Trend following

Ride the wave

A surfer doesn't make the wave. She waits for one to start, paddles in, and rides it as far as it goes. Trend following works the same way.

The trend follower doesn't try to buy at the exact bottom. That's guessing. Instead, she waits until price proves it's moving, then joins and stays in as long as the move keeps going.

A famous experiment

In 1983, a trader named Richard Dennis made a bet with his friend William Eckhardt. Dennis said trading could be taught. Eckhardt said it couldn't. Dennis trained a small group of beginners, nicknamed the "Turtles," using simple trend-following rules, such as buying when price hit a new 20-day high. Several of them went on to make a lot of money, which helped Dennis win the argument.

An example rule set

Made up for learning, in the classic breakout style:

1. Direction: only look for buys when price is above its 50-day moving average.
2. Entry: buy when price closes at a new 20-day high (higher than any day in the last 20).
3. Stop: just under the most recent swing low.
4. Exit: no fixed target. Move the stop up under each new higher low. This is called a trailing stop. Get out when it's hit.
5. Flip everything upside down for downtrends, using short selling.

The strange math of trend following

Trend following often wins fewer than half its trades. Many breakouts are fake starts that quickly hit the stop. So how can it make money?

Because the winners are huge and the losers are small. Picture 10 trades:

• 7 small losses of $100 each: you lose $700.
• 3 big wins of $400 each: you make $1,200.

You were wrong 7 times out of 10 and still made $500. One great trend can pay for a pile of small losses.

When it works

It shines when markets make big, long moves: a stock climbing for months, or gold or oil running for a year.

When it fails

• Sideways markets. Price breaks out, falls back, breaks out again. This is called a whipsaw, and it can mean loss after loss in a row.
• Giving back profit. Because you only get out after the trend turns, you always give some profit back at the end.
• Your feelings. Losing many small trades in a row is hard. Holding a big winner without grabbing the profit early is hard too.

Before using any rule like this, it needs testing on years of old charts, across many markets. Level 8 shows how.

Remember

• Trend followers join a move after it starts, not at the bottom.
• They use a trailing stop instead of a fixed target.
• They often win less than half the time, but the wins are much bigger.
• Choppy sideways markets are where trend following hurts most.