WHAT CAN WE LEARN FROM TREND FOLLOWERS?

I use a multi-strategy approach primarily due to my belief that no two market environments are ever the same.  What works in one bull market or bear market will not necessarily work in the next bull and bear market.  A multi-strategy approach increases the likelihood that some portion of my portfolio will always be hitting on all cylinders.  There truly is no holy grail in the investment world – not buy and hold, not merger arb, not event driven, etc.  This is why trading requires a great deal of flexibility and an ability to conform and adapt to new environments.

Few strategies represent this flexible and adaptive approach better than trend following.   Of course, I’m not a pure trend follower, but there are components of trend following in my strategies. I’ve learned an enormous amount from studying the rules and components that comprise a trend follower’s approach. What exactly is trend following you ask?  We refer to Michael Covel, the premiere expert on Trend Following for the answer:

“Trend trading is reactive and systematic by nature. It does not forecast or predict markets or price levels. Prediction is impossible! Trend trading demands that you have strong self-discipline to follow precise rules (no guessing or wild emotions). It involves a risk management system that uses current market price, the equity level in your account and current market volatility. Trend traders use an initial risk rule that determines your position size at the time of entry. This means you know exactly how much to buy or sell based on how much money you have. Changes in price may lead to a gradual reduction or increase of your initial trade. On the other hand, adverse price movements may lead to an exit for your entire trade.”

Many of the ideas above will sound familiar to regular readers.  Although I don’t necessarily agree with the idea that markets are unpredictable I do believe the rules taught in trend following are vital components behind any good trading strategy.  Having rules, learning how to position size, understanding money management and learning risk management are instrumental in achieving success in any market.

Trend followers also understand the importance of psychology in markets.  As I’ve previously described, a market is the summation of the decisions of its participants.  Markets are inefficient because the participants are inefficient.  The participant with superior emotional control has a decisive advantage:

“Trend trading is not a Holy Grail. It is not some passing fad or hyped-up secret black box either. Beyond the mere rules, the human element is core to the strategy. It takes discipline and emotional control to stick with trend trading through the inevitable market ups and downs. Keep in mind though, Trend Followers expect ups and downs. They are planned for in advance.”

Based on the above core beliefs trend followers implement their strategies based on four primary components.  Covel elaborates:

Price: One of the first rules of trend following is that price is the main concern. If a market is at 60 and goes to 58, 57, 53 – the market is in a down trend. Despite what every news show might predict, if the trend is down, stay with the trend. A trader need only be concerned with what the market is doing, not what the market might do. The price tells you what the market is doing. Think about Bear Stearns, Lehman Brothers, WaMu, IndyMac, AIG, Fannie Mae, Goldman Sachs – didn’t their down trends tell you all you needed to know? Did you fall for the nonsense that they would all bounce back?

Money Management: The most critical factor of trend following is not the timing of the trade or the indicator, but rather the determination of how much to trade over the course of the trend.

Risk Control: Trend following is grounded in a system of risk control and money management. The math is straightforward and easy to learn. During periods of higher market volatility, your trading size is reduced. During losing periods, positions are reduced and trade size is cut back. The main objective is to preserve capital until more favorable price trends reappear. Cutting losses is the way to stay in the game.

Rules Rule: Trend following should be systematic. Price and time are pivotal at all times. Trend Following is not based on an analysis of fundamental supply or demand factors. Trend Following does NOT involve seasonals, point and figure, Market Profile, triangles or day trading.

Trend Following answers these critical questions:

1. How and when to enter the market.
2. How many contracts or shares to trade at any time.
3. How much money to risk on each trade.
4. How to exit the trade if it becomes unprofitable.
5. How to exit the trade if it becomes profitable.

Obviously, trend following on its own isn’t a holy grail, but the rules and lessons in a trend following approach are vital to investment success.  The most famous examples of trend followers were the “Turtle Traders” who made the strategy mainstream.  Legends such as Boston Red Sox owner JW Henry have made the strategy and its lessons a must know.   They proved that great traders aren’t born, but can be taught.  Learning these vital rules and lessons that comprise a trend following strategy are instrumental in formulating your own successful investing approach.

For more info on trend following and its influence please see here.