Understanding the trend following strategy

No matter which investment strategy you choose, it will never be able to predict 100% of the market’s movements. Nevertheless, it is essential for a trader to establish a strategy before investing. Easy to implement, the trend following approach allows investors (even beginners) to follow an effective trading strategy.

Made famous in the 1970s, trend following is an easy trading strategy that works effectively on many different asset classes such as stocks, bonds, commodities and currencies.

Some sites like Market-Signals use trend following with ETFs in an automated way. It’s one of the most popular trading strategy on the market. As its name suggests, this strategy involves discerning a trend already formed and then following it. In this article, we will give you details and insights about this famous strategy.

What is the trend following strategy?

Trend following is an investment strategy that can be used in any type of market and is based primarily on technical analysis.

A trend-following investor will buy an asset when it is rising, since he believes that the market will continue to rise. Conversely, he will sell when it is falling, since he assumes that the market will continue to depreciate. This method is particularly effective over the long term. The idea is to profit from the extension of a movement by trading in the direction of the trend.

Advantages

Trend following has several advantages. First, this method is very simple to understand. It is not necessary to anticipate market movements, only to understand past and current behavior.
In addition, the payoff/time ratio is particularly favorable, especially for someone who does not want to spend too much time on the markets. Finally, there will always be a trend to exploit in a market with this strategy.

Disadvantages

Nevertheless, trend following also has some disadvantages. Some trends are less obvious and are not clear at all. Indeed, it often happens that prices evolve in a trading range or horizontal channel. It is therefore complicated to enter and exit at the right time and almost impossible to enter at the bottom and exit at the top of an uptrend.

Finally, the end of a trend is difficult to detect. Occasionally, prices will fall slightly in an uptrend. This may be a minor correction and you can hold your position, but if you are facing a general trend reversal, then you should absolutely close your position.

Different approaches to trend following

Systematic trading

One approach to trend following is systematic trading. Systematic trading has set rules that dictate entry, exit, risk management and trade management. This method is widely adopted by large hedge funds. Although systematic trading is automated, a manager still has to make key decisions, such as how much to risk or which markets to trade in.

Discretionary Trading

The discretionary trading method has less defined rules than systematic trading that decide entry, exit, risk management and trade management. This approach requires the investor’s attention since trading here is based on technical analysis and more intervention. This method is generally adopted by small individual traders. Although more subjective, discretionary trading is always guided by a trading plan.