What is a Trend Following Strategy?

Summary:
• Almost all markets will trend and taking advantage of these trends is a popular way of trading Forex, but what is a trend following strategy? Find out now.

Almost all financial markets will trend and taking advantage of these trends is a popular way of trading Forex. The general idea behind a trend following strategy is that once a while every financial market will produce a very strong bias. The reason for the trend is typically a fundamental reason causing the price of an asset to strongly move upwards or lower. As an example, in 2014 crude oil prices were trading around 110 dollars per barrel, however, with the introduction of shale crude oil production the market was flooded with crude oil and the price had to adjust lower. Eventually, crude oil prices reached $27 per barrel. Another example is the run-up in bitcoin prices from about $2.37 per coin in 2012 to $19,825 in 2017. One benefit of a trend following strategy is that we do not need to be experts on the market in question, as the smart money creates the trends. The technical trend trader does, however, need to understand market psychology and figure out when to buy and when to exit to ensure profitability. “Smart money” is people that understand the market fundamentals very well such as key industry players, and as they enter the market with large positions they will leave large footprints in the charts such a few days of strong buying or selling. After the early smart money has bought, more smart money investors buy, followed by early trend followers, and eventually, the masses pick up the trend and get involved. At one point the price will have risen or declined to extremes and that causes the smart money to get involved once again. Ideally, a trader tries to catch a trend as early as possible to be able to maximize their returns, but they don’t want to enter too early as it easy to get involved in false trend starts. As trend trading is relatively easy to understand and implement it has gained in popularity amongst retail traders. Another reason why trend following strategies have gained popularity among trading communities is the success of traders like Bill Dunn and his “Dunn Capital Management”.  For decades, trend following traders such as Bill Dunn has been producing significant returns, all by following a relatively simple and mechanical trend following strategy. The following screenshot contains the chart of the USD/JPY pair during the year 1995

USD/JPY Trend During 1995

The aforementioned Bill Dunn managed to capture the downtrend of the pair, at the beginning of 95. He did not produce any returns during May and June of 1995, however, after the market bottomed, he caught the uptrend in July and August of the same year. Let’s analyze the chart by using some simple technical rules and find out how he was able to achieve it. The peak and trough analysis is considered as one of the most effective ways of conducting technical analysis. In this case, the price produced lower lows and lower highs all the way down and is the characteristic of a downtrend. Similarly, uptrends are characterized by higher highs and higher lows all the way up. The chart below is the same chart as above, but with some additional commentary.

Applying Commentary to identify the trends and trend reversals

As seen from the chart above, Dunn’s entry and exit points can be replicated if we analyze the lower lows and lower highs (LLs, LHs) and apply some characteristics of trend reversals. The price had been trading sideways for most of 1994, however, in March 1995 the price slid below the red line and created a new lower low, and at the same time trigger a signal to sell. The price then created a series of lower highs and lows until the prices reached 79.80. After reaching the 79.80 low the price created another higher low at 87.82 (see “A – lower high”), however, in July the price created a higher high, which was followed by what we call a bullish breakout on August 2. The bullish breakout would have been a sign of the markets heading higher and one could have bought here to ride the price towards 102. By following the above points we could have achieved similar returns similar to Dunn, which is one of the most effective aspects of trend trading. Once you’re in a trend, you can ride it as long as the price remains in a trend. In the case of retail traders looking for an easy to understand strategy then a trend following strategy offer clear entry and exit points.

Counter-trend trading strategies

Counter-trend trading strategies are also utilized by some traders, who hope to catch the price corrections experienced during uptrends and downtrends. Price corrections refer to a move against the principal trend. On the other hand, counter–trend trading has more risk potential and much less potential profits as compared to trend trading. If we examine the chart below, we will find the general bias of the market to be upwards, and the corrections are against the general upwards bias. The price corrections will be much smaller if the trend is truly upwards. The blue lines show the profit potential of trading with the trend, while the orange lines show the profit potential of trading against the trend. However, it is not as easy to find those short-term highs that will allow traders to trade against the trend and most of the time the price will trade much higher than most traders will anticipate and lose money.

Applying Commentary to identify the trends and trend reversals

Being able to identify trend reversals correctly is another major point when trading trends. The two major forms of trend reversals are shown in the chart below: A failure swing and a non-failure swing. In the case of a failure swing, the price makes a fresh lower high at point “C”. Even though we know that lower highs occur during uptrends, we still do not know whether the price will be able to make a lower low or not. Thus, the price has to break the price level at “B” in order to make a lower low and confirm the new downtrend. During a non-failure swing, however, the price immediate tends to make a lower low, demarcated by point D. Here, the sell-signal at S2 is more powerful than the first sell-signal which appeared at S1. This is because; all the building blocks of a downtrend have already been formed at point S2. It should be noted that the concepts mentioned above can also be applied to downtrend reversals, in which case, the picture should be turned upside down. If you are new to techincal anlayis, read: A Deeper Look at Technical Analysis and Multiple Time Frame Analysis

Failure Swing

Non-Failure swing

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