What is Trend Following? How do Trend Followers Make Money in OctaFX
What is Trend Following?
Trend Following is a trading methodology that, seeks to capture trends across all markets, using proper risk management.
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.
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
Behind this trading methodology, lies 5 trading principles that every successful Trend Follower must follow.
Secret #1: Buy high and sell higher
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?
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.
Secret #2: Just follow price
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.
Secret #3: Risk a fraction of your trading capital
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?
If you risk 30% of your equity, you’d blow up by the 4th trade (-30 -30 -30 -30 = -120%)
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 advise risking no more than 1% per trade.
Secret #4: 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
If you want to learn more, here are 13 ways to exit your trades to reduce risk, and maximize profits.
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 a low winning rate but, high reward to risk.
Secret #5: 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 do Trend Followers make money?
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.
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.
A few examples in real life:
- Fall of Long Term Capital Management
- Destruction of Bear Stearns
- The 2008 financial crisis
These events caused investors and traders to lose tons of money. But in a zero sum game, someone loses and someone wins.
And the winner happens to be Trend Followers. This is our edge.
Different approaches to Trend Following
Trend Following can be further divided into 2 different approaches.
- Systematic trading
- Discretionary trading
Systematic trading has defined rules that decide the entry, exit, risk management, and trade management.
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.
- How much to risk
- What markets to trade
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.
So moving on…
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
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.
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.
You should be able to trade about 60 markets from these 5 sectors.
- Agriculture commodities
- Non-Agriculture Commodities
A Discretionary 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 tests” 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 consider this trading approach…
A Systematic Trend Following System That Works
- Go long when the price closes the highest over the last 200 days
- Go short when the price closes the lowest over the last 200 days
- Have a trailing stop loss of 6 ATR
- Risk 1% of your capital on each trade
- Gold, Copper, Silver, Palladium, Platinum
- SP 500, EUR/JPY, EUR/USD, Mexican Peso, British Pound
- US T-bond, BOBL, BUXL, BTP, 10-year Canadian bond
- Heating Oil, Wheat, Corn, Lumber, Sugar
The backtest results
- Number of trades: 937 trades
- Winning rate: 42.8%
- Annual return: 9.89%
- Maximum drawdown of 24.12%.
If you trade more markets, you can improve the returns and reduce the drawdown.
Now you might be wondering… “Does Trend Following work on stocks?”
Yes, Trend Following can be applied to the stock markets but with a few exceptions…
#1: Avoid shorting stocks because in the long run, the stock market is in an uptrend. Thus, it’s more profitable to remain on the long side or in cash (and avoid short selling).
#2: Have a filter to rank stocks as there are thousands of stocks available and you need to decide which ones you want to trade.
And here’s a simple Trend Following system for the stock markets…
- Go long when a stock hits a 50-week high
- Have a 20% trailing stop loss
- If there are too many stocks to choose from, select the top 20 stocks with the largest price increase over the last 50 weeks
- Buy a maximum of 20 stocks with not more than 5% of your capital allocated to each stock
- Stocks from the Russell 1000 index
The backtest results:
- Number of trades: 707 trades
- Winning rate: 48.66%
- Annual return: 12.81%
- Maximum drawdown of 40.75%.
If you add a trend filter, you can improve the returns and reduce the drawdown.
And there you have it.
A Trend Following system 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.