There is one single investing/trading strategy that has been proven to be the most successful strategy ever implemented in the financial markets.
This single concept has made more million and billionaires in the market than any other single strategy.
Most all of the largest traders, hedge funds and institutional money managers on earth implement this tactic to dominate the investing landscape.
The multi decade success of its practitioners like Man Investments, TransTrend, John Henry, Winton and numerous others have proven the long term viability of this investing method. Not to mention the thousands of individual investors who successfully implement this strategy on a daily basis in every financial market on earth.
If you haven’t guessed it yet, I am referencing the investing strategy known as trend following.
Investopedia provides a great definition of trend following in the following way:
Trend followers try to find a great up trending stock, buy it and ride it until the trend changes. After all, if a stock keeps going up, wouldn’t it be great to just buy it and let it double, triple, do what it does?
Because up trending stocks go through stages of higher highs and higher lows, these traders should have a loose stop and should not be worried about outside factors such as their stock being overextended, as long as the stock is still going up.
Trend-following trading is reactive by nature. It does not forecast or predict markets or price levels. Prediction is impossible. Trend trading demands self-discipline to follow precise rules (no guessing or wild emotions). It involves a risk management system that uses current market price, the equity level in the trader’s account and current market volatility. Trend traders use an initial risk rule that determines position size at the time of entry. This means they know exactly how much to buy or sell based on how much money they have. Changes in price may lead to a gradual reduction or increase of their initial trade. On the other hand, adverse price movements may lead to an exit for the entire trade. Historically, a trend trader’s average profit per trade is significantly higher than the average loss per trade.
Ok, that’s all good and makes theoretical sense but how is this actually executed in the markets?
Let’s take a closer look:
Traditional Trend Following is simply buying new highs and selling new lows as a way to enter the market.
Trend followers often fine tune the traditional method by buying pullbacks on shorter time frames within the overall longer term uptrend.
The overarching belief among all trend followers is that price is the only thing that matters when making trading decisions.
They completely discount fundamental data, believing that all information is inherent in price itself. Believe it or not, some famous Trend Followers are noted as saying that price makes news, not that news makes price.
Trend Following Step by Step:
Here are the steps to follow to trade with the traditional Trend Following method:
- Determine trend— which way is the stock moving? Take a look at a several year chart, is it trending up or down? Let’s assume your chosen stock is trending up.
- Choose your entry point in advance— the best way to enter a trend trade is hotly debated. As stated earlier, traditional trend traders will buy whenever a new high is reached. Others will wait for a pull back to the Moving average, or a pull back within a shorter time frame chart.
3. Be Paitent— for the trend to continue carrying your position into profits. This is the hardest part for most traders. Trend following is slow, grinding process.
- Exit the trade—-Wait until the trend appears to have changed totally prior to exiting. This is another nebulous trend following rule. The question if this is just a drawdown 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.
What many investors don’t realize is that step #4 is the most critical. It is when you exit a trend trade that the profits are made. In fact, 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 designed to lock in profits while giving the investment a chance to keep profiting as the trend continues in the right direction.
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.
For example, let’s imagine a 75 cent trailing stop. Assume price moves immediately in your favor 80 cents, the trailing stop once set at $19.25 per share on an entry price of $20.00 per share now moves to $20.05 to lock in a 5 cent profit.
The trailing stop will continue to follow the uptrend with a 75 cent distance between the stop order and the actual price of the stock. Remember this is just an example and the distance for the trailing stop can vary greatly based on the volatility of the stock.
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.