TREND FOLLOWING also called MOMENTUM TRADING

The Philosophy of Trend Following

Many successful investors fall into a group called "trend followers". I will try to explain what trend following is all about and why investors should be interested in using these general princi­ples in their investing activities.

The first part is "trend." Every trader needs a trend to make money. If you think about it, no matter what the technique, if there is not a trend after you buy, then you will not be able to sell at higher prices. You will take a loss on the trade. There must be a trend up after you buy in order to sell at higher prices. On the other hand, if you sell first then there must be a following trend down for you to buy back at lower prices.

"Following" is the next part of the term. We use this word because trend followers always wait for the trend to move first, then "follow" it. If the market is in a down direction and then indicates a shift to the upside, the trend follower immediately buys that market. In doing so, the trader follows the trend.

"Let your profits run. Cut your losses short." This old trader's saying explains trend following perfectly. Trend-following indica­tors tell the investor when the direction of a market has shifted from up to down or from down to up. Once in a trend, the trader sits back and enjoys the ride, as long as the trend keeps going in the trader's direction. This is "letting profits run."

If the market coop­erates, the trend follower would get into the trade as soon as the market passed his or her criteria for "trending" and would stay in it for the rest of his or her life.

Unfortunately, the trend usually ends at some point. As a result, when the direction shifts then the "cutting losses short" aspect of the axiom should come into play. The trader sensing that the direction of the market has shifted against the position, imme­diately liquidates. If the position is ahead at that point, then the trader has made a profit. If, at the time, the position is behind, then the trader has aborted the trade, preventing a runaway loss. Either way the trader is out of a position that is currently going against him or her.

The Advantage of Trend Following:

The advantage of trend following is simple. You will never miss a major move of any market. If the market you are watching turns from a down to an up direction any trend-following indicator must flash a "buy" signal. It's just a question of when. If it's a major move, you will get the signal. The longer term the trend-following indicators are the lower the transaction costs a specific advan­tage of trend following.

Strategically, the investor must realize that if he or she can get onboard a major move in almost any market, the profits from just one trade can be substantial. In essence, one trade can make your whole year. This is because the average size of one's winning trades is so much greater than the size of one's losing trades.

The Disadvantage of Trend Following:

The disadvantage of trend following is that your indicator cannot detect the difference between a major profitable move and a short-lived unprofitable move. As a result, trend followers often get whipsawed as trend-following signals immediately turn against them, causing small losses to occur. Multiple whipsaws can add up, creating concern for the trend follower and tempting him or her to abandon the strategy.

Most markets spend a large amount of time in non trending conditions. Trending periods could be as little as 15 to 25 percent of the time. Yet the trend follower must be willing to trade in these unfavorable markets in order not to miss the big trend.

The difficulty people have with the stock market is that (1) there are times when very few stocks are trending up so that the best opportunities are only on the short side; (2) people don't understand shorting so they avoid it; and (3) the exchange regulators make it difficult to short (i.e., you have to be able to borrow the stock to short and you have to short on an uptick). Nevertheless, if you plan for short selling, then it can be very lucrative under the right market conditions.

Is Trend Following for Everyone?

Trend following is probably one of the easiest methods for the new trader or investor to understand and use. The longer term the indicators, the less that total transaction costs will affect profits. Short-term models tend to have a tough time overcoming the costs of doing more trades. The fewer trades you make, if you have the patience for it, the less you spend in transaction costs and the easier it is for you to make a profit.

Day traders may find it difficult to use trend-following models. When day trading, you cannot let profits run due to the time limits of day trading. The day simply ends, forcing the trader to liquidate the position.

If trend following fits your personality and your needs, then give it a try. There are many examples of successful traders and investors who consistently use this time-tested approach to the markets. With the economic world as we know it becoming more unstable, there are constantly more new trends for the trend fol­lower to develop for profit.