When does Trend Following Not Work

Good morning! Today Troy continues with 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, An Introduction into Trend Following, An Introduction into Technical Indicators

In the previous post we discussed how to use moving averages to make trend following work. If the market price crosses over and rises above the moving average, it’s time to buy (bullish position). That’s because a new bullish uptrend has started. If the market price crosses over and falls below the moving average, it’s time to sell (bearish position). That’s because a new bearish downtrend has started.

In the previous post, I mentioned that trend following is automatic – plug in the price, use a technical indicator, and voila! Buy or sell signals are automatically generated. But unlike those “make money on autopilot” scams, trend following has one critical flaw – it doesn’t work when the market is in a non-trending state, also known as a whipsaw market.

A Whipsaw Market

The market doesn’t always have clear identifiable, multi-month trends. Commodity markets are especially prone to whipsawing and being in a trendless state (e.g. gold markets, silver markets).

So don’t trend following indicators work well in a whipsaw market? Well there’s the obvious answer: in order to make money, trend following indicators need trends to at least exist in order to make money. But here’s the less obvious answer: trend following indicators generate the wrong buy/sell signals at the wrong time in a whipsaw market. Here’s an example.

1. The market was falling. All of a sudden the market starts rising. Thus, a trend follower will BUY into the market because it seems like a new bullish uptrend is being formed. But because this is a tendless, whipsaw market, the short term uptrend fails to follow through, and the market falls again. Thus, the trend follower bought into the market at the worst time possible – he bought at the most expensive price.
2. The market was rising. All of a sudden, the market starts falling. Thus, a trend follower will SELL into the market because it seems like a new bearish downtrend is being formed. But because this is a trendless, whipsaw market, the short term downtrend fails to follow through, and the market rises again. Thus, the trend follower sold (when short) into the market at the worst time possible – he shorted at the lowest price.

As you can see, trend following in a whipsaw market buys and sells at exactly the wrong time.

Thus, trend following is not an investment strategy that you can use 100% of the time. You must selectively use it when trends exist. So how do you know if the market is in a trending or non-trending phase? Thankfully, we have another set of technical indicators for that, called the ADX Trend Strength Indicator.

ADX Trend Strength Indicator

What ADX does (sounds pretty obvious) is that it determines how strong a trend is. If the reading on the ADX is low, then the market is closer to a whipsaw stage than a trending stage. Thus, the market isn’t very suitable for trend followers. When the reading on the ADX is high, then the strength of the trend is very strong. If the strength of the trend is very strong, then it means that the market is in a trend phase. That’s exactly the time when trend following techniques are most useful.

The ADX can be a positive number or a negative number. A positive number means that the trend is bullish (uptrend), while a negative number means that the trend is bearish (downtrend). What’s important here is the absolute value of the ADX number. the further the ADX number is away from zero, the stronger the trend (whether it be a downtrend or an uptrend). The closer the ADX number is to zero, the weaker the trend (which means that the market is close to trendless).