Last Updated on June 11, 2021 by Oddmund Groette
Trend following is popular, especially in the commodity markets, and we aim to shed some light on this type of investing.
In this article, we take a deeper look at what trend following is. Do trend following systems work? Which markets do trend following strategies work on? Is trend following complicated? We discuss the performance of six specific trend following strategies, and end the article by looking at the pros and cons of trend following.
What is trend following?
Trend following is when you try to capture extended moves in the financial markets, either up or down. Once in a while prices tend to keep on going (enduring) and these are the moves trend followers like. The aim is to capture most of such moves, not all, but the majority of them.
Trend followers are not trying to predict tops and bottoms. They are not trying to predict anything, really. The aim is, quite simply, to take advantage of moves in different asset classes in the anticipation that some of the positions go their way big time. There is zero forecasting involved.
Trend followers might use different time frames and many asset classes to diversify in order to avoid big drawdowns. Having different strategies is important for a trend follower.
What is a trend?
Trader Joe might argue recent price action is a longer-term mean reversion, while Jim sees a trend. This illustrates the complexity of trading:
There is no exact universal definition of what a trend is. This is what a market is all about: a meeting place of different opinions and goals.
Does this mean that it’s futile to look for trends? No, there are many ways to define trends. It’s all about rules and time frames:
How to identify a trend:
Many like to draw trendlines to define the trend. They pick bottoms or tops in the chart and draw lines between these. As long as the price is following the trendline, the trend is intact. When the price breaks out of the trendline, the trend is broken.
We used the same technique some 20 years ago but found out this involves more hindsight than predictions. If you have success with it, congratulations, but this is not something we recommend. We believe a trend needs to be quantified:
A trend needs to be quantified (how to define a trend):
This website is all about quantifying numbers and statistics, and trend following is no different. A trend needs to be objectively calculated by specific rules.
For example, in the book The Four Cardinal Principles of Trading, one of the traders interviewed defined trends by how using an x-day moving average of the high. If the close was above the moving average, the trend was up until the close was below the x-day average of lows (the trend reversed). Pretty simple stuff.
Likewise, in the stock market, many define the trend by using the 200-day moving average of the closing. If the price is above the average, the trend is up and vice versa.
Paul Tudor Jones once said that the 200-day average is like playing defense. Trading is about survival, and the 200-day moving average takes you out of trouble frequently: you are unlikely to get a huge drawdown, but you are frequently stopped out.
What is a trend following strategy? What is the best trend following systems?
Obviously, a trend following strategy is one that is trying to capture a major move up or down in a financial asset. Some of the original Turtle Systems (the famous Turtle Experiment by Richard Dennis in the 1980s) were republished in Curtis Faith’s Way Of The Turtle:
ATR Channel Breakout strategy
This is a breakout system based on volatility. A seven ATR is added to the 350-day moving average of the closing prices, and three ATR is subtracted the 350-day moving average. A long position is initiated on the open the day after a close above the channel, and a short position if the close is below the channel.
Trades are closed when they end up below (or over if short) the 350-day moving average.
Bollinger Channel Breakout strategy
A channel is formed by adding a band of 2.5 standard deviations to the 350-day moving average. A long trade is entered on the open if the previous day’s close exceeded the top of the channel. A short trade is entered if the close is below the bottom band. This is completely the opposite of what a mean reversion strategy would do.
Positions are closed when they cross the moving average.
Donchian Trend strategy
The Donchian trend system has two components: the trend filter requires the 25-day exponential moving average to be above the 350-day moving average. If the trend is up and the close sets a new 20-day high, a long position is initiated on the open the next day (vice versa for short).
This system uses a 2 ATR stop.
Donchian Trend with Time Exit strategy
This system uses the original Donchian rules but the exit is based on time: an exit is after 80 days without using any stops whatsoever.
Dual Moving Average strategy
As the name implies, the system uses two moving averages: a 100-day moving average and a 350-day moving average. This system is always in the market. Long when the shorter moving average is above the long moving average and vice versa.
Triple Moving Average strategy
This system uses three moving averages: 150, 250, and 350-day moving averages. Buy and sell occurs when the 150-day moving average breaks above and below the 250-day moving average. The 350-day average is used as a trend filter: Trades happen only when both moving averages are on the same side as the longer 350-day average. If both are higher, long trades are permitted. If both are lower, only short trades are permitted.
The results are in
Curtis Faith did a backtest on all the above strategies on a sample of markets:
- Australian dollar
- British pound
- Canadian dollar
- Crude oil
- Feeder cattle
- Heating oil
- Unleaded gas
- Japanese yen
- Mexican peso
- Natural gas
- Swiss franc
- Treasury notes
- Treasury bonds
Notice that he didn’t include the S&P 500 in the backtest. All the above assets were backtested via futures contracts. Some markets were eliminated due to correlation. Curtis Faith was risking 0.5% of the equity per trade. The test period was 1996 until the end of 2006.
How did the strategies perform? Let’s summarize:
- ATR CBO: 49.5% CAGR, 39.9% drawdown
- Bollinger CBO: 51.8% CAGR, 34.1% drawdown
- Donchian Trend: 29.4% CAGR, 36.7% drawdown
- Donchian Time: 57.2% CAGR, 43.6% drawdown
- Dual MA: 57.8% CAGR, 31.8% drawdown
- Triple MA: 48.1% CAGR, 31.3% drawdown
Before you start applying trend following strategies: remember that this is futures contracts, and that involves leverage. Moreover, the drawdown is big and this is a type of trading that suits very few traders: only two systems had a win ratio above 50%: Bollinger CBO and Donchian Time.
Unfortunately, Curtis Faith doesn’t write anything about how these strategies would perform together as a portfolio.
The best system measured in CAGR, the Dual Moving Average system, had a win ratio of only 39%! This makes the system very hard to trade for most of us.
What were Curtis’ main takeaways?
- Time-based exits are probably better than anything else.
- An entry that has an edge can account for the entire profitability of a system.
- Breakouts have probably lost some of their effects over time. Curtis calls this the trader effect (discussed below).
- The Dual Moving Average system performs better than the Triple Moving Average system, indicating simplicity trumps complexity.
- Stop-losses don’t improve performance, quite the contrary.
Do trend following strategies work? Is trend following profitable?
The observant reader easily spots the simplicity of the above-mentioned strategies. Can really something so simple work? Isn’t the markets extremely complex?
That is exactly the point and might explain why they are working, presumably decade after decade. No strategy can ever capture all the variables determining moves in the market, and hence it makes sense to make things as simple as you possibly can.
Curtis Faith’s results show that very simple systems can work extremely well in a wide range of markets. Because of their simplicity, we most likely can expect them to continue working in the future. The systems only require one element: movement.
Some weeks ago we tested trend following on the gold price and the S&P 500, which supported Curtis Faith’s results:
Trend followers like to keep things simple:
A back of an envelope algorithm is often good enough to compete with an optimal formula, and certainly good enough to outdo expert judgment.
Micheal Covel made the statement above in his best-selling book about trend following. We believe he nailed it. The best thing with trend following is the magic that even “naive” systems seem to generate very good results.
Robust trading systems should be simple. This is not a contradiction, quite the opposite. You want systems that can handle the unpredictable, not a system that is fitted to a certain market regime.
The best way to make a robust system is to simplify and diversify. We have both covered the importance of that in previous articles:
Curtis Faith stresses the importance of simplicity. The logic is simple: in times of change complex species are more likely to die off. At those times, the hardiest species are those which are very simple, for example, viruses and bacterias. They are less dependant on their surroundings. In trading, if you have a complex system, you are more likely to face difficulties the bigger the market change.
It’s easy to become a victim of market noise. There is an abundance of info, bells, whistles, indicators, commentaries, expert opinions, movement, etc. that make you deviate from your original plan. A simple strategy can help you rise above all the unnecessary market noise.
But if trend following is so “simple”, why doesn’t it get “arbed” away?
Why do trend following strategies work? Why isn’t the strategies “arbed” away?
Anything that repeats with enough consistency is likely to be noticed by several market participants. Similarly, a strategy that has worked especially well in the recent past is likely to be noticed by many traders. However, if too many traders start to try to take advantage of a particular strategy, that strategy will cease working as well as it did previously.
Curtis Faith mentions something he calls the trader effect in chapter eleven of his book. The quote above is this effect – strategies get “arbed” away.
However, despite being simple, trend following strategies are not easy to follow.
Why are trend following systems hard to follow?
Trend following often experience many whipsaws that feel like “bleeding to death”. Most humans want the pleasure of winning frequently, and most of us prefer many small winners instead of occasionally “lump-sum” big gains. Read more below under “pros and cons”.
What markets trend the most? What are the best trending markets?
Trend followers are mainly looking to capture big moves. Some markets are more prone to sudden and volatile moves than others. For example, the commodity market is most likely best suited for trend following, and we would also like to add the forex market which tends to go in directions for months.
The list provided by Curtis Faith above should guide you to the best markets.
What are the best indicators for trend following strategies?
Which is the best trend indicator? That is a tough question to answer. However, you don’t need any fancy tools to determine the trend. As you’ve probably discovered by now, the very simple moving average is a great tool for trend following:
The great advantage of a moving average is its simplicity.
However, there are other tools in the arsenal you can use:
How do you create a trend following system?
Creating a trend system is not much different than developing or building other trading systems. The same logic applies to all of them: to make a good entry, to have a proper exit, and you might want to have a stop-loss, although most trading systems work better without stops.
However, capturing trends is not so much about making a perfect entry and exit. The main aim is to capture big moves, not noise and minor fluctuations. This leaves room for margins because you are not occupied with catching tops and bottoms, which many traders seem to be concerned about.
Tops and bottoms are only clear in hindsight. Forget the tops and bottoms and focus on the big picture.
The cons of trend following strategies (disadvantages)
Trend following is not like magic and has its disadvantages. It’s not a magical system that makes money without any downside. Trend following does not produce stock-like returns with bond-like risk.
Even though the performance of a trend-following strategy seems to be better than that of its buy-and-hold counterpart, there are several caveats:
Trend following is prone to sudden reversals
You might take on a position and it slowly ticks your way, until it one day suddenly reverses and heads down. When trend followers then sell their positions, the sell-off is exacerbated and volatility increases even more.
Trend followers get whipsawed a lot
Markets spend a lot of time going nowhere and you must expect to find yourself “stopped out” frequently. Sometimes this feels like bleeding slowly to death. This is probably the number one reason why most traders give up trend following.
It’s human nature: it feels better to get a steady income instead of a random and rare lump-sum gain.
What would you rather have? A steady gain of 50 000 a year over five years? Or would you prefer a gain of 250 000 in year one and nothing in the last four? In the latter example, you would have one great year, and four years feeling miserable.
We hope you get the point.
Trend following has a low win ratio (hit ratio)
Curtis Faith’s results above showed that the best strategy had a win ratio of 39%. This means most of your trades end up as losses. It looks so easy on a backtest, but we are confident that most traders can’t tolerate such a system. Most would have given up before the big win came.
Trend followers need to fight the temptation to cut winners
You need to ride the winners. This means you need to accept giving up large profits before the trend resumes, or you get stopped out. The old saying “you don’t go broke by taking profits” is utterly wrong for a trend follower.
For most traders, it doesn’t feel right to buy at 50, see it go to 100, and then watch in disappointment the price drop to 70. It’s tough to be a trend follower.
Trend following requires switching – thus liable to capital gains taxes
Unless you have a tax-deferred account, you need to pay taxes on profits, which is a huge headwind to compound efficiently.
Moreover, frequent switching also means you need to roll over futures contracts when they expire and subsequently you need to add slippage and commissions.
A few trades determine overall profits
If you miss just one or a few good trades, your performance might suffer. The win ratio is low, and you are dependent on the few and rare very profitable trades.
The profit distribution is different than in a mean reversion strategy. A mean reversion strategy is prone to “fat” left tails, while trend following has “fat” right tails.
- How to hedge against tail risk in the stock market
- Negatively skewed trading strategies
- How to create a mean reversion strategy
The pros of trend following strategies (advantages)
Could the advantages be offset by the advantages? We let you decide:
Trend following’s main advantage is the simplicity
As we have described above, you don’t need to be a rocket scientist to exploit market moves. The strategies described in this article are pretty good evidence for that.
Trend following doesn’t require a lot of time to manage
Trend following works best on longer time frames. You can probably do well even by using weekly bars/data and place orders during Mondays and do absolutely nothing during the week.
No timing is required for trend followers
You don’t need to follow the markets daily. As a matter of fact, you are probably doing better the less time you spend following the markets.
Trend followers are somewhat antifragile
Mean revertive traders tend to blow off spectacularly, while trend followers bleed slowly. The latter, we believe, stand a better chance of surviving sharp and sudden moves in the market.
Likewise, as shown in the links above, trend following strategies have frequently more big winners than big losers. The distribution tails are on the right side (the positive side).
Does trend following fit your personality and trading style?
We end the article with a general piece of advice:
The success or fiasco in the markets is ultimately less about your strategies (your entries and exits), but more about your behavior. All traders make behavioral mistakes all the time, and this might have a major impact on trend followers, more so than mean reversion traders.
Are you able to pull the trigger after six losing trades in a row? By employing mean revertive strategies you have many more winners and the occasional big loser. For trend followers, it’s the opposite. Thus, you have to understand how you react after a series of losses. The truth is, most traders give up or don’t take the next signal after a series of losses.
Moreover, can you handle being wrong at least 50% of the time? Trend following might be easy in backtests and on paper, but it’s far from easy to perform flawlessly without behavioral mistakes.
Disclosure: We are not financial advisors. Please do your own due diligence and investment research or consult a financial professional. All articles are our opinions – they are not suggestions to buy or sell any securities.