An Introduction into Trend Following

Good morning! Today Troy continues about the investing for beginners series. You can check the previous posts about What are stocks and how to value them, How does Currency Trading Work, How are Currencies Traded, Investing in Commodities, What Fundamentals Affect Commodity Prices, What are ETF’s, What are Options, How are Options’ Prices Structured, Investing for Beginners Part 2 – Different Investment Strategies, When does Buy and Hold not Work, An Unconventional Approach to Buy and Hold, An Unconventional Approach to Buy and Hold Part 2, How the Investment Advisor Game is Played, An Introduction Into “Secular Investing”, Don’t Short When it Comes to Secular Investing

So far we’ve already covered Buy and Hold & Secular Investing. The following strategies will cover more active investing strategies. In the following posts, we will get into much more detail. There is no point in talking about a complex investment strategy without going in depth (or else we’d just be scratching the surface).

Trend following is simple, and it is what it sounds like.

1. Trend
2. following

In any market, there is a trend. If the market has gone up over the past 4 months, the trend is up. If the market has gone down over the past 2 years, the trend is down. As a trend follower (that’s what you call investors who use trend following), you follow the trend’s direction. If the market is going up, you buy. If the market is going down, you sell!

So what’s the difference between trend following and those suckers who buy at the top of a bullish trend or sell at the bottom of a bearish trend?

Why Trend Following Works

Trend followers say that they do not know how to predict trend changes (eg change from a 5 month uptrend to a 4 month downtrend). However, using this strategy, trend followers can spot new developing trends early in the trends’ stage. So trend followers can’t make 100% of the money because they can’t pick the bottom or top. But they can make 80% of potential profits because they get in during the early phases of a trend.

The suckers, on the other hand, get in during the late phases of a trend. That’s why they lose money. Whereas trend followers buy stocks in the beginning of a bullish trend, suckers buy stocks at the end of a bullish trend.

Why This Strategy is So Attractive

What makes this strategy so unique is that you don’t need to spend a lot of time investing with this strategy. However, it’s also an active investing strategy. Why? Because computers do the work for you. As much as this sounds like one of those “make $632986 an hour with this system on autopilot”, that is similar to what trend following is – an autopilot investment strategy (but unlike one of those scams, I will explain the pitfalls of trend following).

In addition, trend followers don’t care about fundamentals. Trend followers in the U.S. stock market don’t care about how the U.S. economy is doing. Their rationale? Everything that’s going on in the U.S. economy is reflected in the stock market itself. In other words, the price is telling you all that you need to know! The sum total of everything that’s going on in the market is reflected in the market’s price itself. It’s like an election, but this time we’re elected with dollars (one dollar, one vote). The market is just the sum of all the votes – how many people want prices to go up (buy), and how many people want prices to go down (sell).

So how does Trend Following Work

The key part of trend following is to identify the formation of a new trend so that you can get in early in the trend. To do that, we use mathematical formulas called technical indicators.

A technical indicator does exactly what it sounds like – it indicates when a new trend has formed. All technical indicators are based upon the market’s price. These indicators take the market price over the past X days and use that to create a buy or sell signal.

As you can see, this is an “autopilot” system (I don’t like using the word autopilot because it sounds scammy). The technical indicator is just a mathematical formula. Taking inputs (the market’s price), these technical indicators will tell you whether to buy or sell.

There are over a hundred technical indicators out there, and that is going to be the focus of my next post.