The Complete Guide to Trend Following Trading Strategies
Trend following is one of the most popular trading techniques used by retail and institutional traders. But what exactly is trend trading, and how can you use it to profit in the markets? This comprehensive guide covers everything you need to know about trend following strategies.
Key Takeaways:
- Identify trend direction with indicators like moving averages
- Enter trades in the direction of the trend
- Use stops to limit losses when trends reverse
- Let profits run to maximize gains in sustained trends
- Diversify across uncorrelated markets
- Trade trends across different timeframes
What is the Trend Following Trading?
Trend following aims to capitalize on the persistence of trends in the financial markets. The core concept is to identify the overall direction of the market and trade in the same direction by buying in uptrends and selling in downtrends. By staying aligned with the dominant trend, traders can profit as the trend continues.
The key benefit of trend following is that it eliminates the need to predict or forecast where the market is headed next. Trend traders simply react to what the market is doing now without any guesswork. This mechanical, rules-based approach removes emotion from trading and can lead to higher profitability over time.
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How Do You Identify a Trend?
There are many technical indicators and chart patterns that can help determine if a market is trending. Here are some of the most common methods:
- Moving averages – A crossover of a shorter and longer moving average signals a change in trend direction. Trading above the longer MA shows an uptrend.
- Breakouts – When the price breaks above a recent high or below a recent low, it signals a potential trend reversal.
- Chart patterns – Continuation patterns like flags and triangles indicate an ongoing trend, while reversal patterns signal a change in direction.
- Higher highs/lower lows – A series of higher highs shows an uptrend is in play. A series of lower lows indicates a downtrend.
What Are the Benefits of Trend Following?
Some key advantages of incorporating trend following into your trading plan include:
- Ride large directional moves in the market.
- Take advantage of the momentum and persistence of trends.
- Systematic and rules-based trading improves discipline.
- Risk management through stop losses to limit downside
- Diversification across many uncorrelated markets
- Flexibility to adapt to evolving market conditions
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Trend Following Across All Market Environments
Trend following strategies can profit in a variety of market environments, including:
- Uptrends – Going long as the trend pushes higher
- Downtrends – Short selling in a falling market
- Range-bound – Playing breakouts above or below key levels
- High volatility – Trading large swings and momentum
- Low volatility – Taking advantage of directional persistence
Timeframes for Trend Following
Trends occur over different time horizons, from short-term swings to long-term secular trends. Traders can apply trend following across various timeframes:
- Scalping – 5 min to 60 min charts to trade intraday breakouts
- Swing trading – 4-hour to daily charts to capture multi-day moves
- Position trading – Daily, weekly and monthly charts to ride long-term trends
Higher timeframes filter out market noise and focus on higher conviction moves. Lower timeframes provide more frequent trading opportunities.
Markets for Trend Following
Virtually any liquid market with decent trends can be used for trend following. Some of the most popular markets include:
- Stocks – Equity indexes and ETFs work well for trend trading
- Forex – Major currency pairs exhibit strong trends
- Futures – Commodities, bonds, and indices all tend to trend
- Cryptocurrencies – Bitcoin and altcoins are very trending
Diversifying across these liquid markets allows trend traders to profit from trends emerging across different asset classes.
Trend Following Indicators
Here are some of the most popular indicators used in trend following strategies:
- Moving averages – Crossovers and price relation to MA show trend
- MACD – Crossover of signal line identifies momentum shifts
- ADX – Measures the strength of the trend; above 25 confirms the uptrend
- Bollinger Bands – Price hitting upper/lower band shows continuation
- ATR – High ATR represents increased volatility in trending markets
These indicators can be combined in different ways to develop systematic trend-following strategies.
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Trend Following Strategy Rules
A simple set of rules for a trend-following system may look like this:
- Long when price breaks above 20-day high
- Exit long when price drops below 20-day MA
- Short when the price breaks below the 20-day low
- Exit short when the price rises above 20-day MA
- Use 2-3% risk per trade
- Target 1:2 risk-reward ratio
The exact rules can be adjusted and optimized for changing market conditions and timeframes.
Pros of Trend Following
- Captures large directional moves in the market
- Unemotional, rules-based trading
- Risk management through stops
- Diversification lowers volatility
- Flexibility to adapt across assets and timeframes
Cons of Trend Following
- Susceptible to whipsaws and false breakouts
- Drawdowns can be steep during choppy markets
- Lagging indicators may delay entries
- Requires strong discipline to follow rules
How to Build a Trend Following System
Follow these steps to develop a robust trend-following strategy:
- Determine market universe and timeframes to trade
- Select useful trend indicators and oscillators
- Define specific entry rules based on trend direction
- Set exit rules based on indicators and stops
- Incorporate solid risk management and position sizing
- Program rules into the automated trading system
- Evaluate performance through backtesting and optimization
Tips for Successful Trend Following Strategies
Here are some tips to improve your odds of success as a trend follower:
- Trade with the trend across various timeframes
- Use stops to limit losses when trends reverse
- Let winning trades run to maximize gains
- Be patient and wait for high-probability setups
- Diversify across many uncorrelated markets
- Maintain discipline in your trading rules
Frequently Asked Questions
Q: What is trend-following trading?
A: Trend-following trading is a strategy where traders aim to identify and follow the direction of the market trend.
Q: What are trend-following strategies?
A: Trend-following strategies are trading approaches that involve making buy or sell decisions based on the direction of the market trend.
Q: How does a trend follower make trading decisions?
A: A trend follower makes trading decisions by analyzing indicators such as moving averages, Bollinger Bands, and MACD to identify the trend and then takes positions in line with the trend.
Q: What is a moving average?
A: A moving average is a technical indicator used by trend followers to determine the average price of an asset over a specific period of time. It smooths out price movements and helps identify the direction of the trend.
Q: What are the best trend trading strategies?
A: Some of the best trend trading strategies include using moving averages, trend channels, and breakout strategies.
Q: What is a trend reversal?
A: A trend reversal occurs when the market trend changes direction from an upward trend to a downward trend, or vice versa.
Q: How can I identify the best trend to follow?
A: Traders can identify the best trend to follow by analyzing price action, using trend indicators, and considering the overall market trend.
Q: What is the role of systematic trend following in trading?
A: Systematic trend following involves using predefined rules and strategies to identify and follow trends in the market. It helps remove emotions and biases from trading decisions.
Q: How do I determine the current market trend?
A: You can determine the current market trend by analyzing price movement, using trend indicators, and considering different time frames.
Q: What are some popular trend trading indicators?
A: Some popular trend trading indicators include the Moving Average Convergence Divergence (MACD), Relative Strength Index (RSI), and Bollinger Bands.
Trend Following Strategies – Conclusion
Trend following aims to profit from the strong tendency for trends to persist in financial markets. By systematically entering trades in the direction of the trend after confirmation, setting prudent stops, and diversifying across many liquid markets, traders can position themselves to capture large gains from extended moves.
Trend following offers a rules-based approach to trading that can yield sustainable profits across a variety of market conditions. With proper risk management and discipline in executing a strategy, trend trading can be a viable approach for traders of all skill levels.