Trend following is a trading strategy that aims to take advantage of long-term moves and trades both sides of the market. When a market moves in one direction for a sustained period, we call it a trend. Although it’s estimated that markets only trend up or down for about 40% of the time, with the rest of the time spent moving sideways or range trading, it’s recognized that the least risky form of trading is to be found in a trending market. You can seldom if ever identify the exact bottom or top of a price chart until after it has happened, but if you trade with the trend you don’t need to, as by definition a trend means that the price continues going in a certain direction. All you have to do is observe that a trend is in place, and make your trade.
First, to observe whether there is a real trend, you should look for successively higher highs and higher lows to prove an uptrend, and successively lower lows and lower highs to show that you have a downtrend. With anything else, you may just be looking at a range trading stock. By drawing a line through the lows of an uptrend – or the highs of a downtrend – we create an easy reference-point for a trading strategy. In a trend following system, a good way to signal an entry is to look for a moving average crossover, that is the price rising to a single average line (for uptrend) or for the double crossover method, a shorter period moving average rising through a longer period one.
Another method to find a stock that is trending upward strongly is to look for a security that is trading at its recent high, so that the highest price in the last year has occurred in the last week or two. Here, you would be looking at shares that are making new 52-week highs (or lows if considering taking a short position). These stocks would have been going up (or down) for quite some time so the market momentum would be on your side. There are many trading opportunities every day, and you need to consider which ones are in keeping with your risk profile and trading style.
It is worth noting here that trends, both up and down can last for long periods. At any one time, there can be several trends at work in a particular market. So, a share might be in a long-term up-trend, but in a short- and mediumterm downtrend. When you enter a trade, you should make sure that you know where your stop loss for a failed trade will be placed. This is a point that you decide that you have to cut your losses and close the position. Once you know this, you can work out how much of your account you should put in the trade. Many traders recommend that you do not stand to lose more than 2% of your account if the trade fails, and never more than 10% in any one financial instrument.
But assuming that the trade goes in the right direction, where to exit the trade may be the most difficult decision for inexperienced traders. You’ve heard the expression “Cut your losses and let your winners run”. We’ve covered cutting losses in the paragraph above, but to successfully trade you need to fulfil the second part of the expression. Perhaps easiest way to do this is to set a trailing stop order. This will follow the price as it rises, but stop you out of the trade if the price falls back. You can choose a percentage or a value for the trailing stop to be underneath the price. Another way is to use the Average True Range (ATR), a measure of the volatility. Set a trailing stop two times the ATR below the price, and you should be successful trading.
Trend Following vs Contrarian
Several papers have looked recent at the question of what is a more effective kind of trading strategy: trend following or contrarian? James Kozyra and Camillo Lento of Lakehead University in Canada have found that, after adjusting for transaction costs, the contrarian approach consistently outperforms the trending approach, and is able to earn returns in excess of the buy-and-hold trading strategy.
Meanwhile, in another study, Rizky Luxianto from the University of Indonesia has compared the effectiveness of momentum and contrarian strategies in the Indonesian Stock Exchange. He first identifies winner stocks (stocks with highest gains) and loser stocks (stocks with highest losses) and then buys or sells them depending on the whether the strategy is contrarian or trend following. The author uses three performance measures for selecting winner and loser stocks.
The first method is cross section relative return, the second method is cross section relative return plus risk component (return divided by standard deviation), and the third method is historical relative return. According to Luxianto, the results, for all three methods, prove that a momentum strategy is more effective for winner stocks, so in the next period winner stocks will continue to make profit. For loser stocks, it is more effective to use a contrarian strategy because in the next period loser stocks will rebound and make a profit after suffering from high losses.
Kozyra, James and Lento, Camillo, Filter Rules: Follow the Trend, or Take the Contrarian Approach? (August 27, 2010). Luxianto, Rizky, Comparison in Measuring Effectiveness of Momentum and Contrarian Trading Strategy in Indonesian Stock Exchange (August 11, 2010).