What is "Trend Following"?

[Leth]

What is “Trend Following”?
-Humsurfer

Trend following refers to going with the trend – or just trying to follow the direction. If the markets are going up, then one believes that they will continue to go up and they may take a long position. If the markets are going down, they may be of the assumption that markets will continue to go down, hence they start selling or going short. Trend Following emerges from the “Momentum Theory” of stock markets trading – which states that whatever is going up, will keep going up in the short term, and whatever is going down will keep going down in the short term –hence one can benefit from taking trend following positions.
One important thing in “Trend Following” trading strategy is to know you entry and exit points. Say that Microsoft is trading at $30. One week back it was at $25, hence there has been a 20% hike in share price in one week. Hence, there seems to be a “trend” or to be more precise – “an upward trend”.
Now suppose that I follow the trend following strategy, with a methodology that any stock that has gone up by 10% in 15 days or less, will continue to go up. So, when the stock price reached $27.5 from $25, then I will ENTER into this stock (or buy shares). I’ll let my profits run until I spot the exit pattern.
Hence, as long as my Microsoft stock keeps moving UP, from 25, to 28, to 30 to 35 to 40 and so on, I’ll let my profits run. The sky is the limit. I may even keep on accumulating this stock further based upon some capital management calculation.
Suppose I follow an exit methodology that if an upward moving stock takes a U-turn and comes down by 10%, then it will continue its downward direction. Suppose the MSFT stock touches a peak of $40, and then comes down to $36, a fall of 10%. This signals my exit point. Hence I sell shares of Microsoft at $36. If I have not been accumulating this share, my profits would be 36-25 = $11 per share. If I had been accumulating, my profits would be calculated based upon the weighted average cost price with $36 as the sell price. Ultimately, I make money.

Advantages of Trend Following

• Plenty of advantages of trend following – it is simple to understand (though not easy to implement).
• One may usually not miss a major move in any stock. If the market/stocks you are trading turns from a down to an up direction, any trend-following indicator must give a “buy” signal. It’s just a question of when. If it’s a major move, you will get the signal.
• Short term frequent trades will cost you more, because it will hurt on transaction costs. The farther longer term the trend-following indicators are, the lower the transaction costs are, which is a great advantage of trend following.
• Strategically, the investor must understand clearly that if he can get onto a stock on a major move in almost any stock, the profits from just one trade can be substantial.
• In essence, one single trade can make your whole year greatly profitable. Hence, the reliability of one’s strategy can be far below 50 percent and you’ll still obtain a profit. This is because the average size of one’s winning trades is so much greater than the size of one’s losing trades.

Disadvantages of Trend Following

• The major disadvantage is that trend following is not easy. You have to be alert for the entire time the markets are opened.
• It’s not easy to identify the entry and exit points
• Another disadvantage of trend following is that your entry and exit points cannot detect the difference between a major profitable move and a short-lived unprofitable move.
• Most markets spend a large amount of time in the territory where it is not usually possible to establish a trend – called the non-trending conditions. Trending periods could be very small – just 15 to 25 percent of the time. Yet the trend follower must be willing to trade in these unfavorable markets in order not to miss the big trend.

Who can go for trend following? Is it for Everyone?

Trend following is probably one of the easiest techniques for the new trader or investor to understand and use. The longer term the indicators, the less that total transaction costs will affect profits. Short-term models tend to have a tough time overcoming the costs of doing more trades.
The fewer trades you make, provided you have the patience for it, the less you spend in transaction costs and the easier it is for you to make a profit.Apart from that, there is an inherent risk of the markets going against you. So analyze your situation completely, then and only then follow a trading strategy.