Video Why 80% fail at using a trend following technique

How To Trade With The Trend

Commentaries by Bruce Babcock for both New and
         Experienced Traders

There are four cardinal principles which should be part of every trading strategy. They are: 
1) Trade with the trend, 
2) Cut losses short, 
3) Let profits run, and
4) Manage risk. 
You should make sure your strategy includes each of these requirements for success.

Trade with the trend relates to the decision of how to initiate trades. It means you should always trade in the direction of recent price movement.
Mathematical analysis of commodity price data has shown that these price changes are primarily random with a small trend component. This scientific fact is extremely important to those desiring to pursue commodity trading in a rational, scientific manner. It means that any attempt to trade short-term patterns and methods not based on trend are doomed to failure.

A good example of such a doomed method is Japanese Candlestick patterns. This theoretical conclusion is consistent with my previous research. Many years ago, just as Candlesticks came into vogue, I attempted to create a profitable trading system incorporating Candlesticks. I tried many patterns and many types of systems, all without success. I have never seen anyone else demonstrate the effectiveness of Candlesticks using objective rules either. Successful traders use a method that gives them a statistical edge. This edge must come from the tendency of commodity prices to trend. In the long term you can make money only by trading in synch with these trends. Thus, when prices are trending up, you should only buy. When prices are trending down, you should only sell.

While this important principle is well-known, traders violate it surprisingly often. They are looking for bargains so they prefer to try to buy at the very bottom or sell at the very top before new trends become established. Winning traders have learned to wait until a trend is confirmed before taking a position consistent with that trend.

Here's what consummate market expert Jake Bernstein said in my book, The Four Cardinal Principles of Trading: "Of all the common market principles, I put 'Trade With The Trend' at the very top. It's a lesson I've had to learn and relearn practically every year. All traders have the tools to find trends. That's what makes it especially frustrating when we go contrary to the trend or when we try to pick tops and bottoms."

The alternative to trend following is predicting. This is a trap that nearly all traders fall into. They look at the commodity trading problem and conclude that the way to be successful is to learn how to predict where markets will go in the future. There is no shortage of people willing to sell you their latest prediction mechanism. We all want to believe that predicting is possible because it's so darn much fun to make a prediction and be right.
Here's Jake Bernstein again with a little dose of reality: "It took me over nine years to realize that, although it may be a romantic and ego-satisfying goal, forecasting is not necessarily synonymous with profit. To anticipate trends is a difficult and often haphazard task, and it tends to lead to losses more often than profits."

Trading with the trend is hard to do because a logical give-up exit point will be farther away, potentially causing a larger loss if you are wrong. This is a good example of why so few traders are successful. They can't bring themselves to trade in a psychologically difficult way.

You can define the concept of trend only in relation to a particular time frame. When you determine the trend, it must be, for example, the two-week trend or the six-month trend or the hourly trend. So an important part of a trading plan is deciding what time frame to use for making these decisions. While it is perhaps easier psychologically to keep the time frame short, the best results come from longer-term trading. The longer you hold a trade, the greater your profit can be.

Here's what Russell Sands said in an interview with Commodity Traders Consumer Report. Russell was an original member of Richard Dennis' Turtles group and has built a successful career as a money manager and advisor generally using the Turtle methodology.
"The best approach is to be a long-term trend follower. Trend following is statistically valid in the sense that everybody has tested it for years and years, and it works. "I acknowledge that the market trends maybe 20 percent of the time and chops back and forth in consolidation 80 percent of the time. The trick is how to define where the trend starts and where it stops. If when a market does trend, you get in at the right time, ride that trend and then get out at the right time, you'll make enough money to more than offset the losses you take during non-trending periods.

"Another part of the basic philosophy is that we don't know when the market's going to trend and when it's not. In fact, we don't know what the market's going to do at all. We can't predict anything it does. We don't believe in predictions. Instead, we react to the market."

For the greatest chance of success, your time frame to measure trends should be at least four weeks. Thus, you should only enter trades in the direction of the price trend for the last four weeks or more. A good example of a trend-following entry rule would be to buy whenever today's closing price is higher than the closing price of 25 market days ago, and sell whenever today's closing price is lower than the closing price of 25 market days ago.

When you trade in the direction of this long a trend, you are truly following the markets rather than predicting them. Most unsuccessful traders spend their entire careers looking for better ways to predict the markets. If you can develop the discipline to measure trends using intermediate to long-term time frames and always trade in the direction of the trend, you will make a giant step in the direction of profitable trading.

Reason for Trend Following Trading/Investment

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 your account and current market volatility. Trend traders use an initial risk rule that determines position size at the time of entry. This means you know exactly how much to buy or sell based on how much money you have. Changes in price may lead to a gradual reduction or increase of your initial trade. On the other hand, adverse price movements may lead to an exit for your entire trade. Historically, A trend trader's average profit per trade is significantly higher than the average loss per trade.

Trend trading is not a Holy Grail. It is not a passing fad or hyped-up secret black box either. Beyond mere rules, the human element is core. It takes discipline and emotional control to stick with trend trading through inevitable market ups and downs. Trend following seeks to capture the majority of a market trend, up or down, for profit. It aims for huge profits in all major asset classes -- stocks, ETFs, LEAPS® options, bonds, currencies, futures and commodities.

Think of it this way: trend following is the only strategy that you could trade on a desert island. As long as you have market data each day, everything else is useless (i.e. CNBC, news, fundamentals, broker opinions, talking heads, etc.) for making the big money.

Top Reasons for Trend Following Investing

• Profit in up and down markets: Trend following doesn't swear an allegiance to a bull or bear market. It follows trends to the end. No matter how ridiculous trends might appear early and no matter how insanely extended they might appear at the end, follow trends. Why? They always go farther than anyone expects. Ignore momentum at your peril.

• No more buy and hold, analysts, or news: Trend following decision-making doesn't involve discretion, guesses, gut feelings, or hunches. It's not day trading or buy and hope. It doesn't involve passive indexing, in and out trading, or fundamental analysis. No more 24-hour news cycles, daily turbulence, or sensational hype. No black boxes or magic formulas either. Let go of the Holy Grails.

• No prediction: Trends exist everywhere, always coming and always going. Markets are no different: They trend up and down. That said, no one can predict a market trend, you can only react to one. Trend following never anticipates the beginning or end of a trend. It only acts when the trend changes. There is no need to figure out why a market is trending, just follow it. You don't need to understand electricity to use it.

• The big money of letting profits run: Trend following at its best aims to compound absolute returns. It doesn't shoot for average. The goal is to make the knock your socks off returns, not passbook savings interest. Trend following also has the unique ability to lie and wait for targets of opportunity. That means killing it on unpredictable surprises.

• Risk management is top priority: Trend following always has defined exit protocols to control injury to your account. Stop losses and proper leverage usage are standard practice. Trend following also has low to negative correlations with most other investment opportunities.

• Takes advantage of mass psychology: Trend following takes advantage of panicky sheep behavior. Strict discipline minimizes behavioral biases. It solves the eagerness to realize gains and reluctance to crystallize losses. Too many people believe what pleases them. Most behaviors are simply driven by the impulsive moment of now. Trend following wins because of that.

• Scientific approach to trading: Trend following doesn't require a belief, but rather it relies on unwavering scientific principles. It has a defined edge just like the MIT card-counting team that beat Vegas casinos. Be the casino, not the hapless player. Trend following uses rigid rules rooted in numbers. Think process not outcome. Remember, frequency of correctness is not the issue, the magnitude of correctness matters. Winning percentage means zilch.

• Strong historical performance in crisis periods: Trend following is adaptable to differing climates and environments performing best during periods of rising volatility and uncertainty. The unknown will happen again. Are you ready? You have to be able to ride the bucking bronco. Ride the storm out and stay alive.

• No traditional diversification: Trend following is not restricted to any single market or instrument. A focus on price action allows trend following to be applied to an exceptionally large variety of markets. Price is the one thing that all markets have in common. A trend trading system for treasury bonds should also work on the Euro and stocks. Trend following is robust.

• No government reliance: Forget Social Security, bailouts, stimulus plans, and roads to nowhere. Those won't help you to make money; they only help you lose. When the Fed puts on or takes off the training wheels (read: rate manipulation), will you be ready to mint cash or will you sit there and just take it again? If your portfolio is grounded in sound principles you can win no matter what happens.

Not exactly the daily CNBC conversation.

Trend Following

Definition from Wikipedia, the free encyclopedia

Trend following is an investment or trading strategy which tries to take advantage of long, medium or short-term moves that seem to play out in various markets. Traders who employ a trend following strategy do not aim to forecast or predict specific price levels; they simply jump on the trend (when they perceived that a trend has established with their own peculiar reasons or rules) and ride it. These traders normally enter in the market after the trend "properly" establishes itself, betting that the trend will persist for a long time, and, for this reason, they ignore the initial turning point profit. A market "trend" is a tendency of a financial market price to move in a particular direction over time. If there is a turn contrary to the trend, they exit and wait until the turn establishes itself as a trend in the opposite direction. In case their rules signals an exit, the trader exits but re-enters when the trend re-establishes.

Cutting Loss. Exit market when market turn against them to minimize losses, and "let the profits run", when the market trend goes as expected until the market exhausted and reverses to book profit.

This trading or "betting with positive edge" method involves a risk management component that uses three elements: 

1. number of shares or futures held, 
2. the current market price, 
3. and current market volatility. 

An initial risk rule determines position size at time of entry. Exactly how much to buy or sell is based on the size of the trading account and the volatility of the issue. Changes in price may lead to a gradual reduction or an increase of the initial trade. On the other hand, adverse price movements may lead to an exit for the entire trade.

If there is a turn contrary to the trend, these systems signal a pre-programmed exit or wait until the turn establishes itself as a trend in the opposite direction. In case the system signals an exit, the trader re-enters when the trend re-establishes.

In the words of Tom Basso, in the book Trade Your Way to Financial Freedom

“ Let's break down the term Trend Following into its components. 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..."Following" is the next part of the term. We use this word because trend followers always wait for the trend to shift first, then "follow" it”

Considerations

1. Price: One of the first rules of trend following is that price is the main concern. Traders may use other indicators showing where price may go next or what it should be but as a general rule these should be disregarded. A trader need only be worried about what the market is doing, not what the market might do. The current price and only the price tells you what the market is doing.
2. Money management: Another decisive factor of trend following is not the timing of the trade or the indicator, but rather the decision of how much to trade over the course of the trend.
3. Risk control: Cut losses are the rule. This means that during periods of higher market volatility, the trading size is reduced. During losing periods, positions are reduced and trade size is cut back. The main objective is to preserve capital until more positive price trends reappear.
4. Rules: Trend following should be systematic. Price and time are pivotal at all times. This technique is not based on an analysis of fundamental supply and demand factors.