I was 24.
I was on the train, going back home from the ulu NTU. The journey was long and not wanting to waste time, I pulled out Michael Covel’s book on trend following and started reading.
I was more interested in the stock market than my engineering degree. That said, the latter still had an influence on how I looked at markets.
The trend-following concept, being mechanical and simple, resonated with me almost immediately.
I was absorbed in the book and was inspired by the legendary traders’ war stories. Names like Ed Seykota and Richard Dennis stuck in my head and quickly became my trading idols.
Maybe you are like me who would like the trend following approach. Let me introduce it to you.
Concept #1: You need trends to make money.
If a stock doesn’t move at all, how are you going to make money?
If you reduce all investing and trading to its basic elements of making money, it is to be able to catch a trend in the right direction. The differences are in the methodologies.
Value investors use cheapness to identify potential price rebounds. To make money, the stocks that they chose have to trend higher than what they have paid for. Their belief is that using metrics like low price-to-book or price-to-earnings ratios would help them identify price reversals that would trend in their favour eventually.
Passive investors who buy ETFs can only profit if the indices are trending higher in the long run. Their belief is that assets such as stocks and bonds appreciate over time because of inflation and economic growth.
Most methods are indirect, involving the use of non-trend related metrics to identify good investments. Since everything relies on a trend to make money, why not just reduce the strategy to identifying trends instead of looking at indirect metrics? For example, trend followers can solely use moving averages to determine trends and make money.
Trend following is reductionist thinking – reducing the money-making approach to its simplest form.
Apt to use a quote from Einstein,
“Make everything as simple as possible, but not simpler.”
Concept #2: Accept the fact that you won’t know where the market is heading next. (It has nothing to do with your intelligence.)
You might think that you need to predict the right trends to make money. No.
Trend following is not about prediction. In fact, it is the opposite. Instead of being a smart aleck believing that you have some god-like intuition of the markets, you surrender your ego and just ‘follow’ where the markets want to go. Because nobody really knows.
Another apt quote,
“We have two classes of forecasters: those who don’t know – and those who don’t know they don’t know.”John Kenneth Galbraith
As the trend following name suggests, just follow the trend, not predict the trend. This means that trend followers usually wait for a trend to be established first before they put on a trade.
Concept #3: What goes up, can go up even higher!
Have you found a good stock but didn’t buy because you felt it was too pricey?
However, you regretted as the stock shot up subsequently, leaving you with yet another missed opportunity.
Trend following doesn’t care whether a stock is cheap or expensive. It has no concept of that. You can buy as long as it has proven a trend is ongoing and the entry rules have been met. Hence, you would be able to lower your chance of missing out opportunities.
Trend following applies to maximise profits too.
Have you ever sold a stock only to see it go up even more?
It is so difficult to know where the top is. Although trend-following cannot get you out at the top, it can help you get out NEAR the top. This is the most beautiful part of the strategy because it allows you to throw away your predictions and just rely on the exit rules to reap the maximum profit out of a trending stock.
You would often hear trend followers say ‘trailing stops’. What it means is that the trend followers will put a sell order below the prevailing price, to give some room for the share price to fluctuate. As the price trends higher, the sell order will be shifted upwards and yet still have some room for the price to fluctuate. This means that in theory the prices can continue to go up to infinity and a trend follower gets to hold onto all those profits.
One day, the stock price would reverse and touch the sell order. The trend follower would have exited the trade and kept the maximum profits.
Concept #4: What goes down, can go down even lower!
Sometimes you might think that a stock is very cheap and bought it, only to witness it to drop lower. And the next worse thing an investor can do is to continue holding on to the growing losses instead of admitting his mistake.
Trend following will prevent this from happening because they are always prepared to be wrong. Without an ego, trend followers get out if they got the direction of the trend wrong. To do so, trend followers set price levels which they would sell if the prices ever hit those levels.
This simple principle would prevent mounting losses and protect the investor’s capital.
Concept #5: It is a game of probability.
Trend following is about probability and not certainties. Not every trade will work out and there will be losses to be taken. However, given enough trades, the winning trades will generate profits to cover the losing ones and more. This happens because the stop losses will limit the losses to small amounts while the trailing stops will maximise the profits. Hence, trend followers have to continue to put on trades according to the signals regardless of how the past trades performed.
Trend following has to be applied to a portfolio of stocks and not just one or two and expect wonders. This is because the probability only works on a sufficient sample size. Diversification increases the odds of catching strong trends in any industry or stock.
There are many strategies you can use to profit from the markets. However, a few of them have such mechanical and simple rules as with trend following.
If I can reduce trend following to a mantra, this would be it: “cut the losers short and let the winners run“.
Most trend following relies on technical analysis or chart reading to determine the entries and exits.
There are quantitative ways to do it which can be less subjective and emotional.
You can learn more about it in this intro class conducted by experienced fund managers employing the trend following strategy.
If you are already convinced of the trend following strategy but have no time to implement it, you can consider using our trend following signals service. You get daily trade signals via telegram. All you have to do is watch, follow and execute. You can find out more about it here.