What is the best trend following strategy

Learn and apply trend following strategy - definition, indicators and examples

Trend-following strategies are more likely to be considered a more conservative trading strategy. You are particularly successful in trendy markets.

While some traders try to detect trend reversals and get maximum profit from them (such as swing traders), the trend follower only enters the market when he has recognized a trend. The trend following strategy delivers good results even for beginners. Because: the probability that a correctly recognized trend will continue is higher than that it will break.

In this article you will find out what trend following is, for whom it is suitable, when technical chart entry and exit signals arise, which markets can be traded and, last but not least, what a trend following strategy for long-term investors can look like.

Definition - What is trend following

Everyone knows what a colloquial trend is. Namely "the fundamental direction in which something is developing". On the stock exchange, too, this refers to the tendency for a security or other instrument to develop.

In the “real” world, however, there are often no solid clues to define a trend. Often there is a “perceived trend” that does not necessarily have to correspond to reality. It's different in the financial market. There is at least one fixed definition of when there is a trend.

An uptrend is a price constellation where the bottom of a previous fluctuation is lower than the bottom of the current fluctuation. In addition, the high point of the previous fluctuation must be lower than the high point of the current fluctuation.

A downward trend, in turn, is characterized by falling highs and lows of a fluctuation amplitude.

A sideways trend is also possible. Here the highs and lows are on the same line.

Who is a trend following strategy suitable for?

The trend following strategy is primarily a trading strategy. People who actively trade on the stock exchange can cope with this. The basis is therefore the chart technique, the focus is on technical aspects and is not fundamentally justified at first.

As we will see later, the trend following strategy can take many different forms and can be carried out on many time levels. It can therefore also be used by an investor who would like to use technical principles as a decision-making aid to limit losses.

Especially in the long-term area of ​​growth-oriented investors, the trend-following idea is an extremely good decision-making aid to recognize the end of a trend or to sit out heavy months or years of losses. Even the right entry at the beginning of a trend can be traded with little risk thanks to the trend following strategy.

On the other hand, short-term traders can also work with a trend following strategy on the minute or hourly chart. Basically: The trend following can be carried out on any market (stocks, indices, ETFs, Forex, futures, etc.) and at any time level. As a rule, the larger the time level, the more reliable the signals are.

Even with the game of "binary options" a trend following strategy is feasible. However, you should be extremely careful here. I generally advise against this type of bet. A strategy is usually only profitable here if it has a hit rate of 70%. But that is hardly possible ...

Technical chart components of the trend following strategy, entries and exits

First, however, let's look at the technical aspects of the trend following strategy. There are different approaches to getting in and out.

Trend following based on market technology

In market technology, a trend is defined in the form of a 1-2-3 pattern. The following explanation is based on an uptrend, but can also be applied to a downtrend.

Everything in market technology consists of the components Move and correction. In an uptrend, the line between 1 and 2 is the movement, and between 2 and 3 is a correction. Point 3 is also point 1 if there is an intact trend. Since you don't want to anticipate anything, a new point 2 can only arise if the last point 2 has been exceeded.

A sequence of several of these movements and corrections are a trend. How long such a trend can last is of course not known. It can have two successive movements and corrections, but it can also have 5, 10, 20 or 50 of these sequences.

Entry according to market technology

The market trend follower recognizes a trend at the moment when point 2 has been exceeded. Since, according to the definition, the trend has now started, the trend follower can be stopped at point 2.

Stop loss, take profit & exit according to market technology

If a market trend follower has entered, he sets his initial stop loss briefly below the previous point 3. Because this is exactly where the trend would be broken if the price had declined by then.

The trend follower, who acts according to market technology, does not know a take profit, i.e. the closure of his position. He waits until a new point 2 is set and then draws the stop loss.

If the trend is broken, it can be stopped at point 3.

Significance of signals

It is important for a successful trend following that the market technician thinks over several time levels. Because: that which occurs on a smaller time scale than trend represents, is always only one of the two components on a larger level Move or correction.

This means: If a trend reversal occurs on a small time level and this turns from correction to movement on a larger time level, the value of the signal is to be rated higher than if a correction is imminent on the higher time level.

Resistance & Support Lines

However, market technology has two small shortcomings that can often become a psychological problem for traders:

  1. If a point 2 is exceeded, then the movement is already well advanced and the trader fears that he has entered too late.
  2. Since the stop loss is below the previous point 3, and the entry sooo late has taken place, the initial stop is very far away. A correction can go back almost to point 3 and make the trader sweat.

The technique of resistances and supports provides a remedy here. Because, according to the chart technician, it is not arbitrary where a correction goes back to, but can be "predicted" up to a certain point. Or at least significant points can be determined with justifiable probabilities that can improve the risk-reward ratio.

Trend lines

Of particular importance in this context are the Trend lines. The prerequisite here, however, is that the trend has clearly started and has already reached a second significant low point. Fig. 3 shows the principle based on Apple between mid-2012 and the end of 2016 (weekly chart).

The light green lines are resistance lines where the chart seems to bounce down several times. The orange line is a support line that appears to be propping up the stock price. Each of these lines is broken sooner or later, but also confirmed (several times) beforehand.

Especially with the orange support line it becomes clear that it might not be the only possible support. Depending on the tolerance, you could also draw steeper lines that are broken more often.

An entry into the market or a sale of the share is carried out at the moment when the price is at the END of the current candle or at the BEGINNING of the next candle on the other side of the line. I have marked corresponding points with arrows and labels.

With a little practice, the price behavior on the trend lines can be used to determine whether market participants are more willing to accept the trend lines as resistance / support, or whether they are obsolete. Sometimes the share price literally jumps to the other side in such areas. Sometimes he is very subdued.

In the first case, a trend reversal can be assumed. Often the trading range (difference between high and low of the current candle) is particularly large compared to the last periods. The point “re-entry” from Fig. 3 is a typical example. However, it can be made clearer. In some cases, the share price literally jumps above this level. This is often the case with the publication of quarterly or annual figures that were better (or worse) than was previously the consensus among traders.

Moving averages

An alternative way of determining trends is to compare two moving averages (MA): a fast MA (often the 50-period average) and a slow MA (e.g. the 200-period average).

If the GD50 is now below the GD200, it is referred to as a downward trend. However, if the fast GD50 is above the GD200, there is an upward trend. However, the whole thing only works if there is actually a trend and the stock is not in a sideways trend. Then the GD50 "rings" around the GD200 and triggers ambiguous signals.

One criticism of the focus on this trend determination is that a trend reversal may be recognized very late. In the case of strongly fluctuating prices, the trader has to give up many profits again before the signal of exit comes for him.

When roughly determining the trend, different calculations of the averages are therefore used: in addition to simple moving averages (GD), there are also exponential moving averages (EMA), where newer periods are rated above average (exponential). That doesn't do a lot. And here, too, there is criticism: If the average is too fidgety, false signals can quickly arise.

Apart from the function of determining trends, the moving average also has another function:

It can be seen that the 200-day line from Fig. 3 and Fig. 4 also represents a kind of barrier, albeit not as precisely as the resistance zones drawn in (and thus adapted). This can also be used as an entry or exit signal.

It should be noted that there are signals that must be confirmed. A breach of the EMA does not imply an immediate action. The 2-period rule applies here to sales: At the end of the second day (or in this case at the end of the second week) the price has to close on the wrong side of the EMA in order for a sale to be triggered. Before that, the trader has to be patient and wait for the candle to end.

As you can see, it is worth getting started in such areas. It is not uncommon for the 200 or 50 day line to decide whether an overarching trend will continue or break. For trend followers, this means that they can start there with an extremely good risk / reward ratio. If the 2-period rule shows a trend reversal, the trader can (mostly) exit with relatively little potential loss.

If, however, the trend is confirmed, high price increases are quickly possible. Please note the area around April 7/14, 2014 for a long trade, or November 2015 for the short side in the chart in Fig. 4.

Fibonacci retracements

So-called Fibonacci points are also often used for entry points. Fig. 5 shows an excerpt from Fig. 3. This is the period at which the downward trend from 2012 was broken and a bottom became apparent. We are now in August 2013, a trend reversal has been completed, but unfortunately the market-oriented trader missed the opportunity to join. What should he do?

He exercises patience because he knows that the movement will be followed by a correction.

This usually has certain target zones to which the course can decline. If a distinctive high point develops, the trader uses a so-called Fibonacci scale (see Fig. 5). The shows typical areas in which a course can turn. By the way, the most common turning point is the 50% turning point. The 66.67% and the 38.2% retracements, see Fig. 5, are also frequently observed.

The Fibonacci sequence is the infinite sequence of natural numbers that have remarkable mathematical features. Many people believe that this is some kind of law of growth. It is also used, for example, in connection with the golden ratio.

From Fig. 5 you can see that the correction was ended very close to the 50% resistance and there it really bounced off upwards. A trader who missed the previous entry would now have had a second chance to enter.

Using this example, another interesting point can be made:

Entry into resistance that became support

The turnaround at the 50% retracement may not have happened as randomly as one might think. There was also a horizontal support line here, which was a resistance in the movement before (gray line at $ 64.53).

And not only that! It was also the entry point of those traders who traded the break of the downward resistance line (light green) weeks earlier. To recognize such a constellation is worth gold in the truest sense of the word.

Because if you recognized it, you could trade a year-long upward trend right from the start without even being in a loss position once. And a buy & hold investor could also look forward to a hole in the stomach: His position is now (mid-2017), after almost 4 years, 139% up. An average growth of 25% per year.

Indicators

In addition to the “chart-gemale”, the technical chart analysis also has some suitable indicators and oscillators that can be helpful in determining trends and trading in trends.

The MACD indicator

The MACD is typically used. It's an oscillator on the one hand, and a combination of moving averages on the other. It consists of three components: the MACD line is a moving average of the price itself, the signal line in turn is a moving average of the previous GD. It smooths the GD and thus produces trend reversal signals. The histogram, which moves around a zero line, shows the strength of a trend.

Suitable points are clear from Fig. 7. If the signal line is above the GD and both are above zero, then there is a definite upward signal to trade. Vice versa, that is in a downward trend.

In comparison: The normal moving averages 50 and 200, on the other hand, are more delayed.

The RSI - Relative Strength Index

The RSI is an oscillating indicator that shows whether a market is possibly overbought or oversold. It is calculated by adding and smoothing the price changes of the days with a rising closing price and the days with a falling closing price. If you want to take a closer look, you can do so on Wikipedia.

Basically, stocks are considered overbought when the indicator rises above 70 and oversold when the RSI falls below 30.

For our consideration in Fig. 8, the oversold areas are of particular interest. We see a trending share (Facebook). You can see that especially in the EMA50-EMA200 constellation. There are corrections here too. They are very easy to recognize thanks to RSI.

If someone had used the RSI <30 as an entry signal, they would not have done badly at all. The reason it works so well is because the stock has a clear trend. In other constellations, this signal is less useful as an isolated decision criterion. Only the combination of several indicators allows the correct conclusions to be drawn.

Sensitivity of the signals

Let us come back to the objection that the upward trend line could have been drawn in other places as well, as well as the determination of the trend using the moving averages. Here the conflict of goals lies in the trend following strategy.

On the one hand, the trend follower naturally strives to have to accept as few price setbacks as possible and to determine quickly enough when a market is turning, on the other hand, if signals occur too frequently, he must fear that he will enter or exit too quickly (too shakily). There is no clear guideline here, because it always depends very much on the personality of the trader and his chosen trend following strategy.

Probably one of the best options is to combine several clues in your strategy and only take action when both signals force action. The two signals should be as independent of one another as possible.

What does the trend following strategy bring, can it "beat the market"?

This question is very difficult to answer. Because there are several approaches to "prove" sense and nonsense of the trend following strategy.

Studies: Trend-following strategies are humbug

Many very technical studies have found that the strategy is rather nonsensical. It hardly brings anything, since corrections are often sat out in the money, but the entry takes place at about the same price as the exit. Or the course is even worse. However, the basic assumptions are very important here.

Because most studies take into account the simplest system of moving averages, as well as a random selection of securities.Based on these assumptions, the trend following strategy should actually be placed in the "rather bad trading" area. Assumptions would have to be refined here, but they cannot be technically imitated that easily. This includes, for example, fundamental considerations. However, these are never taken into account in the studies.

At higher time levels and based on a stock index, however, an improvement in performance is still possible. The book "Absolute Weekly" by Bernd Vogel presents in great detail various trend following strategies on the DAX, SDAX and MDAX, with which you can actually outperform the index significantly. I highly recommend it to semi-passive ETF investors!

Note fundamental data!

The key word here is: stock picking and resistance. Stock-picking MUST be done in favor of fast-growing companies that are predicted to have a prosperous future. They must also have a very high trend stability.

One possible approach is the Joel Greenblatt pick: high return on investment and low P / E valuation. But many other approaches can also be useful: When it became clear that Apple had a massive impact on society, a general direction of the share price could have been predicted.

And since the topic accompanies us through the entire article, let's just look at the result of a trend follower and a buy & hold strategist.

Calculation example for trend following using the example of Apple

Assumption: Both bought 155 shares on May 6, 2013 for $ 64.50 ($ 9,997.50). The price of the Apple share (05/2017) is currently (05/2017) at $ 154.00. No transaction costs or dividends are taken into account.

Trend followingBuy & Hold
datecoursenumberDeposit valuenumberDeposit value
06.05.2013$ 64,50155$ 9.997,50155$ 9.997,50
15.08.2015$ 116,000$ 17.980,00155$ 17.980,00
01.08.2016$ 104,50172$ 17.974,00155$ 16.197,50
21.05.2017$ 154,00172$ 26.488,00155$ 23.870,00
Total:+ 139 %+ 165 %+ 139 %

The Buy & Hold shareholder now holds Apple shares valued at $ 23,870 (not counting dividends). That is an increase of around 139%.

According to the trend following strategy from Fig. 3, the trader would have sold his shares on 08/15/2015 for $ 116.00. Its proceeds were $ 17,980. A new entry could have been made on August 1st, 2016 for $ 104.50. That would have been enough for 172 shares. His current balance would now be $ 26,488.

Result: Not a top performer, but useful

That makes a difference of around $ 2,618 after 4 years, or an overperformance of around 11% compared to Buy & Hold. Of course, the transactions were not included, and neither were any dividends.

Does that mean that the trend following strategy worked better? In this case, and if exactly this constellation had been acted on, yes. Smaller deviations in the trading logic of the trend following strategy can lead to different results.

However, it would also have been possible that a trend follower at Apple would also have gone short when that was clearly evident. This would have made some profits again. Beginners shouldn't use this tactic. By far the best and most successful strategy in the long term is the long side, due to the generally better probabilities (a share can only lose 100%, but gain 1,000% or more).

What are the advantages of a trend following strategy?

A trend following strategy can still make sense for certain reasons. Because as mentioned before: You can't predict the future.

For example, Apple could run into big problems over the next few years and the stock will lose much of its value as a result. The question that always arises for an investor is: When is the best time to get out?

And this is exactly where the trend following strategy provides a suitable answer. On the one hand, it offers a good, logical entry point that brings the price gain potential into a positive ratio compared to the loss. On the other hand, the trend following strategy can also protect against holding a share too long, so that your own money was taken off the table before the potential collapse of a company. The result is that negative fluctuations in the portfolio can be reduced.

Trend followers can probably sleep better, especially in times of crisis. Because while all long-term investors without an exit strategy have to sit out the bear market and their assets are reduced by 50% or more, a trend follower can go "flat" early enough and relax and wait for the next bull market.

Even a beginner can do that.

What are the disadvantages of a trend following strategy?

Simply focusing on one trend doesn't do it. In order to get really good performances, you need a very high trend stability. Finding this out in advance is almost impossible and can therefore only be justified qualitatively. Does the company have the potential to continue to develop as it is right now? Or even get better?

Therefore, stocks in growth-oriented companies are likely to be particularly good. These are mainly small caps (companies with a market capitalization of up to approx. 250 million euros), but also leaders in future technologies (such as biotech, AI, Industry 4.0, electric mobility). If the long-term plan works here, you can earn a long time with a trend-following strategy. Small caps are a bit more risky than large caps (large companies with> 2 billion market capitalization).

A trend following strategy does not seem to necessarily prove to be a super performer, even for stocks with strong trends. False signals may lead to unnecessary back and forth, which could lead to poor re-entry prices. Then a buy & hold would be better.

As in our example, a few more plus percentages can be achieved, but that is by no means certain.

The boost for the portfolio: leveraged megatrends follow as a long-term investment strategy

There are some companies that have only known one direction for years or decades: Up. Many of these companies are well-known brands or umbrella brands, such as Nestlé, Procter & Gamble, Coca-Cola, Walt Disney, Alphabet, Facebook and more.

They rise and rise. Relatively slow and calm. But steadily. Of course there are declines; there is that in every business. But by and large, these firms grow out of every crisis with higher prices.

You could now put the shares in the custody account as a retirement plan, and sell them occasionally as soon as a major crisis becomes apparent. This is definitely a very good, long-term investment with good annual returns. But it can be done even better.

Banks such as UBS, HVB or Lang & Schwarz offer so-called leverage certificates on many large stocks. These are structured products (caution: risky, not suitable for everyone!), Which have a higher risk of loss, but also perform better in the plus area. A moderate leverage of 2-5 is already sufficient to earn disproportionately high income from price developments.

If a price now reaches a support line, it is likely with a risk of a few points that a trend continuation could get under way. Then it is possible for private individuals to buy smaller lots of such certificates. If the trend breaks, an exit can be made quickly. If the trend continues, an investor can quickly generate 100% to 250% profit with a 50% increase in the price of the base share.

Dr. Michael Proffe from Proffe publishing proved. With the help of this technique, he has demonstrably managed to trade a 30,000 euro deposit to over 1 million in just 10 years. Despite years of crisis.

Conclusion

Trend-following strategies are rightly popular and often work well. Even a beginner can use them. There are certain disadvantages depending on the approach, and the right instrument should be chosen carefully, but once you have focused on a few really good companies, you can take the trend with you.

And the whole thing without the headaches, the economic crises, or other strong negative influences that other market participants have to endure. Because when it gets too tough, the trend follower simply goes out and watches on the pitch line until the greatest battle has been fought without him.

Thanks to modern banking products, you can not only take the bull market with you, but also leverage it for your own purposes.