Trend following is a trading approach (we can even say a trading philosophy), based on the belief that markets and prices tend to be more likely to continue in current direction (trend) than to reverse. In popular trader talk: The trend is your friend.
Only Take Trades in the Direction of the Trend
The implication of the core trend following belief is that you should only take positions in the same direction as the direction in which price has been moving recently (trend) and avoid betting on reversals, because their odds are low and their risk-reward ratio is bad.
A whole big group of quantitative trading strategies is based on this idea. Some big funds base their investing or trading rules solely on the trend following concept.
Is Trend Following Better than Market Timing?
People who like trend following are usually convinced that it is extremely difficult (some even say impossible) to exactly time the turning points in a market and therefore it is better not to try at all and to grab pieces of trend moves instead.
In reality, picking turning points is really not easy. But this doesn’t mean that riding trends is a piece of cake. If it was, Market Wizards would have been much thicker, or (more likely) the book would not have been written at all.
Is Trend Following Profitable?
In one word: Yes.
There are many funds of CTAs who are able to consitently deliver positive returns to their investors, even on a risk-adjusted basis. However and of course, there are even more funds and CTAs who are unsuccessful with a trend following approach. Trend following is like any other style of investing or trading: Some people succeed with it and some people don’t. Sometimes trend following works and sometimes it doesn’t.
The Problem with Trend Following: Sometimes It Doesn’t Work
Like other things in trading and finance, the trend following idea is sometimes right and sometimes it is less right. The reason is that markets’ eagerness to make long trend moves varies over time and across markets.
Some markets move in trends more often than others. While on crude oil or stocks you have nice trending action almost all the time, on stationary vehicles like the VIX (index of implied volatility of options – see What Is VIX?) you need a once-in-a-century credit crisis in order to see something that resembles a trend. Besides, one particular market may show nice clean long trend now and go totally sideways tomorrow. You never know.
Should I Be a Trend Follower?
As you would expect from the paragraph above, the answer is It depends. It depends on many factors, most importantly on the markets you trade, the time horizon you focus on, and (not least) whether you would actually enjoy and be comfortable with a trend following strategy. Sometimes it is just frustrating to take the seventh little loss in a row before your big home run comes.