What is a trend-following strategy, and how can you apply it?
Trend following is one of the most popular approaches to trading, and in this guide, we will explain step-by-step what a trend-following strategy is and how it works. We’ll also show you, with practical examples, how you can use it to properly trade different markets.
Trend-following strategies are based on the analysis of existing price movements. We could compare the trend follower to a surfer riding a wave or a passenger boarding a moving train convinced that he or she will continue to their evident destination.
Unlike other approaches, this strategy doesn’t rely on forecasts about future prices. Rather, it operates under the assumption that if a market is moving in a certain direction, it will continue to do so for a certain period, thus creating profit opportunities.
The most important (and difficult) aspect of this type of strategy is choosing the right time to take advantage of the current trend, just like the surfer with his wave or the passenger who has to get on or off at the right train station.
To do so, you must first understand the nature of market trends, how to recognize them, and how to use them to your advantage (if you have any questions on these topics, click here).
The operational scheme of a trend-following strategy is very simple: the trader identifies an ongoing trend and enters the market hoping that the movement continues more vigorously to make a profit.
Depending on the type of trend, there can be two approaches:
If the trend is bullish, meaning the price of the underlying asset is trending upward, then a position called "long" or "buy" will be opened)
If the trend is bearish, or decreasing, a position called "short" or "sell" will be opened).
As you can see, the process is very intuitive. The difficult aspect lies, as we said before, in identifying the right time to enter and exit the market.
Getting the entry or exit point wrong or incorrectly setting a stop loss can seriously jeopardize the outcome of the strategy and, consequently, your profits. Exactly like a surfer who misses a wave or a passenger who gets off the train at the wrong station, improper timing can yield disappointing results.
Ideally, you should be able to spot a trend as soon as it starts so that you can make the most of it; it’s one thing to ride a trend from $90 to $100, and another to enter at $50 and exit at $100.
In short, the longer you "ride" the trend, the more you gain!
Here lies a key question to trend-following strategies: on which markets should this strategy be used and to which underlying assets does it best apply?
In general, trend-following strategies are particularly suitable for trending markets, that is, markets that tend towards strong, long-term price movements.
A typical example of a trending market is commodities. Commodities rarely move sideways, and therefore are well suited to riding long-term trends.
Although medium to very short-term trends are exploitable, most trend-following strategies ride long-term price movements.
As stated, the commodity market is ideally suited for trading with trend-following strategies. However, this technique can also be used to exploit downturns in the S&P 500 or Nasdaq index or to profit from movements in grains.
As you'll see in the links, the trend-following strategies we suggest are suitable for those trading with low capital, making them perfect for beginning traders or those with a very low-risk profile.
Among the markets that you can approach using trend-following strategies even with little capital are Feeder Cattle futures and Corn futures. These markets are well suited for trend-following strategies and offer a good level of downward scalability.
As you can see, there are many markets that you can trade using trend-following strategies, however, always be careful!
Although some markets are known for their compatibility with this approach, we at Unger Academy caution you to always test markets for their specific features before investing money.
Some characteristics of underlying assets can change over time, so it is good to always test approaches before trading with real money.
In the video below, one of our coaches shows how to use a very simple trading system consisting of just two lines of code to figure out whether or not a market has characteristics suitable for trend following. Don't miss it!
Trend following is one of the main approaches to trading. It's a strategy trying to profit from market trends that are already in place. Trend-following strategies can be bullish or bearish in nature depending on the trend and can be short, medium, or long-term.
Generally, this approach is well suited to trading markets such as commodities, which have characteristics of low volatility and rare laterality. Of course, as with any other strategy, the advice is to test the approach with a demo account before investing real money.
In short, the important thing in trend-following strategies is to ride the movement as much as possible, which is why it's crucial to correctly choose the entry point, exit point, and any stop losses.
Lastly, remember that “trend is your friend”!