Some of the most successful stock market traders and commodity traders have made their fortunes by employing a methodology known as trend following. Trend following is a systematic process through which the trader or investor buys a stock or commodity as it is rising in price with the intent of selling at a higher price, but not until after its price has begun to fall. The goal of this methodology is to capture the “meat in the middle” of market trends, rather than try to forecast turning points.
From the standpoint of methodology, trend following is the easiest way to trade. A trader can create a simple algorithm, plug it into a computerized trading platform, and have the trading signals completely automated. The trader can sit back and tend to other business and not have to worry about how the markets are acting on any given day.
At the same time, the markets do not always move in major trends. For a significant period of time, they can trade in narrow trading ranges. For commodity trading advisors who manage money in these markets, this usually results in negative returns.
This is the main reason why most small investors who attempt to trade commodities fail. They are unaware of the difficulties in following a trading system or trading strategy that looks good on paper.
One popular trading system known as the Turtle Trading System for trading commodities has been marketed as a methodology that will make the investor 100% annual returns for years on end. What the marketer has done is simply add up the profits and losses from each market traded in a basket of markets at year end, and imply that the system would make 100% returns. Unfortunately, this is not the real world of trading.
In the real world of trading a trend following system like this in a basket of commodity markets there are typically significant drawdowns that occur every year. For instance, if you start out with a portfolio of $100,000, at some point, you can expect your equity to drop by 30% or more. If this occurs right out of the gate, you are down to $70,000. Most people find this psychologically difficult to deal with, and give up. Also, when your account equity drops, smart risk management rules will require smaller position sizing in each market. As a result, it will take a while to climb back to the breakeven point. In fact, if initial equity drops by 30%, it will now take a nearly 50% return on current equity to get back to breakeven. This is why most emphasis on trading systems designed for trading commodities is on risk management, rather than the signals for entering and exiting positions.
In the stock market, some traders have experienced significant returns by employing a trend following strategy. William J. O’Neil, the founder of Investor’s Business Daily, is one of these traders. However, his methodology also incorporated some fundamental analysis of a company as well.
Trend following in the stock market tends to be more difficult because the universe of stocks to choose from is so large, and unfortunately, most stocks do not trade in trends that are very persistent.
With all this in mind, however, it would seem that applying a long term trend following system during bull market cycles is a viable way to earn above average returns for the small investor. While the universe of stocks is so large, many of today’s trading platforms and software programs allow the investor to screen stocks very quickly and easily. The investor can then focus on only those stocks that show the characteristics they are looking for in a potential trade. A smart investor can then employ the best risk management techniques utilized by commodity traders to enhance their trading performance.
In conclusion it is clear that trend following has its merits and drawbacks as a viable trading methodology. However, most of the world’s best performing traders and investors do utilize one form or another of this methodology in the trading. While Warren Buffett has often waited for stocks to become cheap, he is the ultimate trend follower in that the overall market itself has stayed within an uptrend for decades, even with the significant bear markets of the last ten years. Buffett has capitalized on this fact because he rarely sells out of a position. With that in mind, small and large investors alike should do significant research into the potential of trend following as a core trading strategy for their portfolio.
Scott Cole is a former commodity trading advisor (CTA). He has specialized in developing trend following trading systems for stocks and commodities. Visit www.besttipsfortrading.com for great insight on trading stocks, commodities and forex markets