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Why Trend Following Works & Why You Should Trade With The Trend

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I am sure you have encountered some stocks (or any other securities) that kept going higher and higher. When you think it’s already at its peak and can’t go any higher, it continues to defy gravity and continues to climb north way beyond your imagination. This phenomenon can continue for months or even years. 

That, my friend, is a trend in action. 

And if you are a trend follower, you move and get into the market after it has made its direction clear, albeit still in an early phase uptrend. You only sell and get out when the trend ends. 

Trend followers do not attempt to use fundamentals to enter a trade or try to predict where the price is heading. Instead, they react to what is currently happening in the market. 

A simple example: There can be 101 fundamental reasons why analysts or economists think the stock market could be heading for a downturn. A trend follower simply does not care. If the price is still going up, the trend follower will continue to buy or at least hold on to their positions. 

So, why does trend following work?

The #1 reason: Human beings like to follow

We are social creatures and we are hard-wired to herd. Human beings just love to follow, with a leader taking charge that will guide the rest of the group. 

This kind of behaviour finds its way into the financial market as well. 

Most traders or investors only start to take action only when a market moves. Only then they will jump on board. 

There will be a lot of attention if a particular market keeps rising. This is self-feeding in nature. When the market rises even further, it will attract even more participants. 

Most likely, it is a large institution (smart monies) that starts the initial move to buy or sell the market. Then the masses or other institutions tend to follow suit. This further pushes the market in the same direction and creating a trend. 

Think of the dotcom bubble in the early 2000s. Many of those dotcom companies were not profitable, but many investors still bought into them simply because everyone else was buying. 

Think of the Bitcoin bubble in 2017. There wasn’t really a way on how to determine the value of a bitcoin. But the cryptocurrency ascended all the way to nearly $20k (before crashing). 

Even right now in 2019, we are still in a bull market, after the Great Financial Crisis ended in 2009. This stock market uptrend is still ongoing, and it has been 10 years already. 

Many Wall Street pros and gurus have been predicting a stock market crash every year since 2011. But what is actually happening? You should know the answer: The market at the point of writing has broken all-time high. 

Why you should trade with the trend?

#1 It is simple

I believe that many people would think that for a profitable trading strategy to work, it should be relatively complex – “It cannot be so simple.”

Trend following is actually quite dumb as a trading strategy. Dumb as in it’s based on very little information.  You don’t need to know a business, an industry or a sector well. You don’t need to understand the balance sheet of a company, or how well the economy is doing. 

Trend following is simple conceptually. For those who need a primer, Alvin wrote an article over here. To put it simply, if prices start moving up, you go long (buy). If they start moving down, you go short (sell). And you try to hold on to your position until the trend changes again.

Instead of guessing where the market is going, you wait for it to establish the trend first. Once it’s clear, you jump on board and ride on the trend that has already begun. 

This means that you will never buy at the bottom and you will never sell at the top. You try to capture your profits in the middle. 

#2 It makes you more money with less stress

If you are doing trend following, you will need to diversify your risks by placing bets in different asset classes or products – futures, forex, commodities, ETFs etc. You won’t know which are the ones that will trend nicely and giving you a handsome profit. So you minimise and diversify your risk by trading with a lot of instruments. 

Sure, there will be many small losing trades because markets don’t trend all the time. There is an adage saying that markets only trend about 30% of the time. So, you will be cutting losses often. That’s part and parcel of trend trading, 

However, when you are right, you should be able to ride the trend up and your winning trades will be much bigger than your losing ones. When a market really trends, it is usually a long term move. Hence you will be making large profits. 

The profits from your successful trend trades will be so much bigger than the amount of risk you have taken on that trade. Also, it will cover all your losing trades. 

As mentioned earlier, big trends are usually long term moves. If you manage to get into the trade,  all you have to do is to hold tight and enjoy the ride. You don’t have to micro-manage the trade and stare at the charts all day long. 

Less stress and more money for you. 

Trend following is simple. You don’t need to be extremely intelligent to trade. 

You just need humility and discipline

Humility as in you accept the fact that you have absolutely no idea where the market is heading in the future and be disciplined enough to follow through the buying and selling process systematically.

Discipline as in you accept the fact that you must rigorously follow what the trend does – even if it means exiting a trade at a loss. Or even if you think the trend can go higher. Trend following is purely mechanical and has been proven to work. Discipline is required to stay the course.

The great trend followers don’t know about the future. They are disciplined and they know about the present – what the market is doing right now. They are just smart enough to follow it consistently and profitably.

Editor’s Note: Trend following has been around for a long time. It’s popular because it works but it also has its flaws in that it is not easy to follow. Not everyone has humility or discipline. Not everyone wants to follow a mechanical strategy. But oftentimes as we’ve found whether in life or investing, simple works best. We run a trend following signals subscription service. In the 3 months it has been active, followers of the subscription have turned USD$20,000 into USD$20,788.

The service is applied only on the DOW JONES INDEX components and signals are generated by a quant model built by quantitative investment professionals, Eng Guan and Patrick.

The trend following signals have so far generated 3.9% or grew $20,000 to $20,788 over 2 months. The portfolio was leveraged by 1.5x. I anticipate great things to come for the subscribers. This is in part because trend following is as aggressive in chasing gains as it is defensive in cutting losses. You can check out the signals offering here. Alternatively, if you wish to learn how to do it yourself, you might wish to check out Eng Guan and Patrick’s Quantitative Investment Course. It’s not for everyone and it’s definitely difficult, but it is incredibly rewarding for those who want stability and defensiveness while still being invested in the stock market.

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