A trend following strategy for trading has turned into one of the most prevalent and commonplace strategies implemented by traders. The reason for the rise in the application of this strategy has to do with the elegant and straightforward nature of the trend.
When we say straightforward it is because in trend trading the trader is rather relieved of the hassle to follow every small and minute detail in price action. Instead, they can find the prevailing trend in the market and use that to identify points of entry and exit.
So, rather than trying to pinpoint a small area on the chart for their position, using trend following strategy, traders are able to trade based on a larger piece of data, i.e. the trend.
Trend Following Strategy: A Precise Definition
Trend following refers to the set of trading techniques and strategies with the help of which traders are able to trade based on trends in the market.
Trading based on the trend is pretty easy looking from the outside. In this situation, when there is an uptrend in the market you would normally go long. On the other hand, when there is downtrend you can opt to go short.
But this is only a broad look at the definition of trend following strategies. The strategies themselves are naturally more detailed and fit for various conditions.
Furthermore, the strategies known as trend following will provide the important feature for users that they only need to focus on the trend. In this case, the main duties of the trader are first detecting the existence of the trend and second to make sure that the trend does not change trajectory.
In this case the trader is not obliged to carry out much calculation with regard to detecting the future and upcoming patterns in the market.
How Do Trends Form in the Market?
Usually when we pose a question it is because there is a complex mechanism behind a phenomenon that we want to elaborate for you and show exactly what is behind all of it.
However, in the case of formation of trends in financial markets, the answer is quite straightforward. Trends form in the market the way any trends form in the real world. Much like trends in social media or even fashion trends.
So what is the key to a trend? Well, people.
When enough people start doing something, a trend forms. The same is true about financial markets. When enough people start buying or selling, a trend can take shape.
Of course, there are other indirect factors that can impact the formation of a trend, including macro-economic factors.
How Can You Identify Trends in the Market?
The way you go about identifying trends in the market is of course with the help of technical analysis indicators. In fact, there is a whole group of indicators known as trend indicators that are specifically used to identify trends in the market.
This group of indicators include the well-known moving averages indicators with various types including the moving average convergence and divergence, relative strength index, stochastic oscillator, etc.
As for the actual trend that might be identified, we have three different categories of them.
- Bullish: this group of trends which are also known as uptrends are those that are specified with a steady increase in prices over a period of time. There might be moments or instances where the trajectory of the market moves the other way around – which is only temporary. These instances are known as retracements. But following a retracement, the trend will resume its direction as before.
- Bearish: the second set of trends, which have a bearish tendency, are called downtrends. Of course as the name suggests, bearish trends have a downward trajectory. Naturally, during such trends, traders and investors alike would want to take a short position and get out.
- Neutral: there is another category of trends in financial markets that are neutral in their tendency and trajectory. So what does it mean? It means the trend is moving sideways. You might think that there isn’t much opportunity in a sideways market. But there are still smaller fluctuations and in these fluctuations you can benefit from the smaller movements.
Example of Trend Following Trading
To provide an example of trend following strategy we can simply look at the recent history of any asset in any financial market. This could of course include the forex market and the currency pairs therein. But for the purpose of this example we are going to pick a rather sought after stock – namely Tesla shares.
If you look at the recent history of Tesla, you can see that from around the middle of the year 2021, Tesla shares started picking up speed toward up. This trend kept going with a rather steep incline. In fact, it kept going with higher highs and higher lows, until approximately in November 2021, Tesla shares hit their all-time high.
Using trend following techniques and strategies, you could have picked up on the existence of this trend. As such, you would have had the chance to start going long. Long position(Long Position in Forex) after long position in the hopes that the price of the shares would keep soaring. And soar they did.
So, whoever went long during that trend certainly benefited in the end. Of course they benefited right then and there.
But there is a second side of this example.
After the uptrend was over, from around November 2021 until March 2022, there was a downtrend in the price of Tesla shares. Again if you have noticed that trend, you could have gone short with your previously acquired assets, not only saving yourself from incurring losses but ultimately giving yourself the chance to buy back your shares even more at a much less price.
Riding two trends is a win-win situation.
Advantages of Disadvantages of Trend Following Strategies
Starting with the advantages of trend following, we can mention the ease of trading. The ease comes from the fact that you do not have to adjust your position constantly – something that you will have to do with day trading or scalp trading. At the same time, exactly because of this ease of trading, trend following takes less time than other strategies of trading.
On the other hand, the disadvantage of trend following is in the nature of trends. Trends can change at any moment. So when you ride one, you never know when and if the trend will change direction and cause you to fall from your position into losing territory.
Trend following trading strategies are a set of trading strategies that involve the trades being executed based on the direction or the strength of the trend that exists in the market. Trend trading has many advantages over other forms of trading. Such as the fact that once you find the trend in the market you can simply start trading it without having to change your position or details of your strategy. But at the same time, you need to be weary of the changes that might occur at any moment in the market trend.