Trend following is one of the more popular approaches to trading employed by money managers who trade primarily in the futures markets. It is also an approach employed by some hedge fund managers who trade in equities.
With that in mind, I thought I would provide a primer on this important concept, as I feel it is one of the best ways for the average investor to build wealth in the markets.
Trend following and the futures markets
Systematic trend following is the strategy most commonly used by the longest running commodity trading advisors (CTAs).
One of the most famous of these traders is John W. Henry, owner of the Boston Red Sox. Henry managed client funds from 1982, until closing his shop at the end of 2012.
Probably the most famous futures trading strategy of all time, the Turtle Trading System, taught by trading legends Richard Dennis and William Eckhardt, is also a trend following strategy.
The concept of trend following simply means that you buy strength and sell weakness.
In the futures markets, this approach was developed to exploit the few large trends in these markets that occur from time to time within the larger context of generating long term, positive absolute returns.
The primary issue with this approach to trading futures is that, when the markets are not trending, these strategies will lose money.
In an effort to generate more consistent returns then, CTAs will employ trend following strategies of varying length to capture long, medium and short term trends.
This weekly chart of crude oil futures going back a couple of years is a prime example of the types of trends that trend followers seek to exploit.
Purple Valley Capital, Inc. is a Commodity Trading Advisor that exploited the trends in crude oil and other futures markets resulting from the Covid-19 pandemic in 2020 and in the early part of 2021.
They generated returns of nearly 200% for their clients in 2020, and were up over 70% through May 2021.
The difficulties of trend following
Trend following generates excellent returns over the long run, but it is a difficult strategy to employ for a number of reasons.
First of all, the majority of the trades end up as losses.
The typical trend following strategy will have only 30% to 40% winning trades. This makes it psychologically difficult for most people to employ a trend following strategy.
Secondly, while most trend following strategies lose when there are no trends, they also lose when big trends peak or bottom, since these strategies NEVER exit positions at the absolute high or low of a long term move.
As a result, the peak to valley drawdowns can be substantial.
Finally, trend following strategies generally require a sizable amount of capital to trade in order to maintain risk at appropriate levels.
Trading this type of strategy with too little money increases the risk of ruin substantially.
This chart of the Japanese Yen over the last couple of years is an example of the difficulties of trading a trend following approach.
Choppy markets such as this produce numerous losing trades.
Basic Trend Following Strategies
There are three basic trend following strategies employed by professional commodity trading advisors and private trend following traders. These include moving average strategies, channel breakouts and reversals off highs and lows.
Simple Moving Average Strategy
The simple moving average strategy produces involves a single moving average. The trader is always in the market, long or short. Signals are generated with price moves above and below the moving average.
This chart of the Corn market demonstrates a simple moving average cross system.
When price rises above the moving average, the trader covers his short position and goes long. When price crosses below the moving average, the trader exits his long position and sells short. As I mentioned, this strategy is always in the market, either long or short.
Dual moving average strategy
In this example, the trader covers a short position and goes long when the 50 day moving average moves above the 100 day moving average, and exits the long position and enters short when the 50 day moving average falls below the 100 day moving average.
Triple Moving Average Strategy
In this example, we have a 50 day moving average (red line), a 100 day moving average (blue line) and a 200 day moving average (green line).
Trades are only taken in the direction indicated by the 200 day moving average.
If the faster moving averages are above the 200 day average, then only buy signals are taken.
On this chart, a bearish cross of the two faster averages is seen in May, but both averages are above the 200 day average, so the signal is ignored.
This is followed by a bullish signal in June. When they cross again, the long position is exited.
Reversal Trend Following Strategy
The Reversal Strategy is one that is always in the market, long or short.
John W. Henry and Bill Dunn are known to have used Reversal Strategies as their core strategies,
A reversal strategy simply exits and short position and goes long when a market rises X% off its recent low price. It will exit a long position and go short when a market falls X% off a recent high price.
This is a very long term trend following strategy intended to hold positions for six months or more.
Dunn Capital Management achieved a 51% return in 2008, largely because of these moves in Crude Oil. They made substantial profits in the uptrend, and then reversed course as the market sold off.
Donchian Channels
Donchian Channels were developed by Richard Donchian, known as the “Father of Trend Following.” He was a pioneer in the field of managed futures.
His basic strategy, known as the Donchian rule, was to buy 4 week breakouts to the upside and sell 4 week breakouts to the downside.
This chart demonstrates a series of 4 week, or 20 day breakouts. The first couple at the left hand side of the chart result in losses.
The third trade results in a sizable winning trade, as it captures a significant uptrend in crude oil.
The last trade exits the long position and enters short. It then captures a substantial portion of the downtrend that occurred later in 2008, as seen in the previous Reversal trade example.
Other trend following strategies include the use of Bollinger Bands, regression channels, envelopes, etc.
Generally speaking, in the world of commodity trading advisors developing trading systems for their own use, complex strategies are uncommon.
The more complex a strategy may be, the less robust it is likely to be in the long run.
What these advisors typically do is employ several different trading strategies that offer different trading signals in an effort to capture trends of different length.
Trend trading and stocks
The stock market also offers opportunities to employ a trend following approach. While it is possible to trade both long and short, I believe it is best to simply stick with the long side.
One of the more popular trend following strategies for trading stocks is the CANSLIM strategy described by William O’Neil in his book “How to Make Money in Stocks.”
O’Neil, the founder of Investors Business Daily, employed both fundamental and technical analysis in this strategy. His preferred entry was to buy when a stock was making a fresh 52 week high out of a base structure of at least seven weeks in length.
Nicolas Darvas described another trend following approach in his book, “How I Made $2 Million In The Stock Market.”
Darvas focused on very high momentum stocks, and would simply enter long after a brief pause.
Mark Minervini, who was featured in Jack Schwager’s book “Stock Market Wizards” still employs a trend following approach that garnered him several consecutive years of 100% returns during the 1990’s bull market.
This weekly chart of TSLA is a classic example of a massive trending move that can occur in individual stocks.
These moves can be exploited with longer term and shorter term trend following strategies.
Final Thoughts on Trend Following
As I mentioned, I believe trend following is one of the best trading approaches for the average investor to build wealth in the markets.
However, unlike the money managers I discussed previously, I believe it is better to trade concentrated positions rather than to systematically trade a very diverse portfolio.
To do this requires a more discretionary approach, similar to that employed by Darvas, O’Neil and Minervini in the stock market.
In fact, the Turtle Trading System is actually a discretionary trend following approach as well.
I’ll continue to touch on this subject down the road.
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