Trend Following

What Is Trend Following?

Trend following is a systematic trading approach based on a simple premise: assets that are trending tend to continue trending. The strategy goes long assets in uptrends and short assets in downtrends, aiming to capture the major portion of significant price movements. Trend followers do not try to predict when a trend will start or where it will end; they react to what the market is doing.

The philosophy is encapsulated in the old trading maxim: "cut your losses short, let your profits run." Trend following does exactly this through systematic rules for entry, exit, and position sizing.

How Trend Following Works

Entry signals are generated by objective trend detection methods. Moving average crossovers (e.g., 50-day crossing the 200-day), breakouts above N-day highs (e.g., buying when price makes a new 200-day high), and momentum rankings (buying the top performers over a lookback period) are common approaches.

Diversification across markets is a cornerstone. Professional trend followers (often called CTAs or managed futures managers) trade 50 to 100 different markets spanning equities, bonds, currencies, commodities, and interest rates. This diversification ensures that even when some markets are trendless, others may be trending strongly.

Position sizing typically uses a volatility-based approach (such as risking 1% of equity per ATR-based stop on each position) to equalize risk across different markets. A volatile commodity and a stable bond position both contribute similar risk to the portfolio.

Performance Characteristics

Trend following has a distinctive return profile: many small losses from false starts and whipsaws, punctuated by occasional large gains when significant trends develop. The win rate is typically only 35-45%, but the average winning trade is significantly larger than the average losing trade, producing positive expected returns.

This profile makes trend following psychologically challenging. Traders must endure long periods of small losses and maintain confidence in the system. The strategy excels during major market dislocations (financial crises, commodity booms, currency moves) when strong trends develop and persist.