Trend Following Trading Strategy: Introduction

There have been hundreds of trading strategies developed, like this one and this one. Traders, market makers and other market participants across the globe keep on experimenting with different strategies to make money by trading in stock markets by buying shares and selling them. Once such common strategy is called “Trend Following”. In this article, I’ll explain what is Trend following trading strategy, what are the advantages and disadvantages of trend following and who should go for trend following trading strategy.

What is “Trend Following”?

Trend following refers to going with the trend – or just trying to follow the direction. If the markets are going up, then one believes that they will continue to go up and they may take a long position. If the markets are going down, they may be of the assumption that markets will continue to go down, hence they start selling or going short. Trend Following emerges from the “Momentum Theory” of stock markets trading – which states that whatever is going up, will keep going up in the short term, and whatever is going down will keep going down in the short term –hence one can benefit from taking trend following positions.

One important thing in “Trend Following” trading strategy is to know you entry and exit points. Say that Microsoft is trading at $30. One week back it was at $25, hence there has been a 20% hike in share price in one week. Hence, there seems to be a “trend” or to be more precise – “an upward trend”.

Now suppose that I follow the trend following strategy, with a methodology that any stock that has gone up by 10% in 15 days or less, will continue to go up. So, when the stock price reached $27.5 from $25, then I will ENTER into this stock (or buy shares). I’ll let my profits run until I spot the exit pattern.

Hence, as long as my Microsoft stock keeps moving UP, from 25, to 28, to 30 to 35 to 40 and so on, I’ll let my profits run. The sky is the limit. I may even keep on accumulating this stock further based upon some capital management calculation.

Suppose I follow an exit methodology that if an upward moving stock takes a U-turn and comes down by 10%, then it will continue its downward direction. Suppose the MSFT stock touches a peak of $40, and then comes down to $36, a fall of 10%. This signals my exit point. Hence I sell shares of Microsoft at $36. If I have not been accumulating this share, my profits would be 36-25 = $11 per share. If I had been accumulating, my profits would be calculated based upon the weighted average cost price with $36 as the sell price. Ultimately, I make money.

Continue to Part 2: Trend Following Trading Strategy: Advantages, Disadvantages and Profits