1/1/2014 Trend Following By Tri, Senior Analyst NUS Students Investment Society NATIONAL UNIVERSITY OF SINGAPORE
Introduction Trend following was introduced by Richard Dennis when he taught trading strategies to a group that became known as the Turtles. Throughout the 1980s and to this day, several in this group became highly profitable traders and fund managers, who returning many multiples of their investor's original capital. In general, trend following is a type of momentum trading strategy, where the trader attempts to capture profits through the strong movements in price. In contrast to fundamental analysis, or even some formed of technical analysis, trend followers do not attempt to speculate the future price movement. Rather, it is a reactive strategy, where the trend follower systematically enters and exits based after observing certain pre-determined conditions. In this article, we will look into more details about trend following as a strategy. Assumptions behind trend-following Like all other technical analysis system, trend-following is based on the assumption that historical price is reflective of future performance. That is, price actions will repeat itself and trend will act in predictable patterns. Moreover, trend-following acts on the assumption that the market is inefficient, and any adjustment as a result of some underlying events that could affect the asset s price will take course over a time period, causing the emergence of trends. Essentially, trend-following is a long-volatility strategy, with traders betting on the future volatility of the market. As volatility is often associated with risk, it can be said that trend-following is the opposite of the fundamental approach, as it performs well with assets with high-risk instead of high historical return. Therefore, trend-following has little to do with the fundamental performance of the asset class, such as historical earning in the case of stocks. In fact, the most profitable assets for trend-following are those with risky fundamental outlooks, such as penny stocks, or those whose fundamental data plays a less important role, such as commodities and futures. Market conditions play an important roles in the profitability of trend-following. In a trending market, when volatility is high, trend-following systems performs particularly well. In a sideway market, however, supports and resistances tend to hold strong, and trend-following systems will suffer a series of small losses in the form of whip-saws. A good trend-following system is one that can cut loss as aggressive as possible in a non-trending market, and one that can ride the trend as long as possible in a trending market. The four stages of a trend 1. Trend Formation: The trend often starts when there is a strong break-out after a period of a sideway movements. The breakout signals the end of the period of uncertainty. Either way, the market takes side following a significant event. Alternatively, but rarely, the new trend is formed after an abrupt reversal of the previous trend. The trends formed in such cases are particularly strong, as the underlying event is so significant that its effect override the current market direction. Either way, the break-out should be accompanied by an increase in trading volume.
2. Accumulation/Distribution: The price movement picks up momentum. In an uptrend, the strong performance of the asset has started to attracted buyers, whereas in a downtrend, the fall in price has started to take toll on the holder of the asset. In either way, this phase is characterized by a series of successive break-out. Additionally, newly formed high and low will be higher than previous level the case of an uptrend and vice versa for a downtrend. 3. Acceleration: Price movement accelerates, and volatility is the highest. This phase is often associated with the hysteria/panic of the market, where the market if fuelled by risk-on appetite in a bullish trend, or risk-of appetite in a bearish trend. Astute fundamental investors, however, will notice the overpricing/underlying of the asset s price, and looks to exit the market before the crash in the case of a bullish trend, or to enter at a discount in the case of a bearish trend. Trend followers, however, will stay in the market in this phase, as they want to maximize return from a strong trend for as long as possible. 4. Reversal/ End of Trend: This phases often marked by an abrupt reversal, often due to a market-changing events such as an adjustment of interest rates in the case of foreign exchanges. In other cases, price undergoes a side-way movement, as market participants become uncertain over the future direction of the trend. For example, in an uptrend, while the market is still in demand, many potential buyers were deterred by the high price, while some asset holders have started to take profit. Of course, this movement could be simply mistaken as a temporary correction in the middle of the trend, and that the trend will continue. If the movement is really just a correction, trend followers can always enter again when price break-out of the previous high, following the overall strategy Buy high, sell higher. 1 2 3 4 (1) Formation: an uptrend formed after price moved above significant resistance (2) Accumulation: price gained upward momentum, higher highs and higher lows were formed (3) Acceleration: upward momentum is at its maximum (4) Reversal: trend reversal after a head and shoulder pattern were formed
The general strategy of trend-following 1. Entry and exit: Although there are many different strategies to trend-following, the universal strategy for all trendfollowing systems is Buy high, sell higher. At first glance, this seems counter-intuitive and is in contrast with the old saying Buy low, sell high. However, the assumption is that if the underlying event is significant enough for price to break out of the supports and resistances, it is a significant enough to cause a long-term trend to emerge. In general, trend followers will trade in the direction of the break-out in hope of catching the trend early, and ride it for as long as possible. Regarding exiting strategy, trend followers will exit as soon as there is potential signals for a trend reversal. Some common exit signals are when price crosses below the Moving Average, when a lower low (in an uptrend) or a higher high (in a downtrend) is formed, or when price shows reversal patterns such as the head and shoulder pattern. Trend followers enter here Trend followers exit here 2. Technical indicators: Although good trend-following systems can make profit with price action alone, many uses technical indicators to fine-tune entry and exit points. In particular, trending indicators such as the Moving Average are commonly used to determine the start of the trend. Oscillators such as the Moving Average Convergence - Divergence, or the Relative Strength Index, may also be used to distinguish smaller short-term movement within a long-term trend, as well as to determine the overall strength of the trend. Overall, oscillators can assist traders in determining the optimal entry point. Finally, since trend-following is a long-volatility system, may traders use volatility indicators such as the Average True Range. The purpose of such indicators is to determine the current conditions of the market regarding volatility, and whether trend-following would be profitable.
3. Money Management: Limiting losses in the major rule for trend-followers. During losing periods, positions are reduced and trade size should be cut back. Alternatively, it is recommended to limit the maximum risk per trade to a fix level, either through adjust the position size or the stop loss level. The main objective in both strategies is to preserve capital during a period of successive small losses, until more positive price trends reappear. Example from a trend-following system To demonstrate the viability of trend-following in the long-run, we will now examine the performance of a simple trend-following system. The system enters a trade when prices break out of the most recent high/low form since breaking out of the 200-period Exponential Moving Average. Exit signals are given when price crosses below the 100-period Exponential Moving Average, or when it reached the take-profit level. For risk-management purpose, each trade s maximum risk will be limited to 3% of the account balance. On the m30 chart, after back-testing using price data of the FX pair NZD/USD since 2000, the system yields an absolute return of 35.61%. The system perform consistently well, and the period 2007-2009 proves to be goods years for trend follower. Fundamentally, this could be explained by the strong trend formed by the events in the US economy, such as the mortgage crisis in the late 2007, the following financial crisis in throughout 2008 and the Federal Reserve s adoption of Quantitative Easing in 2009. 1 2 3 (1) The mortgage crisis (2) The start of the global financial crisis (3) Quantitative Easing 1
These facts demonstrates that trend following works in high-volatility environment, and that it works in both bull and bear markets. Conclusion If done right, trend-following is a profitable trading strategy. However, it is not a suitable strategy for everyone. While this article outlines the general trading philosophy behind trend following, the exact strategy should be determined by the individual traders. More importantly, for any strategy to works, the traders himself should be disciplined and patient with his own system. For more information on trend following, I recommend to read the following book: Trend Following by Michael Covel. Email us @ research@nusinvest.com if you have any questions! We will do our best to answer your queries! This research material has been prepared by NUS Invest. NUS Invest specifically prohibits the redistribution of this material in whole or in part without the written permission of NUS Invest. The research officer(s) primarily responsible for the content of this research material, in whole or in part, certifies that their views are accurately expressed and they will not receive direct or indirect compensation in exchange for expressing specific recommendations or views in this research material. Whilst we have taken all reasonable care to ensure that the information contained in this publication is not untrue or misleading at the time of publication, we cannot guarantee its accuracy or completeness, and you should not act on it without first independently verifying its contents. Any opinion or estimate contained in this report is subject to change without notice. We have not given any consideration to and we have not made any investigation of the investment objectives, financial situation or particular needs of the recipient or any class of persons, and accordingly, no warranty whatsoever is given and no liability whatsoever is accepted for any loss arising whether directly or indirectly as a result of the recipient or any class of persons acting on such information or opinion or estimate. You may wish to seek advice from a financial adviser regarding the suitability of the securities mentioned herein, taking into consideration your investment objectives, financial situation or particular needs, before making a commitment to invest in the securities. This report is published solely for information purposes, it does not constitute an advertisement and is not to be construed as a solicitation or an offer to buy or sell any securities or related financial instruments. No representation or warranty, either expressed or implied, is provided in relation to the accuracy, completeness or reliability of the information contained herein. The research material should not be regarded by recipients as a substitute for the exercise of their own judgement. Any opinions expressed in this research material are subject to change without notice. 2014 NUS Invest