Trend Following Trading Strategy
Trend Following Trading Strategy
Trend following is a strategy to capture a directional (rallying or declining) movement of a given market. Managed futures funds are historically known for using trend following, but it can be applied to any asset class with a directional move, and it is often systematic. Trend following should not be confused with market timing, as market timing may include fundamental inputs, and market timing may not involve trend following. Market timing could be more discretionary or some hybrid combination of systematic and discretionary.[1]
Introduction
Conceptually, trend following attempts to capture a portion of a market move instead of trying to capture market tops and bottoms, which anticipates a continuing trend. The strategy often contains risk management techniques such as a stop order to close the position if the market stops trending in the same direction and either reverses direction or moves into a range-bound market.
The strategy may miss the beginning of a move in order to increase the probability of a trend occurring. If a trader enters into a developing trend position too early, it could increase the probability of a false signal. Trend following is derived from a basic perspective of buying into strength and selling into weakness. Trend followers tend to be reactive to market movements instead of predictive of market movements.
Background
Trend following entails long and short positions as a market moves higher or lower. This strategy is often systematic, therefore a change in the data input is required for the trading strategy to indicate a buy or sell signal. Trend following signals are often derived from a price movement but may include other input variables.
The concept of trend following is not new. The English Political Economist David Ricardo (1772-1823), also known for his trading skills, had three market principles. Two of the principles discussed the idea of trend following, and they were: 1) Cut your losses short and 2) Let your profits run.[2] Those two rules are usually considered the tenet of trend following. Mackay (1841)[3] discusses various trends that occurred in prior centuries.
Details of Trend Following
Trend signals may be derived from various sources such as technical analysis or quantitative analysis or simply the market price exceeding a certain price threshold above or below a given lookback period (i.e., 30 days). For example, when a market breaks above a high of the last 30 days, a buy signal may be generated. Alternatively, when price breaks below the low of the last 30 days, a sell signal may be generated. This is sometimes known as a breakout model. In its basic concept, trends are a directional move after the market has traded sideways for a period of time, therefore “breaking out” of non-directional trading.
Trend following is also known as a momentum strategy as momentum, or market force of buyers or sellers, will move the market higher or lower. Momentum in physics is defined as having “magnitude” (strength or energy) and “direction”.[4] Market momentum is similar as it contains a force or strength and a direction.
Academic literature discusses market momentum. Jegadeesh and Titman (1993)[5] analyze momentum of the equity markets. Moskowitz, Ooi, and Penderson (2012)[6] examine momentum of the futures markets.
Momentum can be argued as a reason for the theoretical concepts of perfect arbitrage to have its limits, as markets can trend for extended periods of time, thus violating arbitrage theory. As a side note, limited arbitrage is a central theme of behavioral finance.[7]
Trends can be parsed into three categories: 1) A major trend is considered greater than a year. 2) An intermediate trend lasts about one to six months. 3) A minor trend is less than one month.[8]
Risk Management in trend following may be similar to systematic trading in that it may include stop-loss orders, profit targets and/or adjustment of position size.
Advantages and Disadvantages of Trend Following
Trend following has multiple advantages. Similar to systematic strategies, it tends to remove the emotions of trading and is usually based on a rules-based methodology, thus allowing the strategy to be back-tested. Trend following also allows for diversification, as the strategy may be applied to multiple markets and asset classes. Disadvantages of trend following include false signals when a trend is developing with initial market momentum, followed by the disappearance of a trend, which can lead to moments of “choppy” returns with several back-to-back false signals.
[1]Black, K. H., Chambers, D. R., & Kazemi, H. (2012). CAIA Level II: Advanced Core Topics in Alternative Investments. Hoboken: John Wiley & Sons.
[2] http://www.michaelcovel.com/2011/04/21/david-ricardos-golden-rules-trend-following-in-the-1700s/
[3] Mackay, C. (1841). Memoirs of extraordinary popular delusions. London: R. Bentley.
[4] https://www.britannica.com/science/momentum
[5] Jegadeesh, N., & Titman, S. (1993). Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency. The Journal of Finance, 48(1), 65-91.
[6] Moskowitz, T. J., Ooi, Y. H., & Pedersen, L. H. (2012). Time series momentum. Journal of Financial Economics, 104(2), 228-250.
[7] Shore, M. (2021). Large Hedge Funds vs Small Hedge Funds: Is Asset Size an Allocation Variable to Consider? Working Dissertation.
[8] Murphy, J. J. (1999). Technical analysis of the financial markets: A comprehensive guide to trading methods and applications. New York: New York Institute of Finance.
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