Jesse Livermore, the most famous trader of all time, made $100 million in 1929.
Richard Dennis, the founder of the turtle traders, made $400 million trading the futures market.
Ed Seykota, possibly the best trader of our time, achieved a return of 250,000%, over a 16 year period.
And do you know what is their trading approach?
Trend Following.
What is Trend Following?
Trend Following is a trading methodology that, seeks to capture trends across all markets, using proper risk management.
You’re wondering:
Why does Trend Following work?
The reason is simple.
Markets are driven by emotions, greed, and fear.
When either side is in control, there will be a trend, and Trend Followers can take advantage of this phenomenon.
I absolutely believe that price movement patterns are being repeated. They are recurring patterns that appear over and over, with slight variations. This is because markets are driven by humans, and human nature never changes. – Jesse Livermore
Here are a few pieces of research that further validates Trend Following:
- Studies by M Potters proves that Trend Following is profitable over the last 200 years
- Studies by Kathryn M. Kaminski validates that Trend Following thrives during crisis periods
- Following the trend by Andreas Clenow explains how hedge funds and professional traders have been consistently outperforming traditional investment strategies
Now:
Behind this trading methodology, lies 5 trading principles that every successful Trend Follower must follow.
And I’m going to reveal them to you, right now…
Buy high and sell low
Imagine:
You walk into a supermarket and you see apples being sold, 3 for $1. So, you get some apples for a nice healthy snack.
The next day…
You go back to the supermarket and, realize the same apples are now being sold, 3 for $5.
Would you buy it?
Probably not because the price is too high. You’d rather wait for the price to drop, or find other alternatives.
Now you’re wondering:
What does buying apples have anything to do with trading?
A lot.
Because your attitude towards buying apples is brought over to your trading endeavor.
Here’s what I mean…
Overbought on (USD/JPY):
Price Rally (USD/JPY):
Oversold on (EUR/USD):
More Oversold on (EUR/USD):
The takeaway is this…
The market is never too high to go long, or too low to short.
Just follow price and you’re on the path of least resistance
You want to be right.
It feels good to know you called the tops and bottoms in the market.
However, when you start making predictions in the market, it clouds your judgment, and you start losing objectivity of the markets.
This leads to fatal trading mistakes like:
- Refusing to take a loss because you want to be right
- Averaging into your losses because you can get it “cheaper” now
- Revenge trading because you want to make back your losses
Now, what should you do instead?
The best thing you can do as a trader is, just follow price.
Here’s what I mean…
Uptrend on (NAS100USD):
Downtrend on (XCU/USD):
What’s the takeaway?
If you notice the price is forming higher lows, with resistance constantly breaking, chances are it’s an uptrend. You should be looking to long.
If you notice price forming lower lows, with support constantly breaking, chances are it’s a downtrend. You should be looking to short.
Risk a fraction of your equity to allow your edge to play out
Imagine:
You have a trading system that wins 50% of the time with 1:2 risk reward.
And you have a hypothetical outcome of L L L L W W W W
It’s a profitable system, right?
It depends.
If you risk 30% of your equity, you’d blow up by the 4th trade (-30 -30 -30 -30 = -120%)
But…
If you risk 1% of your equity, you’d have a gain of 4% (-1 -1 -1 -1 +2 +2 +2 +2 = 4%)
Having a winning system without proper risk management isn’t going to get you anywhere.
You need a winning system with proper risk management.
And not forgetting…
The recovery from the risk of ruin is not linear, it could be impossible to recover if it goes too deep.
If you lose 50% of your capital, you need to make back 100% to break even. Yes, you read right. 100%, not 50%.
That’s why you always want to risk a fraction of your equity, especially when your winning ratio is less than 50%.
So, how much should you risk exactly?
This depends on your winning ratio, the risk to reward, and your risk tolerance. I would advise risking no more than 1% per trade.
And a quick training video on how to determine your position size…
No profit targets so you can ride massive trends
Although trend followers have no profit targets, it doesn’t mean we don’t exit our trades.
We exit our trades using a trailing stop mechanism, instead of having a profit target like support & resistance etc.
Here’re a couple of examples…
Support take profit on (UKOIL):
Trailing stoploss on (UKOIL):
Resistance take profit on (XAU/USD):
Trailing stoploss on (XAU/USD):
Some ways to trail your stop loss are:
- Moving average crossover
- Price closing beyond moving average
- Break of price structure
- Break of trendline
- Number of ATR away from the peak/trough
The hardest part about Trend Following is riding your winners. Because you’ll watch many small wins turn into losses while attempting to ride the trend.
This results in low winning rate but, high reward to risk.
Trade all markets to increase your odds of capturing trends
Markets spend more time ranging than trending. Thus, it makes sense to look at a variety of markets, to increase your odds of capturing trends.
Trend followers trade everything from currencies, agriculture, metals, bonds, energy, indices, orange juice, pork bellies, etc.
If you recall, most major currencies were ranging during the 1st half of 2014…
But if you looked at more markets, you could capture a trend…
Low volatility on (EUR/USD):
Low volatility on (AUD/USD):
Decent volatility and trend on (DE10YBEUR):
Decent volatility on (SPX):
What’s the key takeaway?
Trading across different markets help reduce your drawdowns and improve your profitability.
And this is one of the biggest secrets behind a trend follower’s success.
Now, you’re probably wondering:
How does Trend Following have an edge in the markets?
Imagine this:
A company called Orange has been trading higher over the last 6 months.
Orange currently trades at $100 and you think it’s overvalued. You decided to short 1000 shares of Orange, at $100 with a profit target at $90, using no stop loss.
You apply this trading principle across all markets you’re trading. A small profit target with no stop loss.
What do you think will happen?
You’ll win often but, eventually, there will be a trade that goes against you, till you blow up your trading account.
Now imagine…
What if I’m on the opposite side of your trade?
I would lose often but, all I need is one trade to make it all back, and more.
And this is the same trade that caused you to blow up your account.
Different approaches to Trend Following
Trend Following can be further divided into 2 different approaches.
- Systematic trading
- Discretionary trading
Systematic trading
Systematic trading has defined rules that decide the entry, exit, risk management, and trade management.
It requires usage of computer models, trading based on technical analysis, with limited intervention.
This approach is widely adopted by big hedge funds like Dunn, Winton, and MAN AHL.
Although systematic trading is automated, there are still key decisions that a manager has to make.
Decisions like…
- How much to risk
- What markets to trade
The manager has to decide how much risk to accept, which markets to play, and how aggressively to increase and decrease the trading base as a function of equity change. These decisions are quite important—often more important than trade timing. – Ed Seykota
Discretionary trading
Discretionary trading has lesser defined rules that decide the entry, exit, risk management, and trade management.
It requires a trader’s attention, trading based on technical analysis, with more intervention.
This approach is widely adopted by smaller individual traders.
Although discretionary trading is more subjective, it is still guided by a trading plan.
Does Trend Following work on stocks?
According to research by Blackstar Funds, Trend Following can work well on stocks.
Buying stocks at new all-time highs, and exiting them after they’ve fallen below a 10 ATR trailing stop, would have yielded a significant return on average.
Trend Following trading strategy
Now you’ve learned the 5 secrets of Trend Following. Let’s put the information to use and develop a trading strategy.
To develop a Trend Following strategy, it needs to answer these 7 questions:
- Which time frame are you trading
- How much are you risking on each trade
- Which markets are you trading
- What are the conditions of your trading strategy
- Where will you enter
- Where will you exit if you’re wrong
- Where will you exit if you’re right
Timeframe
You must choose a time frame that suits your personality and schedule.
If you’re someone who holds a day job, trading the 4 hour and daily charts would suitable.
Risk management
You must risk a fraction of your equity on each trade to survive the inherent drawdowns. Keep your losses to no more than 1% on each trade.
Markets universe
You should be able to trade about 60 markets from these 5 sectors.
- Agriculture commodities
- Currencies
- Equities
- Rates
- Non-Agriculture Commodities
Trend Following Trading Strategy
If 200ma is pointing higher and the price is above it, then it’s an uptrend (trading conditions).
If it’s an uptrend, then wait for “two test” at the dynamic support (using 20 & 50-period moving average).
If price test dynamic support twice, then go long on the third test (your entry).
If long, then place a stop loss of 2 ATR from your entry (your exit if you’re wrong).
If the price goes in your favor, then take profits when candle close beyond 50ma (your exit if you’re right).
Vice versa for a downtrend.
Here’re a few examples…
Winning trade on (XAU/USD):
Winning trade on (UKOIL):
Losing trade on (AUD/USD):
If you prefer less subjectivity in your trading, then you can consider trading a…
Trend Following Trading Rules
In his book, Following the Trend, Andreas Clenow reveals his Trend Following system.
If 50 ema is above 100 ema, then look to go long.
If you’re looking to long, then wait for the price to close above the 50-day high.
If price closes above the 50-day high, then enter your trade at the next open.
If a trade is entered, then have a stop loss of 3 ATR away from its peak reading.
Vice versa for shorts.
An example:
Guidelines
- Do not shift stop loss to break even. You either get stopped out on the initial stop loss or the trailing stop loss
- Trade as many markets as possible with low correlations
- Risk no more than 1% of your equity on each trade
- Continue trading even if the price has “tested” the zone many times
These are not hard and fast rules. Some considerations you can ask yourself:
- Do you wait for “confirmation” before entry
- How do you exit your trades
- What time frames are you trading on
- Which markets are you including in your portfolio
And there you have it.
A complete Trend Following strategy that allows you to profit in bull & bear markets.
To be honest, the strategy is least of your concern. Instead, you should focus on your risk management, markets universe and trading consistency.
**Disclaimer: I will not be responsible for any profit or loss resulting from using these trading strategies. Past performance is not an indication of future performance. Please do your own due diligence before risking your hard earned money.
So, what’s next?
You’ve just learned what Trend Following is all about.
Now it’s time to put these techniques into practice.
“If you don't find a way to make money while you sleep, you will work until you die.”
- Warren Buffett
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