Trend Following

What Is Trend Following?

Trend following is a systematic trading approach built on a deceptively 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 substantial middle portion of significant price movements. Crucially, trend followers do not attempt to predict when a trend will start or where it will end; they react to what the market is already doing, entering after a trend is established and exiting when evidence of that trend deteriorates.

The philosophy is encapsulated in the old trading maxim: "cut your losses short, let your profits run." Trend following operationalizes this through systematic, rules-based frameworks for entry, exit, and position sizing, removing discretionary judgment from the equation.

How Trend Following Works

Entry signals are generated by objective trend detection methods. Moving average crossovers (such as the 50-day crossing above the 200-day, known as the "golden cross"), breakouts above N-day highs (buying when price makes a new 200-day high), and momentum rankings (buying the top performers over a trailing lookback period) are the most common approaches. Some systems combine multiple signals to filter noise.

Diversification across markets is a cornerstone of professional trend following. Managed futures managers and commodity trading advisors (CTAs) typically trade 50 to 100 different markets spanning equities, bonds, currencies, commodities, and interest rates simultaneously. This breadth ensures that even when some markets are trendless and generating small losses, others may be trending strongly enough to more than compensate.

Position sizing typically uses a volatility-adjusted approach, such as risking a fixed percentage of equity (often 0.5% to 1%) per unit of average true range (ATR) on each position. This equalizes risk contribution across markets: a volatile crude oil position and a stable short-term interest rate position both contribute similar dollar risk to the overall portfolio, preventing any single market from dominating outcomes.

Why It Matters for Traders

Trend following matters because it provides genuine diversification against traditional long-only equity and bond portfolios. The strategy's return profile is largely uncorrelated with equity beta during normal markets, and it has historically delivered its strongest returns precisely when traditional portfolios suffer most: during sustained bear markets, commodity supercycles, and currency crises. This "crisis alpha" property makes trend following a meaningful portfolio construction tool, not merely a speculative strategy.

For individual traders, understanding trend following principles helps contextualize why certain systematic funds behave as they do, why momentum anomalies persist in academic literature, and how to think about position management in a disciplined, rules-based way.

How to Read and Interpret It

The most widely watched trend following signals include:

• Moving average crossovers: The 50/200-day crossover is the most cited. A golden cross (50-day rising above 200-day) signals a potential long entry; a death cross signals a short or exit.
• Donchian channel breakouts: Buying a new 20-day or 55-day high, selling a new low. Richard Donchian popularized this in the 1970s, and the Turtle Traders famously used 20-day and 55-day variants in the 1980s.
• Time-series momentum: Measuring whether an asset's return over the past 12 months (excluding the most recent month) is positive or negative. Academic research by Moskowitz, Ooi, and Pedersen (2012) documented this effect across 58 liquid futures markets.

A practical threshold many systematic managers use: a position is initiated when price closes above its 200-day moving average with a stop placed 2 ATR units below entry. The trade is exited when price closes below the 200-day or when the trailing stop is hit, whichever comes first.

Historical Context

The 2022 macro environment provided one of the most compelling recent demonstrations of trend following's value. As central banks globally pivoted to aggressive rate hikes, bonds sold off sharply, the US dollar surged, and energy prices spiked following the Russia-Ukraine conflict. The SG CTA Index, a benchmark for managed futures trend followers, returned approximately +26% in 2022, while the traditional 60/40 portfolio lost roughly 16%. Trend followers were short bonds, long energy, and long the dollar, all positions that had been building systematically throughout the year.

Earlier, during the 2008 financial crisis, the Barclay CTA Index gained approximately +14% while global equities fell over 40%. Trend followers had built short equity and long bond positions as those trends developed through mid-2008, capturing the bulk of the dislocation.

Conversely, the 2009-2019 period was broadly difficult for trend following. Low volatility, frequent central bank interventions, and mean-reverting markets produced a decade of modest or negative returns for many CTA funds, illustrating the strategy's cyclicality.

Limitations and Caveats

Trend following fails in choppy, range-bound markets. When prices oscillate without directional conviction, the strategy generates repeated small losses from false breakouts and whipsaws. The 2011-2012 period and much of 2018 exemplified this: frequent reversals punished systematic trend followers repeatedly.

The strategy also suffers from crowding risk. As assets under management in managed futures grew substantially through the 2010s, many CTAs began holding similar positions. When a trend reverses sharply, correlated liquidation can amplify losses and cause the strategy to underperform its historical backtest.

Lag is inherent: trend following by definition enters after a trend has begun and exits after it has turned. In fast-moving markets, this lag can mean giving back a significant portion of open profits before an exit signal triggers.

Finally, survivorship bias inflates historical performance data for the strategy. Many trend following funds that failed during difficult periods are excluded from index calculations, making the historical record appear more robust than live experience.

Practical Application

For traders incorporating trend following principles, several concrete steps apply:

1. Define your trend filter clearly before entering any position. A simple rule: only take long trades in assets trading above their 200-day moving average, and only take short trades in assets below it.
2. Size positions using volatility, not fixed dollar amounts. Calculate ATR over 14 to 20 days and size so that a 2-ATR adverse move equals no more than 1% of portfolio equity.
3. Track the SG CTA Index or Barclay CTA Index as a proxy for what systematic trend followers are doing. When these indices are performing well, trends are likely intact across multiple asset classes; when they are struggling, expect choppy conditions.
4. Be patient with drawdowns. Trend following strategies routinely experience drawdowns of 15% to 25% before recovering. Abandoning the strategy during a drawdown is the most common way traders destroy its long-run edge.