The Right Way To Trend Follow

One of the primary truths in the stock market and in life is that the simple way is often the most effective.  This rule can be applied across nearly every endeavor that one may encounter during a lifetime of exploration.

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  • The stock market represents an ideal example of the simple is better rule.  Investors are constantly seeking more and more complicated ways to create profits in the stock market.  Some of these complicated methods actually work.  Advanced strategies such as high-frequency trading have proven to be very effective profit creating strategies.  Even with all the success of high-frequency trading, there is one much simpler tactic that has earned big profits for a much longer time frame.

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  • Not to mention that getting into true high-frequency trading takes an investment that can reach into the millions for infrastructure, programming, and systems.  This fact alone makes high-frequency trading only the Provence of institutions or extremely well-capitalized hedge funds and individuals.  Plus, make no mistake, not every high-frequency trading system makes money!

    This simple investing method that I am referring to takes advantage of the one truth of the stock market.  The truth is that there is an inherent upward drift in stock prices.  Just look at any long term stock market stock since trading started.  Without fail, every chart of the overall market or index moves higher over time.  Sure, there are periods of downward moves.  In fact, these periods can be for a long period of time but overall, the stock market moves higher.

    long term DJIA chart

    The trick to making long-term money in the stock market is to avoid these periods of price decline and allow the overall upward drift to build profits.

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  • A tactic known as trend following is the simple investing method I am referring to.  When properly executed, trend following allows one to avoid the downturns within the overall upward drift of the stock market. 

    Let’s take a closer look.

    Trend Following is truly a simple investing method. Boiled down to its core, trend following is simply buying new highs as a way to enter the market.  The idea is that market strength begets strength, meaning that new highs will lead to even higher highs.

    Other Trend followers wait for a pullback within the overall upward trend to buy.  For example, if they are trading from a daily chart and there are 5 days of upward movement, the pullback entry system would buy after a single down day believing that the overall upward trend will continue. In other words,  buying pullbacks on shorter time frames within the overall longer term uptrend.

    The primary market philosophy among all trend followers is that price is the only thing that matters when making trading decisions.

    Trend followers completely disregard fundamental data firmly convinced that all information is inherent in price itself.  If you really think about this, it makes sense.  Despite fundamentals “driving price”, it is price itself that reflects all known and unknown data.

    This belief is so deep in the trend following world, some famous Trend Followers have been quoted as saying that price makes news, not that news makes price. This is an extreme view, but can make sense on a practical investing level.

    How To Be A Trend Follower

    Here are the steps to follow to trade with the traditional Trend Following method:

    1. Define trend— This step is the hardest for most investors, although it does not have to be.  Take a look at a year or longer daily chart of the stock or index you want to trade.  Is the price moving higher or lower over the last year?  Once you determine the trend, it is time to move onto the next step

    2. Clarify your entry price— The best way to enter a trend trade is a subject of debate among trend followers.  Some trend followers wait for a pullback on a shorter time frame to enter.  While others enter on a break out move to a new high. It depends on what method you are most comfortable using.  Both have their place when trend following.

    1. .Relax— This is very hard for some investors.  Now is the time to be patient for the trend to continue carrying your position into profits. This is the hardest part for most traders.  Trend following is slow, grinding process and is not very exciting.  However, it has proven to be very profitable!

    4. Exit —-Wait until the trend appears to have changed totally prior to exiting. This is another difficult to execute trend following rule.  The problem is to determine if this is just a pullback or an actual change in trend is a difficult one to answer in real time.  However, it looks like an easy one in hindsight.  One needs to follow strict rules concerning exits when Trend Following. Discipline is critical for this strategy.

    The Most Critical Step

    There is no question that step #4 is the most critical.  This is because profits can only be earned by closing a trend trade.  Everything is just speculation and paper profits prior to actually closing the trade and taking the profit or loss.

    I firmly believe that exits are much more important than exact timing on the entries.  One can have sloppy entries in the direction of the trend and still profit with correctly managed exits.

    We have discovered that using trailing stops is the ideal way to exit trend following investments.

    Trailing stops are an exit method built to take profits while giving the investment a chance to keep profiting as the trend continues in the right direction.

    What Are Trailing Stops?

    Trailing stops are sell orders which follow price at a certain distance as it moves in a profitable direction.  Fortunately trailing stops can be set automatically via your trading platform.  There isn’t any need to manually move the trailing stop.

    Many investors use a concept called Average True Range or ATR to determine a smart distance for trailing stops.  ATR helps keeps you in the trade during price noise that are not actually a change in trend.

    There are many variations on this same theme but this is the basic idea.

    Trailing stops can be a powerful tool for the trader when the market is trending.  Remember, my 75 cent increment is just an example for illustration purposes only.  The increment can be anything and is based on your personal preferences or ATR of the instrument you are trading.

    Some investors implement a stop and reverse policy when trend trading.  What this means is that once your trend trade is stopped out by a trailing stop, an order is entered to try to catch the trend in the opposite direction.

    The theory behind this “always in the market” trend following strategy is that if the market moves far enough to trigger your trailing stop, it could very likely be the start of a new trend in the opposite direction.  Therefore, it makes sense to ride this trend in the current prevailing direction.

    Problems with stop and reverse are magnified in non-trending or choppy markets. However, in trending periods, stop and reverse tactics can quickly build your account size.

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