Trend following is one of the most popular trading styles because of its effectiveness and profitability, aside from its straightforward technique.
Several traders in the financial market have applied this technique and achieved great success.
However, to get desired results, you’ll need discipline, patience, thorough research, and most importantly, a risk management system to get desired results. This is because trend following is a strategy for making gains in the long term.
Furthermore, you can apply the trend following technique in different trades such as cryptocurrency and forex. In this article, we’ll take a look at what trend following is, how it works, as well as the pros and cons of using this strategy.
What is “Trend Following” and How Does It Work?
Trend following is a trading style that helps you take advantage of the different market scenarios. Primarily, this strategy involves riding the trends by buying an asset when it seems to be appreciating and selling it off when it begins depreciating.
As such, this strategy demands that you closely monitor the existing trends while keeping an eye out for emerging trends.
Trend following works by identifying when there’s a trend, entering the market in the direction of that trend, and holding that position until that trend reverses.
Does Trend Following Work?
The trend-following strategy works most times, but you’ll need:
- A basic understanding of trends and how they work.
- A means of identifying when there’s a trend in place – you can use common market indicators like Morning Averages, Bollinger Bands, Moving Average Convergence Divergence, On-Balance-Volume, Relative Strength Index, etc. These indicators analyze the strength of a trend and the probability of that trend continuing.
- A low-risk entry point.
- An initial stop loss point. This ensures that you exit the trade quickly if the market works against you.
However, it is essential to note that the trend-following strategy does not work every time, even after following all the rules. So, if you intend to use this strategy, you need to have a high-risk tolerance. You must be willing and ready to tolerate several losses when using this system.
Nonetheless, you can make huge profits when your trend-following strategy works. These gains typically make up for those losing trades.
Advantages of Trend Following
Seeing how popular trend following is, it’d be a surprise if there were no benefits to the strategy. Some of the advantages of trend following include:
Lower transaction costs: Since this strategy is a slow-paced trading style, you never have to worry about transaction costs. Unlike other trading styles, like day trading, which has transactional costs that can make some strategies untradable.
Huge profits: If you’re right about a trend, you can make a significant profit that’ll cover past losses.
You can cut losses as soon as possible. Once you notice a downward trend in the market, you can quickly exit the trade.
Disadvantages of Trend Following
Regardless of how good this choice of strategy is, it’s essential to know that trend following has its downside. These cons include:
- Trend following is time-consuming. You’ll need to pay close attention to the market at all times. It not only requires time, but you’ll also need discipline, as well as mental and emotional commitment. This strategy is very different from passive investing.
- It can be challenging to catch the beginning of a new trend. Since the market moves in a volatile manner, it’s difficult to time the start of a trend cycle. As such, you may experience a ton of false signals.
- Market trends are typically few. It only trends about 20% of the time. More often than not, the market moves chaotically. Therefore, you’re likely to experience more losing trades than winning ones.
- Trend following is risky. Even if you try to keep your losses small, an accumulation of several losses equals one big loss.
Bottom Line
Trend following isn’t for everyone. With many losses, the lengthy period of major trends, and the fluctuations you’ll need to tolerate while waiting for your trend to grow, it’s essential that you incorporate risk management when trend trading.
This would help you minimize your risk on each trade so that you can tolerate a long series of losses without a huge drawdown.
We provide you with all the information you’ll need for financial planning and investment allocation at the art of financial planning. We can also work with you to manage your risks as you invest. Contact us now.
