What is the Trend Following Strategy in Trading?
As an amateur or even a pro in trading, one of the trading strategies you will be curious to know more about is trend trading. If you are only hearing about trend following for the first time, our guide will explain its meaning and other facts about it in simple terms.
It is wrong to think that trading is a matter of luck because traders have to do all it takes to succeed. They research a lot about the market, read and analyze trading charts and study the past trading trends to help them make their next moves.
So, what exactly is a trend following strategy? Let’s get straight to that.
Trend-Following Strategy Explained
To get a pattern, trend following is a trading practice that traders apply by studying the different movements across the market. Think of the movement of prices. When they move either upwards or downwards over a period, they create a trend.
Traders use the trend to know which move to make. They buy most of their securities when prices are lower and sell them when prices rise to add profits. Trend followers do not forecast a trend but follow the existing one and stay alert of any changes.
However, while following the trend, there are some concepts that a new trader, or one who is not familiar with this strategy, needs to know.
- You should follow your trend-identification rules when trading. This means that you should stick to the direction of the trend depending on the rules.
- When the price is no longer trending, you can exit your positions. This enables you to evade too many drawdowns, which could lead to losses.
- You should aim for bigger returns in a single trend so that you can cover up for the frequent losses you could incur if the trend takes a turn.
Facts about the Trends in Trend Following
The best way of determining a good trend following strategy is by analyzing various market structures. Once the market leaders and influencers do so, they create a buzz that attracts investors.
As market influencers generate this buzz, their final results are based on a market data analysis while also focusing on the intangible aspects related to trading. They will use the different variables that influence a trade to create the trend.
However, investors and traders should know that you cannot bank on a single indicator to determine a trend. To get an excellent trend-following system that will be feasible, you should combine different strategies.
Before we look at some of the best trend-following strategies, let us first look at some basic facts about trend-following.
- Prices move in four different ways. They are either moving upwards or downwards, sideways, or in a range-bound direction.
- A single trend carries multiple trends. It all depends on your intervals.
- You cannot predict the future of a trend because it uses past market events. However, you can follow a potential movement. Traders who do that use identification criteria that have a solid risk management strategy.
- There are chances of getting a low win rate by following a trend-following criteria. This does not affect your trades a lot as long as the profit factor is higher.
- Traders can anticipate when a trend is likely to bend, but they cannot predict this. Sometimes the change comes unexpectedly and can be the most dangerous part of the trend if you did not see it coming.
- Trend following rules are only there to guide trades but cannot predict the trend.
Trend Following Strategies to Know
Here are the trend following strategies you should know.
Moving average direction was and is still the most commonly used tool in the market analysis. Some traders call it the green and red light because it shows if the trade is on the right side of a moving average, increasing the trader’s chances of success.
The moving average strategy uses a 10-day policy whereby you are on the right side when trading above the 10-day, and a green light indicates this. This means that the market is in positive mode, and you should buy securities.
When you are trading below the 10-day mark, you are trading below the average. This is a red light to the trader and an indication that they should be selling securities.
Bollinger Bands consist of bands that estimate the instability of the prices of securities. This trend following system suspects that security prices will bounce back. It has bars that evaluate the fluctuation of prices of securities.
Market leaders use them to determine the highest and lowest points of securities. They are also used in uptrends, downtrends, and ranging markets.
Here is an explanation of how traders monitor trends using Bollinger Bands.
When prices are trending closer to the outer bands, it is an indication of trend strength. If the prices do not move further from the outer bands, the trend is still good.
There are sporadic cases of immediate reversal if the price is constantly moving close to the outer bands. A trader that knows about Bollinger Bands will be confident when trading because they understand what is happening and know what to expect.
This is another popular trading strategy that traders choose to use. With this trend-following strategy, the trader can determine when a trend has reached its limit and when a new trend is emerging.
The name head and shoulders have their significance because the two parts of the body represent various situations. The head shows the highest or lowest prices that security can reach, and the shoulders indicate two high or two low points.
What Is Trend Trading?
Let us think of a trend as a person that will benefit you only if you are friends. When the friendship ends, they cut off the benefits. This example also applies to trend trading.
To explain trend trading better, we can say that it is a systematic investment strategy that takes advantage of the long, medium, or short-term market movements.
The traders who use trend trading first consider particular trading reasons and rules to establish a trend and then jump on it. They assume that after the trend gets established, it will remain there for a long time.
When the trend starts to take a different turn, the traders exit the market and watch until there is a newly established trend from the turn. The reason for leaving the market when the movement is no longer predictable is to minimize losses.
Trend following has five primary concerns: price, money management, risk control, rules, and diversification. Price is the primary concern because traders use it to know where the market is going.
How much a trader is willing to trade during the trend ties into the concept of money management. The traders apply risk control not to incur losses. If a trend is not stable, the rules are that the traders should exit the market until it establishes a new trend.
There must also be guiding rules to ensure that trend following is systematic. And the other vital part of trend following is cross-asset diversification.
The positive side of trend trading is using the past market movements to know when it is safe to trade to make profits. However, the trader can incur losses when trend trading, particularly when the trending signal unexpectedly reverses.