Traders who use good trend-following systems and have a good trading plan that includes a proper money management strategy are able to make substantial and consistent profits over time.
Trend following is a fantastic strategy because it’s simple, doesn’t take a long time to run, and has a long and consistent performance record. The return for winning trades is exceptionally high and it is possible to manage this type of trading system easily, even for people who have a day job, or when the trader wants to travel and dedicate much of his time to other passions. Like your family and friends!
When talking about trend-following strategies, one of the interesting questions that arises is “Why do trend-following strategies really work?” closely followed by “If this method makes money consistently, can it be taught?” and if it is not such a complicated methodology, then “Why is it not used by all traders?”
These are really interesting questions and in this article, we are going to explain the main reasons why trend following strategies work and should continue to work in the future.
Trend tracking is simple but not easy
Trend following is actually a simple trading strategy. A great trend-tracking system doesn’t have many rules, and these rules can be very simple. This means that the trader does not have to be a rocket scientist to create and apply his own trend-following system. Given their simplicity and profitability, anyone would think that all traders could employ these systems and make huge profits on the market.
However, this is not the case and now we will explain why.
Tracking trends isn’t emotionally straightforward, but the fact is, it works
Most investors are unwilling to deviate from their decisions regarding their market operations and quickly lose confidence in a trading system, especially when it is a long-term system where 60% -70% of their Trades are losers (even if you end up making a large amount of money in total with positive trades). Many factors play a role in this, but let’s say arrogance, insecurity, impatience, and the need to always be right are major influencing factors.
Impatience is one of the main reasons. Many people are simply unwilling to wait patiently and DO NOTHING while a trend is moving in the right direction and providing them with ideal conditions to enter the market. Due to this impatience, many people simply cannot follow a trend-following system.
I would say that the second most important reason is that our educational system teaches us that we must always be right. In school we want to get 100% on a test, and if we get less than 90%, 80%, 70% or 60% we will have failed. This way of thinking in school may be fine, but trend following requires the trader to try to enter many potential trends and exit quickly with a small loss if they are wrong. This means that trend followers have a lot of small losses and are often wrong.
Most people (because of our educational system) don’t like to be wrong. When a trader using long-term profitable trend-tracking systems tells people that they are wrong in 60-70% of their trades, others look at him in horror: the expression on their faces says’ How can this be? so stupid? He must be the stupidest trader on earth. But when this same trader tells them that he gets 10 times more on his winning trades than the total amount lost on his losing trades, they get confused and stop asking questions.
The math of trading is something to be learned. The expected profit per trade is an important indicator, the percentage of winning trades is not. But most people are emotionally more comfortable with a high percentage of winning trades, even if they end up losing money in the end, as they can at least say that they are right and that their small number of losing trades is just “bad luck.” . They blame someone else like the market or their broker for those losses and only focus on their high percentage of winning trades. They delude themselves that they will earn money this way.
Systematic trading, such as that applied when using trend-following systems, removes human emotion from all areas of trading, if done correctly. It simply allows the trader to identify when a price movement occurs and capture it. Removing human emotion from market decisions really is the key to making consistent profits in environments as complex as financial markets.
We know that trends really do happen, a glance at almost any price chart of any market will show it. So when our trend-tracking system finds a trend and allows us to enter it at a good point, we benefit from both the change in fundamental conditions and the change in investor sentiment.
When a trend is reversed, the trend monitoring system takes us out of the market (without the intervention of emotions) and allows us to capture the profits. Emotion-driven traders and buy-and-hold investors lose money because they expect prices to return to previous highs. On the contrary, at this point the follower of the trend has already exited and has his profits.
Trend tracking and mutual funds
Mutual funds cannot be trend followers because they have to be fully invested. They also often have a mandate (such as a certain sector) and have to have a portfolio close to the relevant index, otherwise they have too high a risk of underperforming the index and the other mutual funds if they mess up.
Trend tracking systems have a great advantage over mutual funds because they have the ability to exit markets that are moving in the wrong direction and only stay in markets that are going in the right direction. If there are no relevant trends in the market, the trend-following trader can stay on the sidelines waiting for the right conditions (or if he is more advanced, he will have other trading strategies that allow him to make money in the markets when there is no trends).
In addition, a good trend-following system allows you to make money in both bull and bear markets since it focuses precisely on following these trends. By contrast, mutual fund managers lose money by the handful as the bear market progresses.
This means that the equity curve when using a good trend-tracking system can be much better than the equity curve of a mutual fund, especially if the market has had periods of downtrend. Let’s just look at the following example of a trend-tracking system whose equity curve overlaps the return of the ASX200 stock index. An investor who had applied a buy and hold strategy on this index would have gone nowhere and rather would have experienced very large drawdowns during this period. On the contrary, if this trend-following strategy had been applied, the performance would have been much higher, with lower drawdowns.
Of course, not all trend-following systems produce such good results. There are good and bad ones, and in the end much of the success of a system depends on the trader who uses the methodology.
Obviously, there is no guarantee that these results will continue into the future, nor am I suggesting that the same benefits will be obtained. But when a market shows signs of a turnaround, trend-following traders do not stick to the previous trend: this is a clear advantage over investing with a mutual fund manager who has to build his portfolio in such a way that it follows very closely. closely the market index or compared to investing in an index fund, which is a very passive strategy.
Spaciousness and flexibility
The great advantage of trend-following strategies is that they can be applied in any market and produce good results in all. All markets, including Forex, stocks, raw materials, etc., present short, medium and long-term trends with their corrections, which can be used by traders and their trend-following systems to enter the market and ride movements They can last for days, weeks, months and even years.
The principles of trend following strategies can be used in all markets as trends behave in much the same way, regardless of whether we are trading EUR / USD or crude oil. In an uptrend, there will always be downward corrections while in a downtrend there will always be upward corrections.
Certain conditions may vary, such as volatility, the fundamental factors that move the market, the amplitude of the movements, etc., but the way in which the trends behave is always the same. And in all of these markets, a medium-long-term trend can produce big profits if the trader can enter at the right time.