Trend Following Trading Strategies and Systems Explained Including Backtest and Statistics

trend following strategies

The most basic approach to follow a trend is to use trend indicators like moving averages, Bollinger Bands, and the Average Directional Index (ADX). While not typically considered a trend-following indicator, chart patterns can be used to determine entry and exit points. To calculate the MACD, you subtract a 26-period Exponential Moving Average (EMA) from a 12-period EMA. The Exponential Moving Average is a moving average that gives greater weight to more recent price data.

  • If the price is above the average, the trend is up, and vice versa.
  • Traders can use price charts to identify trends by looking for patterns of higher highs and higher lows in an uptrend or lower highs and lower lows in a downtrend.
  • In this article I investigate which moving average type actually works best.
  • If a trader purchases a stock for 100 and places a stop loss at 90, there is 10 trade risk.
  • Besides using technical indicators, there are some great strategies that rely on chart patterns.

Trend followers believe that trends exist across numerous markets and industries and that there is a reason for them existing. They believe that the price of a security is the most important thing to understand. Everything you need to know about a market can be ascertained from its price action.

What is your current financial priority?

In this example, we have used the 25-day exponential moving average. Not all strategies include this aspect of trend trading, but it’s just as important to keep in mind as entering and exiting a position. A specific strategy using certain indicators may work for a while – months, years, maybe even decades, but eventually, almost all strategies become obsolete.

Discretionary trading has lesser defined rules that decide the entry, exit, risk management, and trade management. Systematic trading has defined rules that decide the entry, exit, risk management, and trade management. If you notice price forming lower lows, with support constantly breaking, chances are it’s a downtrend. Collectibles, such as art, stamps, and coins, can be a unique investment option for some investors. The collectibles market can be complex, and many investors find it difficult to make informed decisions in this market. Even the largest CTAs are very small relative to other kind of funds (hedge funds, mutual funds, etc.).

Before you continue reading, you might want to look at our video which contains 3 simple trend following strategies that anyone can follow. In this article, we take a deeper look at explaining what trend following is. We discuss the performance of six specific trend following strategies and end the article by looking at the pros and cons of trend following systems. We’ve highlighted 10 of the best trend following trading strategies, but without a proper forex trading education, you’ll struggle to implement them correctly. They are made with the channel pattern tool on your charting software and used to pinpoint highs and lows in market price.

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This shows that even though the price is oscillating up and down, the overall trajectory is up. One basic MACD strategy is to look at which side of zero the MACD lines are on in the histogram below the chart. If the MACD lines are above zero for a sustained period of time, the stock is likely trending upwards.

The Best Trend Following Resources

Because the next section will show you the key indicators and tools that are suited for making trend following strategies. While we use algorithmic trading i.e quantitative trading strategies to curb sentimental trading, the same can also be used to utilise and monetize sentiments. We have all heard of things going viral, thanks to the power of the internet. It requires a trader’s attention, trading based on technical analysis, with more intervention.

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There is another indicator that serves as a powerful helper when it comes to working with trends. H. Pee developed to measure the strength of a trend in the market. It compares the proportion of prices for the previous 30 days above or below today’s 60-day moving average.

Donchian Channel strategy

The histogram grows more significant as the speed of the movement accelerates. The fund is actively managed and seeks to achieve positive returns that are uncorrelated to broad market equity or fixed income returns. The search box in the instruments panel of the FlowBank trading platform makes it very easy to find ‘managed futures’. Managed Futures ETFs are a way to passively invest using exchange traded funds into a managed futures fund or index. Since 2008, the performance of trend following has been sporadic causing some to claim that the strategy no longer works. 2014 was a good year but apart from that performance has been declining.

If the close was above the moving average, the trend was up until the close was below the x-day average of lows (the trend reversed). The benefits of trend following include the potential for higher returns during market uptrends, as well as reduced risk during market downtrends. Trend following also helps investors avoid emotional decision-making by relying on objective technical indicators. To successfully implement a trend following strategy, traders must be able to identify trends, trade with the trend, manage risk, and optimize their strategy using historical market data. One of the advantages of trend-following strategies is that they can help traders avoid emotional decision-making. By following objective rules based on market trends, traders can avoid making impulsive decisions based on fear or greed.

  • In the rules of this strategy, you will exit the trade if the lines cross over again.
  • As with any form of investing, it is important to carefully research and understand the potential risks and rewards before making any decisions.
  • The  On Balance Volume (OBV) Indicator is a momentum based indicator that measures volume flow to gauge the direction of the trend.
  • Trend traders attempt to isolate and extract profit from trends.

For example, the well-cited study by hedge fund AQR called A Century of Evidence on Trend Following. This paper lays the groundwork for a momentum trend following strategy all the way back to 1880. Adopting trend following strategies has different forms with different tools you can use. Solemnly swear that I will backtest all of the strategies shared with me today first and make necessary tweaks to this strategy before risking my hard-earned money.

Does Trend Following Work On Stocks?

The two most straightforward options are taking a long position for an uptrend and placing a short position for a downtrend. Trend following may also include short-term, intermediate-term, and long-term trading strategies. Because this is a very well defined strategy, it is easy to go back and see if the strategy would have generated profits using historical data.

trend following strategies

It is actively managed and seeks to achieve positive total returns in rising or falling markets that are not directly correlated to broad market equity or fixed income returns. The fund is managed using a quantitative, rules-based strategy designed to provide returns that correspond to the performance of the WisdomTree Managed Futures Index. The trouble is that access to these types of risky alternative investments, which are in effect hedge funds is heavily gated. Oftentimes there are minimum investments in the hundreds of thousands of dollars.

All in all, many traders believe that trend following is the best strategy because it allows them to capture the majority of the trend and potentially make large profits. Trend trading is also relatively simple to understand and implement, making it accessible to both novice and experienced traders. Whether trend following trading works or not depends on the specific strategy and market conditions. Like any investment strategy, trend trading has its pros and cons. One advantage of trend trading is that it can potentially capture large gains when the market is trending strongly. However, trend trading can also result in losses when the market is choppy or in a range.

Some traders also use moving averages in combination with price charts to confirm trends. For example, if the price is above the moving average, it may suggest an uptrend, while a price below the moving average may indicate a downtrend. The trader no longer needs to monitor live prices and graphs or put in the orders manually. The algorithmic trading system does this automatically by correctly identifying the trading opportunity.

As I’m spilling all my trend following trading secrets in this guide. If, however, the OBV shows a decline with respect to the increasing price trend, then it could signal a price trend reversal. OBV is used as a confirmation tool with regard to price trends. If the OBV increases with respect to the increasing price trend, it can be inferred that the price trend is sustainable.

However, I first need you to take the consistently profitable trader’s oath. A lot of traders love gathering tips and pieces of advice just to enter a trade. Each brings their flair to the dance floor, offering traders different paths to success. This indicator can be flexible enough to capture all types of trends. It’s like the trend-following maestro, constantly measuring the average movement of the price.

The benefits of using a moving average are that it tends to eliminate any short-term fluctuations in the market, giving a less noisy view of the overall market direction. There are a disproportionately high number of stocks that make much larger price moves – 10%, 200%, 500% or even more in some cases. These are the long-tail stocks that trend followers are hunting, since they offer the biggest opportunity for profits. The same long-tail principle applies for investors who follow trends.

Like the Moving Average Convergence Divergence indicator, the Relative Strength Index (RSI) is also an oscillating indicator. The goal of the RSI indicator is to predict if a security is currently overbought or oversold. RSI is conveyed as a number between 0 and 100, which measures the magnitude of recent cost arbitrage changes in a security price. Additionally, it’s considered bullish when the MACD crosses above the signal line. And when the MACD crosses below the signal line, it’s deemed to be bearish. The MACD Histogram represents the difference between the MACD and its nine-day EMA, also called the signal line.

trend following strategies

Although systematic trading is automated, there are still key decisions that a manager has to make. You’ll win often but, eventually, there will be a trade that goes against you, till you blow up your trading account. And this is one of the biggest secrets behind a trend follower’s success. Because you’ll watch many small wins turn into losses while attempting to ride the trend. This depends on your winning ratio, the risk to reward, and your risk tolerance. However, when you start making predictions in the market, it clouds your judgment, and you start losing objectivity of the markets.

The goal of a trend-following strategy is to enter into a long or short position when a trend is identified and ride the trend until it shows signs of reversing. Moving averages are technical indicators that help smooth out the price data by calculating the average price over a specified period. Traders and investors use different types of moving averages to identify trends in the price movements of an asset.

In other words, when the dots are below the price, it’s considered a bullish signal, and when they are above the price, it’s considered a bearish signal. It was developed by Richard Donchian, who is considered the father of trend following trading. It consists of two bands, an upper band, and a lower band, that are drawn based on the highest and lowest prices over a set period of time, typically 20 days. The upper band represents the highest price over the past 20 days, while the lower band represents the lowest price over the past 20 days. The trend-following strategy assumes that trends in the market persist over time and that there is a higher probability of a trend continuing than reversing. The strategy is based on the idea that it is easier to make a profit by following the trend than trying to predict market movements.

A short trade is entered if the close is below the bottom band. This is completely the opposite of what a mean reversion strategy would do. A seven ATR is added to the 350-day moving average of the closing prices, and three ATRs are subtracted from the 350-day moving average.

Trend trading is a strategy that involves traders analysing the direction of trends for financial instruments. When an asset is seeing an upward trend, traders would often look to enter into a long position and buy. In the opposite scenario, when trend direction is downward, traders would go short and sell.

However, depending on your trading strategy, you can experiment with moving averages of other periods. For example, if you spot an upward trend, a trader will apply a moving average of a duration of their choice. As such, in their view, the upward trend will remain as long as the price is above this moving average. If it comes close to the moving average, it will be a signal that the trend is about to end. Trend following (or trend trading) is one of the most popular day trading strategies in the market.