Trend trading (or trend following) is an outstanding way to profit from large moves in the markets without spending a lot of time in front of the computer. Trend traders identify trends and find low risk entry points from which they hold their position until the trend reverses. This style works in most asset classes and can be highly profitable given sufficient diversification, strong risk control and the discipline to stick to the system.
What Is A Trend?
A trend is simply a sustained price movement in one direction. This may occur in any financial instrument. Trends occur in stocks, futures and forex markets. They occur in all time frames, however, the longer the time frame, the larger and more rewarding trends can be.
The nature and magnitude of trends varies by asset class, however, trend following can be used in stocks, futures and forex markets.
Components Of Trend Trading Strategies:
The great thing about this trading strategy is that similar (or indeed identical) trading systems can work across many markets. For example, one of our trend following systems works exceptionally well on stocks, but also works on futures and FX with no modifications at all. This is because most markets trend and the trading strategy is very robust. All it requires is:
- A way to identify when a trend is in place
- A low risk entry point
- An initial stop loss to gets you out if you are wrong
- An exit rule that gets you out when the trend changes
If your trading strategy has all of these components, combined with good risk management rules, you are on your way to a profitable trend trading system! (Of course you will need to undertake the correct trading system development for yourself to be sure as there are no guarantees your rules will be profitable)
Trend following works effectively in the stock market, futures and commodity markets and in forex / currency trading. There are, however, some slight nuances which are discussed below.
Trend Following Stocks:
Stock trends occur because of changing fundamental conditions for the stock and also because of overall market sentiment. Both long (up) and short (down) trends in stocks are tradable, although long side trends can be substantially longer than short side trends.
By far the best trends in the stock market occur when a company is growing rapidly and the broader market sentiment is increasingly positive. However, strong stock trends can occur at any time. With a total universe of many thousands of stocks globally, there are always some good trends underway – your trading system’s job is to find them!
Trend following stocks on the long side also has the added benefit of the trader receiving dividends for the duration of the trend – bringing the benefits of income as well as capital gain through the appreciation of the stock price.
The strongest stock trends can last many years and provide a return of many hundreds or thousands of percentage returns over this time. To illustrate the magnitude and duration possible in stock market trends, here are some historical charts of a number of very significant trends that a trend following system may have captured:
Trend Following Stocks Example: Incitec (IPL:ASX)
Trend Following Stocks Example: Cochlear (COH:ASX)
Trend Following Stocks Example: Jb Hifi (JBH:ASX)
You can see why trend following stocks can be so profitable – you only need a couple of these great moves each year to offset your numerous small losses and you can earn substantial returns. With good risk control and diversification this strategy can perform very well indeed.
In our trading systems section you will see that these trends can be identified and exploited using simple mechanical trading systems which look only at price data – it is not necessary to do hundreds of hours of fundamental research to identify a stock that is trending and profit from it.
If you want to learn more about trend following stocks and you would like a free consultation please click the button below and enter your details and I will give you a free 30 minute consultation to address your questions:
Futures Trend Trading:
Trend trading in the futures market can also be extremely profitable. Similar to stocks you will find that long side trends are larger and more profitable than short side trends, but both are tradable.
The important distinction for trend following in futures and commodities is that because futures contracts expire, the trader may have to intermittently roll over to the next contract month to stay with the trend.
These contract rolls add a slight degree of complexity relative to stocks, but this is well worth it given the additional diversification and returns that are available through trend following in futures.
Just as in stocks, futures trend following can be undertaken on a purely mechanical basis using only price data.
Trends in futures markets may not be as dramatic as the stock trends you saw above, but there are many examples of great trends in the futures markets. A trend in gold is illustrated below using continuous contract price data.
Futures Trend Trading Example: Gold
There are a limited number of tradable futures markets globally (<100 depending on your definition of tradable). This means there are typically fewer trends at any one time in the futures market compared to stocks, so it becomes important to catch every major trend that occurs when trading futures or commodities.
If you miss a trend in the futures market, that may just have been the big one that would have made your entire year’s profitability…whereas if you miss a trend in the stock market, there will likely be many more trends for you to catch. This has some implications for how you structure your entry trigger for futures trades compared to stock trades.
Despite this drawback, trend following in the futures markets is extremely powerful because there can be much more diversification between futures instruments than there is between stocks. This diversification can give a futures trend following system higher risk adjusted returns than a stock system because stocks tend to be so highly correlated to each other.
Forex Trend Trading:
A forex trend occurs when one currency strengthens in comparison to another currency. For example if the Australian dollar is strengthening because Australian interest rates are going up (making the currency more attractive) and the US dollar is weakening because interest rates are dropping in the US, then the AUDUSD exchange rate would likely exhibit a good trend.
Just as in stock and futures trend trading, a forex trend following system can be based solely on price movements and perform well over a long period of time. Forex trend trading systems can have the same mechanics as stock and futures systems, however, the selection of currency pairs to trade is important because of the high correlation between many currency pairs.
Generally the best forex trends occur in the USD exchange rates rather than the cross rates between other currencies. Below is an excellent example of a forex trend in the Australian dollar exchange rate (AUDUSD) that could have been traded using this strategy.
Forex Trend Trading Example: AUDUSD
How Does Trend Trading Work?
Trend trading is simply an approach in which you identify that a trend is in place, enter the market in the direction of the trend and hold the position until the trend reverses.
After entering at a low risk entry point, trend following generally uses an initial stop loss point which is fairly close to the entry point. Once a trade is profitable a wide trailing stop allows plenty of price movement before exiting a trade. This ensures you remain in the trade for the duration of the trend and don’t exit too early.
The wide trailing stops work because trends can get volatile and may move against you quite a way before rocketing off in the desired direction again. If you use too tight a trailing stop then you will be forced out of the trend and miss out on the potential profit from the big move later in the trend.
When your trend following system is right (around 30% of the time) and the trend continues, large profits are made on the trade. When the system is wrong (around 70% of the time) you exit quickly at a small loss and move on to the next trade.
Trend following systems make money overall, even with this low percentage of winning trades, because winning trades are much larger than losing trades.
Trend Trading and Risk Management
When buying trending instruments, there is a high probability that your position could reverse and hit it’s stop loss before turning into a major trend. So the win rate of a typical trend following system is between 30-50%. This means you need to be willing and able to tolerate a large number of losses when following a trend trading system.
The large number of losses combined with the long duration of major trends and the fluctuations you must tolerate as you wait patiently for your trend to grow make it extremely important to incorporate risk management in your trading strategy.
For trend trading systems risk management is about keeping your risk on each trade small so you can tolerate a long string of losses without a large drawdown.
Your positions must also be small so you can hold a highly diversified portfolio of instruments. With greater diversification there is a better chance you will catch a large trend in one of your positions. The flipside of this is if you diversify too broadly your positions will be so small that when you do catch a large trend you will not make much money.
Backtesting your trend following system and optimizing the risk per trade and the maximum exposure on each trade will help you find the sweet spot for your position size. The table below illustrates the tradeoff that risk management balances with trend following trading systems:
Trend trading has a lower initial trade risk profile than mean reversion trading systems because you are entering in the direction of a trend which is in place when you execute the trade. Mean reversion trading systems try to anticipate a change in the direction of the trend so they are often subject to “catching a falling knife” which means the positions can move a long way against you before they recover… this is usually not the case in trend following where losses can be kept small compared to the size of winning trades.
In a trend following trading system, you have clear-cut answers for questions like when to get out of a losing position or when to reap the rewards of a winning position. Remember that one of the components of trend trading is identifying your position size upon entry, which means you have a specific rule about how much you can buy or sell depending on how much money you have.
Leverage and Margins in Trend Trading
As with other kinds of trading, trend trading is possible using leverage. Through leverage, you can trade shares, forex lots, or contracts by combining a small portion of your own money with a more substantial sum of borrowed money.
Leverage allows you to trade even when your capital isn’t enough, which is why it’s expressed in ratios to represent the money you can trade based on the actual money you have. Say, you choose 100:1 leverage, it means you can increase the size of your trade up to 100 times. So, if you have approximately $1,000 in your trading account, you can trade as much as $100,000.
Of course, you’ll need a minimum amount of cash to be allowed to trade—this is called margin. The margin is usually expressed in percentage to indicate how much your brokerage firm requires from you to open or maintain a position in the trading market.
Based on the example above, you can trade on a $100,000 contract as long as you meet the 1% margin requirement of your broker. Tying these things up, the margin can help you determine the maximum leverage you can get in a particular trade.
When used properly, leverage can result in more trading activity than what you can afford if you were trading with cash alone. Unfortunately leverage is a double edged sword. It can increase your exposure and allow you to grow profits more quickly, but when you are leveraged and the markets move against you your losses mount up extremely quickly.
It’s always advisable to choose the right leverage level, which can be summed up in these rules:
- Maintain low leverage levels, which can range from 1:1 to 1:4 in stock trading, and from 5:1 to 10:1 in forex and futures trading. Your broker may give you more, but that does not make it a good idea – the risk of blowing up your account increases exponentially as leverage increases
- Use trailing stops as a way to lock in profits and to set a cap on potential downfall
- Limit the risk per trade to between 0.5% and 1% of your trading account depending on the system. The level of risk should be backtested to understand the drawdown potential and ensure you are comfortable with the level of risk assumed.
Trend Trading Can Be Emotionally Challenging:
The psychological difficulty most people have is that trend following requires you to be wrong most of the time. This can be emotionally challenging because most people have the subconscious desire to be right (this comes from our school education system which was not designed to produce outstanding traders!!!)
Trend following is practically very simple but can be emotionally challenging.
New traders looking for reassurance that they are doing well expect reassurance to come in the form of winning trades – these may be infrequent with this trading strategy. However, total profitability is what we should really be interested in, not just being right.
Can A Trend Trading Strategy Fit In With A Day Job?
YES! Trend following is a form of trading that can be learned and can fit in easily with whatever else you have in your life at the moment.
Trend trading systems require very little time each day to execute and can be run while you still have a full time job.
Once you understand the concepts and codify them into a mechanical trading system it becomes a matter of simply running your system scans each day and executing to the rules.
Trend following strategies should not involve any judgment, so assuming everything is documented properly in your trading plan the decisions are very quick to make on a day to day basis. Our major stock system takes about 30 minutes a day to execute.
What Are The Components Of A Trend Trading Strategy?
Trend following strategies are simple systems that mechanically identify when a trend is in place. The system gets you in to ride the trend as long as it remains in place. They are applied to a broad range of securities or instruments and so need to be simple and robust to work effectively.
The standard components of a trading following strategy include:
- Entry Trigger
- Initial stop loss
- Exit rules
- Money management and position size rules
Trend following strategies typically do not employ profit targets or time based exits because profits come from letting trades run and develop for as long as possible within your chosen timeframe. Profit targets and time based exits are more commonly used in swing trading and mean reversion systems.
Trend Trading Indicators
Trend traders use technical indicators to analyze the strength of a market trend and how likely that trend will continue. You should use one or more of these trend trading indicators as signals to help you determine the best time to enter and exit trend trading positions.
- Moving Averages
Moving averages are one of the most commonly used trend trading indicators. They make it easier to see the predominant market trend by smoothing out price data in a chart in a single flowing line, so that you can distinguish between actual trend direction versus mere market “noise.” This indicator takes the average closing price over a set period of time.
A moving average may be simple or exponential. Unlike the latter, the former doesn’t take spikes into account so you may see a smoother moving average line but the picture it forms is less detailed, preventing you from reacting to price movements quickly.
Moving averages are used as trend filters to ensure that a stock or instrument is actually trending before getting into the trade. For example when the price is above the 50 bar moving average and the 50 bar moving average is above the 200 bar moving average, there is little doubt that the trend is up as illustrated in the chart below:
A breakout is when a price movement goes beyond a certain trading range. When we talk about breakouts, there are three main types:
- Support / Resistance Breakouts
- Donchian Channel Breakouts
- Volatility Breakouts
Support / Resistance breakouts are the most widely discussed of the three breakout types A breakout through resistance is when the price of a stock / commodity / asset is rising and it approaches a resistance level. If the resistance level holds and the price retraces from the resistance, there is no breakout, but if the price pushes through the resistance level then the price is “Breaking Out” of the resistance level.
Conversely, a support breakout is when the price of an asset or commodity is falling and there is a level of support that tends to stop the decline. When the price moves down through the support level it is “Breaking Out” below the support level.
Support / Resistance breakouts are actually the least useful for systematic trading because they are subjective and hard to codify into a trading system. Traders using support and resistance levels and breakouts from those levels have more difficulty being consistent than traders using the other types of breakout.
The Donchian Channel breakouts are breakouts from a previous high / low range. For example a 50 bar Donchian Channel is formed by looking back over the last 50 price bars and finding the highest and lowest price over the past 50 bars. This high and low value is plotted on the chart at the current price bar. A breakout occurs when the price today rises above yesterday’s upper Donchian Channel line or drops below yesterday’s lower Donchian Channel line.
Donchian channels are much more useful in systematic trading than support and resistance because they are simple to codify, place into system rules and backtest. This approach clearly shows you when there’s a buildup of prices moving to higher highs or higher lows on intraday, daily, or weekly charts. For example, if today’s close is the highest over the last 50days, then you have a 50-day breakout.
An example of a 50 bar Donchian Channel breakout on the S&P500 chart is shown below:
The third type of breakout is the volatility breakout. This is when the price moves up or down at a rate that surpasses recent volatility levels. For example, if today’s close is more than three times yesterday’s average true range (ATR) above the previous close, then it’s considered a short-term volatility breakout. In a short-term volatility breakout system, you may choose either the day’s opening price or the previous day’s closing price as your entry trigger in trend trading.
When calculating volatility breakouts you can measure volatility by using the Average True Range indicator. . ATR refers to how much price moves outside the previous bar’s range. This is explained in detail in this post on the uses of Average True Range.
- Moving Averages: Convergence Divergence (MACD)
The MACD is an oscillating indicator—a line graph that shows fluctuation between two extremes—that measures both trend and momentum. Like the moving average, the signal line indicates the average difference between two moving averages, with a second “smoothing” line providing more details to give you a clearer picture of the trend.
A crossover of the MACD above the signal line points to an uptrend or a buy signal, but a crossover falling below the signal line may indicate a downtrend or a sell signal.
As illustrated at the bottom of the chart below, the MACD can do a good job of catching short to medium term trending moves:
- Relative Strength Index (RSI)
The RSI is one of the best complimentary indicators in trend trading, helping you track price movements over any given period. At the same time, the RSI gauges overbought (OB) and oversold (OS) conditions, which are valuable in giving warnings about potential price reversals. A stock with an RSI of 70 or more falls under the OB category, which may suggest that its current price rally is about to end, so a price decline may follow next. A stock with below-30 RSI is considered OS, suggesting that the price decline may be ending soon and give way for the price to recover.
This can be used in two ways for trend following systems. The first is as a short term timing indicator for your entry trigger. Once a trend is clearly established, entering on a short term oversold condition as measured by a short term RSI (say 5 bars) can give you an excellent entry price while the trend is still intact.
The second method of using the RSI is as a breakout condition. If a longer term RSI (say 30 bars) hits an overbought reading, this can indicate that a strong trend is in place, and stocks like this can remain overbought for quite some time as the trend continues.
- On-Balance Volume (OBV)
The OBV puts together information about trading price and volume and compiles it into a single line indicator to measure cumulative buying/selling pressure. The volume of a trading instrument with a higher closing price bar gets added to the OBV, while the volume of a lower closing price bar is subtracted from the OBV. You can then use the running total of volume to see when buyers are overcoming sellers and vice versa, which can then tell you when prices are likely to surge or drop.
Trend Trading Exit Strategies
As a trader, it’s vital that you know when to exit a trade so you can protect your capital and profit as well as cap any loss if the trade doesn’t work in your favor. Having an exit strategy is also helpful in keeping your emotions in check as you make trading decisions.
Here are some recommended exit strategies when you get into trend trading:
1. Stop-loss and take-profit
In this strategy, you give specific orders to your broker at which exact price point you want to close your losing and profitable position. The vast majority of trend trading systems use a stop loss. The key most traders don’t understand is that a wide stop loss performs much better than a narrow stop loss. This is because a narrow stop loss gets hit much more often than a wide one. This locks in a loss more often and leads to long streaks of losing trades. Wider stops give a higher win rate and smoother equity curve!
Most trend trading systems do not use a profit target because the goal of trend following is to capture big trends – you can’t do that if you cap your profits with a profit target. HOWEVER, you can often do very well if you set a very high profit target to take you out on an unusually large and fast move. This is useful because it banks the profit rather than waiting for the move to reverse all the way back down to the trailing stop loss exit point.
2. Average True Range (ATR) Initial Stop Loss
The ATR is a volatility calculator, showing you how far an asset moves on average during a specified time frame. You can use the ATR to determine when to issue a stop-loss order, which is usually placed some multiple of the ATR below the entry price. This normalises the width of the stop between instruments – stocks with higher volatility have a wider stop and stocks with lower volatility have a narrower stop as explained in this post about the Average True Range.
3. Support and Resistance
This approach involves setting a stop or limit near support (where a large number of traders are willing to buy) and resistance (where there are more sellers than buyers) levels. A rule of thumb is to set stop-loss orders slightly below the support level and slightly above the resistance level.
The difficulty with using support and resistance levels in your trend trading system is that they are very subjective and hard (impossible) to backtest properly. I much prefer to use stop losses based on Average True Range as explained above because these can be rigorously and objectively backtested to build confidence in them.
Some traders will use overhead resistance to exit trades anticipating that the trade will not be able to push through the resistance. With trend following, this is typically a huge mistake because you need to give your trend trades the benefit of the doubt. We can never predict just how far a trend will travel and exiting just because it approaches a historical resistance level will limit the size of your winning trades.
4. Trend weakness
As the name implies, you use a trend weakness as a signal to exit trade. You may, for example, exit based on moving averages—once a price crosses from one moving average line to the other, you may take it as a signal to close the position due to shifting price trends.
Exiting when the price (or a short term moving average) crosses below the long term moving average is a good trend following exit provided you use a sufficiently long term moving average (say 150-200 bars). Shorter term moving averages (say 30-50 bars) will get you out of your trade too quickly and thereby limit the size of your winning trades… resulting in lower profitability of your trading system.
5. Exiting when entry criteria disappears
This exit strategy suggests that the best time to get out of a winning trade is when the reason you’ve entered a particular position is no longer present. For example, you may have entered a position in a bullish market, but market conditions may turn bearish, so you take the change as a signal to give up trade. Since this approach is quite subjective in nature, it’s best to be cautious in relying solely on this exit method unless it can be quantified into an objective rule.
One way to do this objectively would be to exit your trade if the trend filter is no longer showing that the trend is in place. If this is true, then the trend may have finished and exiting may be a good idea.
All of these rules and ideas should be thoroughly backtested before trading them because each market and system behaves slightly differently and there is no one universal best set of trend trading rules.
Trend Trading Mistakes and How to Avoid Them
Mistake #1—Focusing only on the short-term
Trend trading requires identifying and following an established market trend, making it a long-term trading strategy rather than a short-term one. Needless to say, paying attention to short-term trends may not give you a good reward:risk ratio.
How to fix it: Go for long-term strategies that give you enough time to make profit from winning trades and bounce back from unsuccessful ones.
Mistake #2—Not understanding diversification
This is when you’d rather limit your trading to one or two well-performing stocks rather than a bigger stock portfolio, which reduces the likelihood of generating returns that exceed your benchmark.
How to fix it: Avoid allocating more than 5% to 10% of your portfolio to any one trade and holding a diversified portfolio of trend trading positions.
Mistake #3—Not understanding long/short bias
You’re in a long position when you buy/own a stock that you think will have its value increased in the future. On the other hand, you’re in a short position when you sell assets that you do not own, hoping to buy them back when the price goes down. The problem arises when you hold either too many long or too many short biases, hoping to ride the potential upside and downside in price moves.
How to fix it: Aim for the right balance of taking both long and short positions. Trend following stocks on the long side is a great strategy most of the time, but when the bull market turns it can suffer large drawdowns. The solution is to combine long side trend following with a short side system that can profit when the long side trend trading system is losing money.
Mistake #4—Ignoring market conditions
The high volatility and downward bias of most stocks in a bear market make it very difficult to profit on the long side with trend following. Continuing to buy breakouts hoping they turn into a solid long term trend while the broader market falls is usually a losing strategy..
How to fix it: Use a market filter, such as the 200-day moving average on the S&P 500, to know when the market is doing well or otherwise. Taking trend trades only in the direction of the broader market increases your chances of success and reduces your likely drawdown. As always, backtest your market filter to ensure it adds value for your system.
Mistake #5—Trading against the trends instead of with the trends
You’ll find the momentum of the market working for you when there’s historical basis for that directional movement, which is what trend trading is all about. Conversely, the push isn’t as favorable when you counter the trend since market movements become less predictable.
How to fix it: Always analyze and follow the trend in the stock or instrument you are trading using technical indicators, so you can manage your trades properly. My preferred approach is to use a trading system to define every decision that I make in my trading. A trend trading system should have a strict trend filter to ensure that you are only trading in the direction of the primary trend of the instrument. Don’t try to catch a brand new trend right at the beginning because that is a low probability trade. You will have far more success if you employ a strict trend filter that only allows you to trade once a trend has proven itself!
What Does A Successful Trend Trade Look Like?
As an example of how a trader may benefit from one of these trades, let’s say you entered Incitec Pivot (IPL – Australian stock shown in the chart above) on a 200 day breakout on 24 Dec 2006 at $0.79 with a 3 ATR initial stop at $0.75 and risked 1% of your $100,000 account on the trade. You then held the trade and used the 200 day moving average as a trailing exit point which kept you in the trade until 11 August 2008 at $6.23.
On the above trade, risking 1% of your hypothetical $100K account you would have risked $1000 on the trade, which would have allowed you to purchase 25000 shares (Number of shares = Dollar Risk / Risk per share = $1000/($0.79-$0.75)). This would give a position size of $19,750.
According to the above example, when the position was closed the shares had appreciated to $6.23 per share, giving you a total profit of $5.44 per share or $136,000 PROFIT. This translates to a 136 times return on your initial $1000 risk.
Warning: This trade is a hand picked example and is not typical. There are no guarantees you will get trades like this. However, these monster trades can come along every so often though, and this strategy is a good way to profit from them.
Trend trading systems which have the potential to capture monster trades like this one are discussed more extensively in our Trading Systems section.
What Trend Trading Software Do You Need?
To explore a trend trading strategy and ultimately develop a trend trading system, you will need a charting package, daily market data covering the markets you intend to trade and software capable of backtesting and optimizing your trading strategy.
If you are just getting started you do not have these packages, I recommend you use Amibroker to display your charts, backtest your trading system and manage your trades. Amibroker is the most powerful and best value backtesting software on the market.
If you are a more advanced trader or intend to backtest and trade multiple systems in a portfolio then consider purchasing TradingBlox. TradingBlox is a more expensive solution, but allows far more sophistication in the backtesting and optimization of your trading strategies. TradingBlox is the portfolio simulation tool of choice, but has a much more high-end price tag than Amibroker!