What is trend following? Why Market Wizards use it?

What is Trend Following?

Trend following is an investment strategy that aims to capitalize on the momentum of existing market trends. Traders using this approach identify and follow the direction of a market trend, whether upward (bullish) or downward (bearish), and hold positions in line with that trend until it shows signs of reversal.

Key Principles:

1. Identifying Trends:
   - Using technical analysis tools like moving averages, trendlines, and momentum indicators to determine the direction of the market.
2. Entering the Market:
   - Buying assets in an uptrend and selling (or short-selling) assets in a downtrend.
3. Riding the Trend:
   - Staying with the trend until there are clear signals of its end, such as trendline breaks or reversal patterns.
4. Risk Management:
   - Implementing stop-loss orders and position sizing to manage risk and protect against significant losses.
5. Discipline and Patience:**
   - Being disciplined in following the trend and patient in waiting for confirmed trend signals before making trades.

 

Why Market Wizards Use Trend Following

Market Wizards, as described in Jack D. Schwager's book series, are highly successful traders and investors who have achieved significant market returns. Many of these traders employ trend-following strategies for several reasons:

1. Simplicity and Clarity:
   - Trend following is straightforward and based on the observable direction of price movements, making it easier to understand and implement.
   
 

2. Objective Decision-Making:
   - The strategy relies on clear technical signals rather than subjective opinions or emotions, leading to more disciplined trading decisions.

 

3. Risk Management:
   - Trend followers use predefined entry and exit rules, along with stop-loss orders, to manage risk effectively. This helps in limiting losses and protecting capital.

 

4. Profitability:
   - By capitalizing on major market trends, traders can achieve significant returns. Trends often result in substantial price movements, providing opportunities for large gains.

 

5. Adaptability:
   - Trend-following strategies can be applied across various asset classes, including stocks, commodities, forex, and cryptocurrencies, making them versatile.

 

6. Empirical Success:
   - Historical data and numerous studies have shown that trend-following strategies can be successful over the long term. Many Market Wizards have proven their efficacy through consistent profitability.

 

7. Behavioral Insights:
   - Trend following leverages the natural tendencies of market participants to follow trends due to herd behavior, creating self-reinforcing cycles that trend followers can exploit.

 

 8. Reduced Need for Fundamental Analysis:
   - While some traders use both technical and fundamental analysis, trend followers primarily focus on price action, reducing the need for extensive research into company or economic fundamentals.

 

Examples of Trend Following Strategies

1. Moving Average Crossovers:
   - Using short-term and long-term moving averages to identify trend changes. For example, buying when a short-term moving average crosses above a long-term moving average and selling when it crosses below.

 

2. Breakout Trading:
   - Entering trades when the price breaks above resistance levels (buy signal) or below support levels (sell signal), indicating the start of a new trend.

 

3. Trendlines:
   - Drawing trendlines to identify the direction of the trend and using breakouts of these lines as entry or exit signals.

 

4. Relative Strength Index (RSI):
   - Using RSI to identify overbought or oversold conditions, which can signal potential trend reversals.

 

Conclusion Trend following is a widely used and effective trading strategy that focuses on capitalizing on the momentum of existing market trends. Its simplicity, objective decision-making process, and proven profitability make it a favored approach among many successful traders, including those featured in Jack Schwager's "Market Wizards" series. By following clear technical signals and implementing robust risk management, trend followers aim to achieve consistent returns and manage market risks effectively.

 

Related:

-  What is an uptrend? What is considered an uptrend? What happens after an uptrend?

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