Following the Crowd: What is Trend Following?

In today's fast-paced and ever-changing financial landscape, keeping up with the stock market can be extremely tough.

We, as retail investors are inundated with an exorbitant amount of information and as such it maybe difficult to understand which direction the stock market is heading. A couple of years ago, I made an effort to learn about the behavior of markets and how it can be applied to every day investing, when I stumbled upon a paper by Meb Faber on trend following.

First off, if you’re like me, you’re probably asking yourself "What is trend following, and how does it apply to me?" Well today, we are going to go over trend following, its origins, and how it impact on your investment decisions.

What is Trend Following?

Before we embark on this path, I have to remind you that timing the market typically doesn’t work and you should focus more on time in the market. With that said, with regards to investing, timing is everything.

Trend following is a strategy that looks to utilize market trends (i.e. behavior) by identifying and following along with the direction of asset price.

To do it effectively, it requires analyzing historical price data and using technical indicators, like the Exponential Moving Average (EMA) or Relative Strength Index (RSI) of an asset, to determine the potential/developing market trend (i.e. behavior).

If done correctly, a trend follower can ride the wave of the market (or assets) momentum to make a profit.

A Historical Perspective…

Trend following is not a new concept; it has been utilized by traders for decades. In fact, some of the earliest trend followers can be traced back to the legendary traders of the past.

Market Wizards, written by Jack D. Schwager is a great book to read about some successful traders who often used trend following to enormous success.

Today, trend following is often thought to be extremely difficulty due to the evolution of technology and trading algorithms, however its core principles remain unchanged.

Patience is a Virtue…

If you read Market Wizards, you’ll quickly realize that to become a successful trend follower, you’ll need to be patient, adhere to rules, and not override the system you have in place.

Markets are unpredictable in the short term, but it has been shown (i.e. read the Meb Faber paper) that trends tend to remain in place over long periods of time.

As a trend follower, you need to have the patience to wait for a trend to develop and confirm its strength before entering a trade. This approach helps to filter out market noise and focus on sustained price movements.

Trend Following Indicators…

There are a number of technical indicators that can aid in identifying and confirming market trends. Moving averages, for instance, smooth out price fluctuations and are helpful in identifying the underlying trend of an asset or index.

Breakout strategies can also be used to identify significant price movements when assets break through key resistance or support levels.

There are lots of indicators and choosing the right one is up to you.

Managing Risk is Everything…

Risk management is an integral part of trend following. If you don’t know your risk tolerance, this won’t be the strategy for you.

A success trend following strategy requires limiting the risk on the downside, thus some trend followers utilize trailing stop-loss orders to protect profits and limit potential losses.

The whole goal is to keep their risks under control and not allow one trade to destroy the entire account.

You Must Adapt…

Trend following is a flexible strategy that can be applied to various asset classes and timeframes. Whether you're trading stocks, commodities, or currencies, trend following principles can be adapted to suit different markets.

Trend following can be employed by anyone. Thus whether you’re a day-trader (remember Stay the F**k Away From Day Trading) or a long-term investors (i.e. us) aiming to ride major market cycles, trend following can be a great adjunct to your portfolio.

In Conclusion…

Trend following allows you to take a rules based, disciplined approach to investing. For a retail investor, i.e. you and I, trend following can be a great addition to a portfolio. However to implement the strategy successfully in today’s technologically advanced world, you’ll likely need to invest in a fund.

It’s important to remember, that trend following is not for everyone, is sure the hell not foolproof, and comes with its own set of risks. As with any investment strategy, you need to do your own research, understand your risk tolerance, and continue to learn and adapt to the changes you uncover.

You don’t have to implement every strategy you come across, however I do believe you should at least be aware of them.