Trend Following

Trend following is one of the oldest and best documented trading strategies. The idea is simple: when a market has been rising, buy it; when it has been falling, sell or short it; stay in until the trend ends. Trend followers do not try to predict tops or bottoms. They accept being late into a move and late out of it, in exchange for capturing the middle, which in big trends can be very large.

The core idea#

Markets sometimes move in sustained trends driven by slow changes in fundamentals, gradual spread of information and human behaviour such as herding. A trend follower aims to be in the market whenever such a trend is under way and out (or on the other side) when it is not.

Common trend following rules#

The Turtle Traders, a group trained by Richard Dennis and William Eckhardt in the 1980s, famously used channel breakouts: enter on a 20 or 55 day high or low, exit on a 10 or 20 day opposite breakout, with position size based on volatility.

What results look like#

Trend following has a distinctive profile:

• Low win rate: often 30% to 45% of trades are winners.
• Large average win compared with average loss, because winners are allowed to run.
• Long flat or losing periods in choppy, range bound markets.
• Strong gains in crisis periods when markets trend sharply, which is why it is sometimes called "crisis alpha".

The evidence#

Research by Hurst, Ooi and Pedersen at AQR studied trend following across many markets back to the 1880s and found positive average returns in every decade, with especially good results during major market declines. Moskowitz, Ooi and Pedersen documented "time series momentum": a market's own past 12 month return tended to predict its next month's return across equities, bonds, currencies and commodities. Returns vary greatly over time, and long drawdowns of several years have occurred.

Making trend following work#

1. Diversify widely. Big trends are rare in any single market, so trend followers trade many: stock indices, bonds, currencies, energy, metals and agriculture. See Diversification.
2. Size by volatility. Give each market a similar risk budget. See Volatility and ATR-Based Sizing.
3. Let winners run with trailing exits. See Trailing Stop Orders.
4. Cut losers quickly at predefined stops.
5. Accept drawdowns and stick to the system through flat periods.

Common mistakes#

• Taking profits too early, which removes the large winners the strategy depends on. See Disposition Effect.
• Trading too few markets, which makes results depend on luck.
• Abandoning the system after a few losses. See Recency Bias.
• Over optimising lookback periods on past data. See Parameter Optimization.

Trend following vs momentum#

The terms overlap. Trend following usually means time series momentum: each market's own trend. Cross sectional momentum compares markets with each other and buys the strongest relative performers. Both are covered in Momentum Trading and Momentum Factor.

Trend followers use many filters, from moving averages to the Ichimoku Cloud and the Supertrend indicator.

Frequently asked questions#

What is trend following?#

A strategy that buys rising markets and sells falling ones, staying in until rules signal that the trend has ended.

Why do trend following strategies have low win rates?#

Many trends fail to develop and are stopped out with small losses, while a few large trends produce most of the profit.

Does trend following still work?#

Long term research shows positive results across many decades and markets, but returns are uneven and multi year drawdowns occur.

Next, learn how to trade the moment a trend begins with Breakout Trading.

Sources#

• Hurst, B., Ooi, Y. H. and Pedersen, L. H., A Century of Evidence on Trend Following Investing, AQR. Summary: Wikipedia, Trend following