S&P rises above its 200 dma, and sells whenever the S&P falls below its 200 dma.
He begins the strategy in late-2015
As you can see, this trend following strategy generated a lot of small losses in late-2015. The trend follower constantly bought at a slightly higher price and sold at a slightly lower price.
But nevertheless, the trend follower continued that strategy into 2016 and 2017.
Overall, the trend follower makes profits. The massive gains more than exceed the small losses.
You may be wondering
How does trend following make money if most of the trades lose money?
*Most of the trades that trend followers execute lose money. Some of the world’s most successful trend followers say that 70-80% of their trades end up as losses.
Herein lies the first problem.
Most traders assume “as long as most of your trades are profitable, you will be a profitable trader in the long term”. That is wrong.
The outcome of your trading is determined by the following equation
Expected outcome = (Average profit per profitable trade X number of trades that are winners) – (Average loss per losing trade X number of trades that are losses).
Traders who are profitable in the long run need their “expected outcome” to exceed $0.
In order for “expected outcome” to exceed $0, EXPECTED profit must be greater than your EXPECTED loss.
This can be done in 2 ways:
- The number of profitable trades > number of losing trades, OR…
- The average profit for a profitable trade > the average loss for a losing trade.
Here’s an example of how trend followers profit in the long run, even though most of their trades are losses.
Let’s assume Trend Follower XYZ makes 10 trades. 8 of those 10 trades lose $1, and 2 of those 10 trades make $5
The trader starts with $10 in capital. He loses $8 but gains $10. He now has $12, up $2 from his starting capital. That’s a 20% gain, even though 8 of those 10 trades lost money.
Here’s the secret to trend following
Trend followers recognize that many small losses are a part of the process. But they try to limit each loss so that there is no single big loss.
As long as a single profitable trade is big enough to exceed all the small losses, the trend follower will be successful in the long run.
In other words, a trend follower doesn’t try to hit singles. He either strikes out, or hits a home run. In statistics, this is akin to betting on the fat tails instead of the most probable events.
How can you make money in the long run by betting on unlikely events?
If the single home run more than makes up for all the small losses.
Going back to the chart, all the small losses in the stock market from 2015…
… were more than made up for by the massive profits in 2017
Remember: trend following is about numbers, statistics, and expected outcome. It isn’t as exciting as listening to “experts” talk their opinion on the news every night. Everyone has an opinion. Most can’t back it up with data and expected outcomes.
What isn’t trend following
As we already mentioned, trend followers don’t try to predict tops and bottoms.
- They don’t use fundamental analysis to predict tops and bottoms.
- They don’t use technical analysis to predict tops and bottoms.
Predictive technical analysis includes contrarian indicators such as mean reversion indicators, sentiment, and reversal chart patterns.
Why doesn’t trend following use these indicators? Why doesn’t trend following try to predict reversals, instead of going long and short AFTER the market has already reversed?
Because trend following is based on the idea that it is VERY hard to predict reversals in the market consistently and accurately. Trend followers let the trend make them rich. Trend followers do not predict trends – they merely identify trends.
It’s not to say that no one can predict tops and bottoms. Everyone gets lucky sometimes. But if you’re going to try to pick tops and bottoms, your accuracy rate needs to be better than random. Even a monkey tossing a coin can get lucky and predict a few exact reversals.
Most finance professionals can’t even beat buy and hold. These are the same people who advocate market timing and base their trades on reversal predictions.
- “I think the stock market will top right now”
- “I think the stock market will bottom right now”
While these market timers get lucky and watch their predictions succeed sometimes, most of the time their predictions are no better than random guessing.
Let me give you a recent example.
A lot of traders thought that the stock market would top in 2013. Why?
Because the S&P 500 had risen to the top of a 13 year range.
“Stocks are in a secular bear market! This is the top! Major resistance!”
The stock market blew past that “major resistance”. The trend was intact and never waivered at that major resistance.
Moral of the story: no matter what kind of fancy analysis you use, consistently and accurately predicting tops and bottoms is very hard. All of the world’s biggest hedge funds with legions of PhD’s know this. That is why they don’t try to predict exact tops and bottoms.
What to do: principles and beliefs behind trend following
Trend following is based on several principles and beliefs. Some of these principles are core to trend following. Other principles are generally adhered to by trend followers, but not all the time.
Principle #1: trends occur regularly in the markets
Trend following assumes that
Trends occur regularly in the markets. Trends exist MAJORITY of the time.
If the market goes through a period of non-trends (i.e. choppy market) a trend will soon emerge.
This principle is generally true. However, it is more true in some markets than others.
For example, trends occur more often in the stock market than forex and commodities. Why?
Here’s the S&P 500 on a monthly bar chart. Notice how there are clear long term trends.
*This is a log scale.
Here’s the U.S. Dollar Index on a montly chart. While the USD does have long trends, it also has long periods in which there are no trends.
Here’s gold on a monthly bar chart. While gold does have long trends, it also has long periods in which there are no trends.
As a result, trend following works better in some markets than others. We will demonstrate this later using simple statistics.
Principle #2: don’t try to pick exact tops and bottoms
Trend following is based on the belief that NO ONE can consistently and accurately catch exact tops and bottoms all the time. Sure, you might get lucky a few times. But when you stack up the failures against the successes, it’s no better than flipping a coin.
Hence, trend followers do not try to pick exact tops and bottoms. They try to jump on a trend that is emerging, i.e. AFTER the exact top/bottom is already in.
Here’s an example where this logic makes sense.
Oil crashed in 2014. As oil was crashing, many traders were trying to catch the bottom.
“Oil will bottom at $70”
“Oil will bottom at $60”
“Oil will bottom at $50”
“Oil will bottom at $40”
All of these people were very, very wrong. Anyone who bought oil at $70-$40 because “oil is very cheap and oversold!” would have lost their shirts.
Only trend followers could have sidestepped the whole crash, and maybe even profit from it by shorting oil.
Here’s an oil chart demonstrating how a trend follower using the 200 day moving average would have avoided the whole crash completely.
Principle #3: cut losses and let profits run
Trend followers don’t try to predict things that may never happen. Instead, they identify a trend early and jump on that bandwagon before it really starts to take off.
This means that:
Trend followers need to cut their losses.
Sometimes a trend that emerges is a false start. Here’s an example with gold in 2015.
Gold breaks out above its 200 dma. The trend follower goes long.
Gold then very quickly breaks down below its 200 dma. A trend follower MUST cut his losses, otherwise his gold position will lose more and more money throughout the rest of 2015.
This is part of the beauty behind trend following. NOTHING can guarantee that price will go down, except price itself. If the price is going down, then it is going down. There’s no point in arguing with the price.
Trend followers must let their profits run
Trend followers do not set a pre-determined target for their positions. They don’t say “once the market rises to $10, I’m going to sell at a 20% profit and lock in my profit”. Trend followers don’t lock in their profits, UNLESS the market reverses (i.e. trend reversal).
Here’s a very simple example.
Value investors in the stock market like to buy stocks when they are cheap and sell stocks when they are expensive. A lot of value investors in the mid-1990s turned bearish on stocks because “stocks are EXPENSIVE! Time to sell!”
They took profits, and promptly missed out on the bull run of the late-1990s
Trend followers who used a very simple 100 weekly moving average would have stayed in most of the bull market and avoided most of the eventual bear market.
Many traders have missed out on a lot of profits because they didn’t let their profits run. Many traders try to identify profit targets by using technical analysis or fundamental analysis. The problem?
Those “profit targets” are just random numbers these traders made up, no matter what kind of “analysis” they use. The reality is that NO ONE knows with 100% certainty how far a trend can go once it starts going.
For example, this is a far too common scenario.
You buy a stock at $100. It goes up to $120, you sell because you think the stock might fall. The stock eventually goes up to $180 before falling. You would have made more money waiting for the stock to go above $180 and then falling to $160 before selling.
A $60 profit > $20 profit
Other types of trading are different, such as contrarian trading. For example, contrarian traders let their losses grow and cut their profits at a profit target.
- Contrarian trader buys Stock XYZ at $100. XYZ falls to $90. The contrarian buys more. XYZ falls to $80. The contrarian buys more. XYZ falls to $70. The contrarian buys more.
- Contrarian trader buys Stock XYZ at $100. XYZ rises to $120. He sells, locking in a $20 profit.
Here’s the secret to trend following. Trend followers make a lot of trades that don’t work out. But the 1 trade that does work out should more than make up for all the losses.
Traders who try to predict tops and reversals believe in a different form of technical analysis. They believe that “price action” signals will tell them of impending reversals in the market. They believe that “the smart money will establish a position in the market and give advanced warning of an impending reversal in the market”
There are several flaws with this idea:
- There is no clear “smart money” and “dumb money”. For example, conventional trading wisdom states that “professionals are the smart money” and “mom and pop retail is the dumb money”. Well the simple reality is that most professionals can’t even beat buy and hold.
- The smart money doesn’t always leave a “clue” in the market that they’ve moved in. Reading too much into price action is like reading the tea leaves: you think you’re doing something very advanced, when in reality all you’re doing is voodoo.
It’s not that predictive technical analysis doesn’t “work”. It works, just like a monkey can throw darts at a chart and make money in the stock market. But the more important question is: does predictive technical analysis “work” better than just buying and holding a S&P 500 ETF?
In most cases, no.
Principle #4: price is all that matters
Traditional trend following only uses price. It doesn’t use fundamental analysis, sentiment, etc.
Because traditional trend following states that it’s impossible to use fundamental analysis to consistently predict market movements. “Price is all that matters. The price itself reflects all the known fundamentals to man”.
Trend followers support this claim by stating that “predictions based off of fundamental analysis didn’t foresee the 2008 stock market crash”.
This claim is usually right for most markets, but it is often wrong for the stock market.
We disagree with “price reflects all the known fundamentals to man”.
Reality: price reflects the AVERAGE belief of the AVERAGE investor. The market’s price reflects the AVERAGE trader’s opinion. The market often deviates massively from fundamentals.
The reason why most fundamental analysis is useless is because most people are doing fundamental analysis all wrong. If anyone uses a proper strategy in a wrong way, he/she will fail.
We demonstrate consistently on the website that proper fundamental analysis can be used to time the stock market more accurately.
Principle #5: diversify and trade all markets
Traditional trend following states that you can trade all markets using the same form of trend following. It states that
- You should diversify and use your trend following strategy across all markets. Stocks, forex, commodities, bonds, etc.
- You should only risk a fraction of your capital on each trade. (This is logical. If you trade 10 different markets, you can only allocate 10% to each market anyways).
This is a trend following principle that we think is flawed.
As we will show in a later part of this post, trend following does not work equally well across all markets.
- There is no such thing as a “timeless and universal” strategy
- There is no one-size-fits-all
When someone tells you “to avoid curve fitting a trading system, make sure it works in all markets”, you can easily know that this person hasn’t backtested a system.
- A strategy that works in the stock market will not work equally well in forex or commodities or bonds.
- A strategy that works in forex will not work equally well in stocks or commodities or bonds.
- A strategy that works in commodities will not work equally well in forex or stocks or bonds.
No strategy will work equally well in all markets. This is fact that we will very easily prove with numbers later in this post.
Trend following works better in some markets with clearer trends than in markets with less clear trends.
Diversification across markets doesn’t always work. For example, all markets moved lockstep with eachother in 2008. In other words, diversification fails when you need it the most.
The problem with “risk only a fraction of your capital” is that while this advice is true for beginners who have a high risk of blowing up their account, it is terrible advice for intermediate and advanced traders who already know risk management.
A lot of good traders have big position sizes. They bet big when the odds are in their favor. Greatness isn’t achieved by swinging small. For example, baseball legend Babe Ruth’s mantra was “go big or go home”.
What not to do: things to be careful of when building a trend following system
There are some things that you should be careful of when using a trend following strategy. A lot of these “don’t do” apply to all trading strategies in general
#1 watch the successes AND the failures
When a lot of traders learn a new strategy, they always look at the successes and OHHHH AHHHHHH
Here’s an example with gold. The strategy is simple: buy gold when it is above its 200 dma.
As you can see, trend following worked VERY WELL on this trade.
But herein lies the key mistake that all new traders make
They do not look at the FAILURES too
No trading strategy is flawless. If you only look at the cases in which a strategy worked, and don’t look at the cases in which a strategy didn’t work, then you are misguided into thinking that the strategy works very well.
In reality, you need to stack up the profits against the losses.
This isn’t entirely your fault. Too many trading “gurus” teach you strategies like trend following, and then only show you the successful cases. They don’t demonstrate that there are A LOT of unsuccessful cases too.
As a proper trader, you need to stack up the profits (successful trades) against the losses (failed trades). You cannot stick your head in the sand and ignore the losses.
You should only care about the OVERALL profits. A single trade or two means nothing.
#2 Some risk management is good, too much risk management kills the golden goose
Risk management is useful, particularly for a new trader. New traders are always at a higher risk of blowing up their account.
This means that new traders should use tighter stop losses rather than looser stop losses.
However, too much of a good thing is a bad thing.
For example, working out every day for 1 hour is good for your body. Working out 4 hours every day? That will probably hurt your body. There’s an optimum amount of workout that’s good for you before it starts to do you more harm than good.
The same thing applies to trading. Some risk management is good. Too much risk management is bad.
If you exercise too much risk management, the size of each loss on a failed trend following trade will decrease.
But at the same time, the number of failed trades (small losses) increases because you get whipsawed more.
In other words, too much risk management increases your chance of being hurt by a countertrend move instead of merely waiting for a trend reversal.
Here’s the same example with gold. A trend follower uses a simple risk management method:
- Buy and hold gold only when it is above its 200 dma
- Sell gold when it breaks below its 200 dma
In this case, the risk management strategy (200 dma) worked well. There were no whipsaws.
Let’s take the same trade, but using a 50 dma as a stop loss.
Using this strategy, you would have a lot of false sell signals that hurt your performance.
In trading as in life, too much of a good thing is a bad thing.
#3 Always backtest with lots of data. I.e. many decades of data
This is a problem that I see all the time among new and experienced traders like
- They discover a trading strategy (e.g. trend following)
- They backtest it on 10-20 years of data
- The backtest looks terrific. Profits!!!! $$$$
- They use it, and over the next 5 years returns are VERY different from what the backtest looks like.
This problem is very prominent on quantitative traders. They build models on 10-20 years of data, and when they use it in real time, they soon realize that future returns are very different from backtested returns.
What went wrong?
They backtested their strategy on limited data.
In order to truly understand how well a strategy works, you need to backtest it on 40+ years of data.
Because if you backtest your strategy on a period that just so happens to suit the strategy, you will be misled into thinking that the strategy is more useful than it really is.
Here’s a chart of the S&P 500.
- Trend following would work poorly on the S&P in the 1970s because the market was very choppy.
- Trend following worked well on the S&P in the 1980-1990s because the market was trending strongly
A trend following strategy backtested on 1970s data would give you the false impression that trend following doesn’t work in the stock market. In reality, the 10 years did not reflect how well trend following works in the long run.
A trend following strategy backtested on 1980s-1990s data would give you the false impression that trend following works ridiculously well in the stock market. In reality, the 20 years does not reflect the fact that trend following in the stock market can go through LONG PERIODS of underperformance.
Always use as much data as possible when backtesting your strategy.
#4 Do not always feel the urge to trade
Many traders have what’s called Itchy Finger Syndrome.
They always want to trade.
They is especially a problem when traders are constantly glued to the screen, watching the price change minute by minute.
The reality is that a lot of time, the best thing to do is to do nothing. If there aren’t a lot of good opportunities right now, you should not be trading. Like life, trading goes through ups and downs.
- When times are good, play offensive
- When times are bad, play defensive
The easiest way to play defensive is to do nothing. Sit and wait for better opportunities. Life is full of opportunities.
#5 Quantitative trend following is better than discretionary trend following
When you are trading with a discretionary trend following strategy, you are still subject to your own behavioral biases.
It is impossible to remove human emotions from trading unless you remove the “human” from the trading.
By using a quantitative trend following system, you are repeating the exact same decision making process over and over again when trading, without flaw. You remove one-at-a-time decisions, force discipline, and remove emotions.
- Successful businesses operate on systems
- Successful entrepreneurs follow routines
- Successful traders use systems instead of allowing their human judgement to potentially make errors.
#6 Trend following on the short side is different from trend following on the long side, especially for stocks
For the stock market, trend following on the short side is much harder than trend following on the long side. This is because the stock market spends more time going up than down.
Every single time the market “breaks down” and it looks like a downtrend is emerging, there’s a very big probability that the “break down” is actually a false break down, and that the stock market will eventually reverse higher.
Here’s a chart of the S&P 500 (U.S. stock market)
Why many people don’t like trend following (even though it’s so profitable)
Trend following works. We will easily prove this with math in Part 2 of this trend following guide.
But first, if trend following works, why do many people dislike trend following?
There are several reasons
#1 trend followers will have losses. Lots of losses. Trend followers must accept them
Humans are panicky. The instant they start to see losses, they abandon a winning strategy, even though no strategy wins every single time.
Trend followers will experience losses. Lots of losses, because the whole premise behind trend following is that
One big gain (from the real trend) will more than make up for all the small losses (from the false trends).
Many people experience a few small losses, then panic and stop trend following.
Or they try an implement “risk management” strategies to minimize their losses. In minimizing their losses, they also minimize their profits. It’s impossible to avoid all whipsaw losses unless you stop trading.
Here’s a famous example.
Peter Lynch was the famous manager of the Fidelity Magellan Fund. His fund made an average of 29.2% per year from 1977-1990
However, it’s estimated that more than half of his investors lost money!
How can this be?
- After Peter Lynch was on a winning streak, investors plowed into his fund. Of course all winning streaks end. They are followed by losing streaks.
- After Peter Lynch was on a losing streak, investors withdrew from his fund. Of course all losing streaks end. They are followed by winning streaks.
By jumping in and out of a winning strategy because they let their emotions get the best of them, most investors ended up turning a winning strategy into a losing strategy. They got into the strategy at the wrong time, and jumped out of the strategy at the wrong time.
Trend followers need to not only accept losses as a regular part of the process, but they must also be humble enough to TAKE a loss.
A lot of traders aren’t humble enough to take a loss and admit that they are wrong. These traders dig in their heels when they are wrong. A losing trade keeps “looking better” the more it goes against them.
Trend followers know that not only will they have big losses in some months, they will also have losses in some years. If you can’t accept that you will lose money in some years, you should not be trading.
You cannot have the ups in life without some of the downs. We can try to minimize the downs, but it is impossible to completely eliminate the downs without also eliminating the ups.
For example, many trend followers lost a lot of money in 2000, a year in which the stock market was very choppy. But by sticking to their proven strategy, they made back all of their losses and more in 2001, when the stock market trended downwards.
Every non-trending market is followed by a trending market.
#2 trend following is boring
Trend following is boring. There’s nothing sexy or fancy about it.
- You don’t need to draw crazy complicated patterns worthy of Michelangelo on a chart
- You don’t need to come up with a very smart-sounding fundamental “story” to explain and predict why the market will go up/down
All you need to do is have a process, and stick to it every single day. That’s it.
Some people don’t like this because it’s not exciting.
Here’s the reality. You’re not in the markets for excitment. You’re in the markets to make money.
If you want excitment, go to Vegas, or start trading options. I have seen options traders’ accounts go from $20k to $240k to $80k to $2k back to $10k. It’s an emotional roller coaster, and doesn’t do the trader much good in the long run.
You can have short term success by doing what amounts to reckless gambling. But in the long run, the gamblers will be taken out on a stretcher.
As Warren Buffett says:
Only when the tide goes out do you see who is swimming naked
Final words for the Ultimate Guide to Trend Following: Part 1
Trend following works. We will prove that with cold hard numbers in part 2 of the Ultimate Guide to Trend Following.
But remember that it doesn’t work every week, month, or even year. There are weeks, months, and years when trend following will result in losses.
But what matters is the long run. You are in the markets for long term profits. Do not approach the markets with a “hit it and quit it” attitude. As long as a strategy works in the long run, stick to it.
Have confidence in your strategy, and ignore the short term drawdowns. Focus on long term results and have patience.