Most traders fail because of a volatile market and over-trading, hence the missing of opportunities and large losses.
Trend following is a disciplined approach to trading that tends to ride on sustainably established market movements without constant expectations of predicting the markets. This way, one is able to focus on the established trends and avoid the emotional stress involved in making decisions.
In this article, we are going to discuss three simple yet effective trend following strategies supported by historical performance data. We will also talk about the advantages and disadvantages of trend following in order to help you decide whether this approach is suitable for your trading goals.
Understanding Trend Following
By its very nature, the trend following trading technique captures extended price movements whether to the upside or downside direction of the financial markets.
This is quite different from most techniques and strategies that seek out or predict market tops as well as bottoms. Actually, trend followers tend to enjoy the ride with regards to momentum until clear cut indications of reversal begin manifesting.
The Simplicity of Power
One reason the beauty of trend following is its simplicity. This method does not depend too much on complex analysis and continuous observation of market conditions; it is very simple, rule-based about when to buy and when to sell.
Strategy 1: Monthly Moving Average Crossover
Trading Rules
- Buy Entry Signal: Buy at close when the closing price of the current month crosses above the 12-period simple moving average (SMA).
- **Close and cash when closing crosses below the 12-mo. SMA
Backtest
We backtested the strategy on the S&P 500 forward from 1960. The backtested results are astounding:
- Annual Return: 6.6% with the trade, compared to 7% buy and hold.
- Drawdown: This will have significantly fewer drawdowns as it peaks out at 26%
- Time in Market: This is only invested in 68% of time.
This means that the risk-adjusted return is approximately 9.6%, and it seems that this strategy has good returns relative to risks.
Equity Curve
This strategy has an equity curve that clearly shows how effective it is. Its drawdowns are much smaller than those of buy-and-hold strategies, and thus it is much more resilient during market downturns.
Strategy 2: The Golden Cross
Trading Rules
- Long Signal: Long when the 50-day moving average crosses above the 200-day moving average. That’s a bullish signal.
- Short Signal: Short when the 50-day moving average crosses below the 200-day moving average. That’s a bearish signal.
Backtest Results
This strategy has an extremely long history and is one of the best known performers:
There have been 32 trades since 1960 for this strategy.
- Annual Return: Approximately 6.6% similar to the first method and a lower figure compared to buy-and-hold returns.
- Drawdown: Invested with much reduced risk as it only invested in 69% of the time.
- Risk-Adjusted Return: A risk-adjusted return of about 9.5%.
Example Trade
This means you will be able to short sell the S&P 500 in July 2020 when it was 2867 and close this one in March 2022 on 4173 a great 32.4% return; and of course not every trading is a success in managing trades.
Strategy 3: Super Trend Indicator
Rules Trading
- Long signal occurs by the close cross higher as the prior value that goes with the Super Trend indicator.
- Sell Signal: Close at the point in time when the close crosses down through the previous level of the Super Trend indicator.
Backtest Performance
The Super Trend indicator with a more dynamic rule shows the following results:
- Annual Return: 5.9%, lower than the annual returns from a buy and hold.
- Drawdown: It’s a strategy that has been exposed to the market for only 62%, the risk profile is very conservative.
- Risk-Adjusted Return: The risk-adjusted return is about 9.5%.
Equity Curve
The equity curve of this strategy does show that it will not significantly outperform buy-and-hold but its disciplined nature would definitely help avoid major pitfalls in downturns.
Why Trend Following?
- Easy to Understand: The above strategies are very easy to understand and to execute. You do not have to know all the ins and outs of the markets to trade.
- Reduced Psychological Stress: You would reduce the psychological stress concerning the trade by adhering to a few previous guidelines.
- No Market Timing Required: Trend followers are not looking at market timing but reacting to the market which makes the whole trading a lot more structured.
Trends Following Drawbacks
- Sideways or Choppy Markets: There will not be good output from the trends following as it tends to fail if the markets tend to operate in the sideways or choppy conditions in which you are going to face quite a lot of whipsaws and thus losses due to those.
- Delayed Entry and Exit Signals: Strategies often offer delayed entry and exit signals, which would be missed opportunities.
- High Probability of Large Drawdowns: Although the systems have an average drawdown reduced to a minimum, large losses are still in play at the time of the trend reversal.
Conclusion
Trend following is an attractive strategy for traders wishing to ride on the trends of financial markets. These three strategies above will provide a framework for managing financial markets in an orderly fashion.
And concerning the strategy of following trends, this specific methodology must be weighed against the above. On one hand, it is emotionally less taxing and easier to work with overall; on the other, its capabilities are less fitting for trading during wild and side price movements.
Then it is up to whether or not this strategy works for you, in the light of your overall objectives, risk tolerance, etc. Backtest all of this before you settle into a strategy that works for you; happy trading!