Trend following or trend trading is a trading strategy according to which one should buy an asset when its price trend goes up, and sell when its trend goes down, expecting price movements to continue.
There are a number of different techniques, calculations and time-frames that may be used to determine the general direction of the market to generate a trade signal, including the current market price calculation, moving averages and channel breakouts. Traders who employ this strategy do not aim to forecast or predict specific price levels; they simply jump on the trend and ride it. Due to the different techniques and time frames employed by trend followers to identify trends, trend followers as a group are not always strongly correlated to one another.
Trend following is used by commodity trading advisors (CTAs) as the predominant strategy of technical traders. Research done by Galen Burghardt has shown that between 2000-2009 there was a very high correlation (.97) between trend following CTAs and the broader CTA index.
Trend following is an investment or trading strategy which tries to take advantage of long, medium or short-term moves that seem to play out in various markets. Traders who employ a trend following strategy do not aim to forecast or predict specific price levels; they simply jump on the trend (when they perceived that a trend has established with their own particular reasons or rules) and ride it. These traders normally enter in the market after the trend "properly" establishes itself, betting that the trend will persist for a long time, and for this reason they forego the initial turning point profit. A market "trend" is a tendency of a financial market price to move in a particular direction over time. If there is a turn contrary to the trend, they exit and wait until the turn establishes itself as a trend in the opposite direction. In case their rules signal an exit, the traders exit but re-enter when the trend re-establishes.
Cutting Loss. Exit market when market turn against them to minimize losses, and "let the profits run", when the market trend goes as expected until the market exhausted and reverses to book profit.
This trading or "betting with positive edge" method involves a risk management component that uses three elements: number of shares or futures held, the current market price, and current market volatility. An initial risk rule determines position size at time of entry. Exactly how much to buy or sell is based on the size of the trading account and the volatility of the issue. Changes in price may lead to a gradual reduction or an increase of the initial trade. On the other hand, adverse price movements may lead to an exit from the entire trade.
In the words of Tom Basso, in the book Trade Your Way to Financial Freedom
Let's break down the term Trend Following into its components. The first part is "trend". Every trader needs a trend to make money. If you think about it, no matter what the technique, if there is not a trend after you buy, then you will not be able to sell at higher prices..."Following" is the next part of the term. We use this word because trend followers always wait for the trend to shift first, then "follow" it.
The key reasons for trending markets are a number of behavioral biases that cause market participants to over-react:
Herding: After markets have trended, some traders jump on the bandwagon, and thus prolonging the herding effect and trends.
Confirmation Bias: People tend to look for information that confirm their views and beliefs. This can lead investors to buy assets that have recently made money, and sell assets that have declined, causing trends to continue.
Risk Management: Some risk-management models will sell in down markets as, for example, some risk budgets have been breached, and buy in up markets as new risk budgets have been unlocked, causing trends to persist.
"Don't fight the tape" is a term that means do not bet or trade against the trend in the financial markets, i.e., if the broad market is moving up, do not bet on a downward move. The term "tape" refers to the ticker tape used to transmit the price of stocks. It is analogous to the trader's maxim, "The trend is your friend."
A trader would identify a security to trade (currencies/commodities/financials) and would come up with a preliminary strategy, such as:
The trader would then backtest the strategy, using actual data and would evaluate the strategy. The simulator would generate estimated number of trades, the fraction of winning/losing trades, average profit/loss, average holding time, maximum drawdown, and the overall profit/loss. The trader can then experiment and refine the strategy. Care must be taken, however, to avoid over-optimization.
It is possible that a majority of the trades may be unprofitable, but by "cutting the losses" and "letting profits run", the overall strategy may be profitable. Trend trading is most effective for a market that is quiet (relative low volatility) and trending. For this reason, trend traders often focus on commodities, which show a stronger tendency to trend than on stocks, which are more likely to be mean reverting (which favors swing traders).
In addition to quiet low volatility markets, where trend following strategies perform well, trend trading is also very effective in high volatility markets (market crash). Trend traders "short" the market and benefit from the downside market trend.
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