Last Updated on 19 September, 2022 by Samuelsson
Known as one of the most popular trading styles, many new and experienced traders resort to trend following to ride the bigger moves of a market. However, as with every trading style, there are some disadvantages and advantages you should know about!
In this article, we are going to explore trend following and look at its advantages and disadvantages, and try to decide whether it’s a good fit for you and your trading!
What is Trend Following
Trend following is a trading style that attempts to catch the longer trends in a market and ride them for as long as possible. Normally traders use simple signals, like a breakout above a high or low, to know when to enter a trade. In essence, this was also the method that Richard Donchian, who is considered the father of trend following, used to construct the Donchian channels indicator back in the ’50s. If you yet haven’t heard about the Donchian channels indicator, you definitely should pay it some attention. While being more than 70 years old, in the right configuration, it remains useful still in these days.
Below you see an example of how a breakout above the upper Donchian channel band marked the beginning of a new trend!
So, now that we have had a brief look at what trend following is, it’s time to move on to what this article is going to be about, namely the advantages and disadvantages of trend following.
We’ll start with the advantages, and then move on to the disadvantages!
Advantages of Trend Following
Being one of the most popular trading methods, trend following has a lot of advantages. Low transactional costs and the ability to ride trends for long are only two of them.
So, let’s explore the benefits of trend following!
1. You’ll Catch Trends From the Very Beginning
Many trend following strategies try to identify when a market is gaining enough momentum to form a new trend, and as a result, you’ll find yourself catching most, if not all major trends. Considering that trends can last for years, you could be in for a long fine ride!
Of course, there is a downside to this, which we’ll return to later!
2. Your Entries and Exits Don’t Need to Be That Exact
As a trend follower, you’re trying to capture the big moves in the market, and aren’t that concerned with minor fluctuations. You simply have a lot of margins to play with and can afford to not get out at the top of the trend.
In fact, if this wasn’t the case, trend following would be nothing but a futile attempt to profit in the markets. You’ll never be able to exit at the top of a trend on a regular basis. You may very succeed a couple of times, but that’s luck, and nothing more!
3. Doesn’t require much time
Trend Following is a slow-paced trading form, that can be traded even by those who have a full-time job. Trends develop long term, and as we just said extreme precision isn’t a critical factor. Thus, you may place your orders for the next day after the market has closed. With some trend following strategies, it might even be so that orders only need to be placed once a week.
In other words, you don’t have to sacrifice your free time as a trend follower.
4. Lower Transactional Costs
Being a quite slow-paced trading form, transactional costs won’t be an issue at all. This is a huge advantage compared to many other trading forms, like daytrading, where transactional costs may even make some strategies untradable!
5. You Cut Your Losses Early
All great traders will attribute a large portion of their trading success to being able to control downside risk while maximizing the upside potential. And while this may seem very obvious, it’s actually not for many new traders.
The issue often lies in that many hold on to losing trades, hoping that the market eventually will return and cover their losses.
While this may work decently in a bull market as everything constantly appreciates, it will lead to disastrous consequences as soon as your clinging on to stocks in a bear market, as everything tumbles and collapses. In fact, holding on to losers is highly ineffective even during bull markets, since you’re not making efficient use of your trading capital. The reason is simple. While you wait for the stock or security to come back at the price at which you entered the trade, you’ll have missed a handful of other great trades.
Trend following done right solves this issue, since tight risk control is inbuilt into the model. You simply exit a trade when it goes against you, and save your capital for the next big move. And as soon as you stumble upon a trend that takes off, you’ll be there, riding the trend “until it bends”, as Ed Seykota once said.
Disadvantages of trend following
Having looked at some of the most prominent advantages of trend following, we’ll now turn our attention to the disadvantages.
While being a profitable and worthwhile trading form when carried out correctly, there are some less positive aspects you at least should have heard of!
1. A Lot of False Breakouts
As a trend follower, you’re constantly trying to find and ride the trends as they occur in the market. But since markets spend most of their time consolidating, it means that there will be long periods of times where no trend really gains traction, despite the market breaking out from its most rigid trading ranges.
In fact, you’ll find yourself being wrong most of the time, with as many as 80-85% of all trades ending as losses, in the extremes cases. This isn’t strange or unrealistic numbers for a trend following system, and is compensated by outsize winning trades. Expressed in another way, you really make a lot of money as you succeed to ride a trend for a long period of time. In fact, enough to both cover previous losses and make you end up with a profit.
2. Low Hit Rate
The low hit rate might not sound like an issue at first. The most important thing is that you make money, right?
Well, to be able to make any money from a trading system, you not only need a profitable trading strategy, but a willingness to execute the signals. And with a hit ratio of as low as 20%, it means that you’ll easily get 10 losing trades in a row, still needing to take the next trade as it occurs.
This is by no means an easy task. In fact, one of the biggest reasons why traders fail, apart from not having a real edge, is that they cannot cope with the psychological pressures that come with executing their trading strategy day after day.
In this sense, trend following strategies bear a significant disadvantage when compared to other trading forms like mean reversion, where you’ll instead be right about 8 out of 10 times with a good strategy.
3. You Shouldn’t Miss a Trade!
As a trend follower you’re basically waiting for those few trades that will turn the tables, and make your trading a positive venture. This means that you never want to miss an opportunity, since any trade could be the one which makes all the difference.
Of course, you should always follow your trading strategy as closely as possible, but with other trading styles where profits tend to be more evenly split between trades, a missed trade or two usually doesn’t make that much of a difference.
4. Trend Following Is Lagging
Some people like to argue that the tools used by trend traders are mostly lagging. For instance, many trend traders will use moving averages or previous highs and lows to determine when a market has broken out of its range and is likely to start a new trend.
This is completely true, but we don’t necessarily see it as a disadvantage. Most technical tools are lagging but many still work quite well. Simply put, historical price data is relevant for those who want to predict futures price moves with some level of significance.
5. Riding a Trend Can Be Hard!
Even though it might sound easy to just ride the trend until the end, that’s seldom the case.
Every time you enter a new trade, you never know how the market is going to develop. Thus, you may be inclined to exit a trade as soon as you have made a little profit, at least to keep what you’ve got so far.
But as you might have figured out, this would be devastating, since trend following once again relies on those few big winners that need time to develop.
As we’re in a trade we’ll have to face a lot of fear and angst that may prompt us to take actions we shouldn’t. And since trend following relies on trades that go on for long periods of time, you are more likely to fall for the psychological pressures that are so common in trading.
The Impact of Automated Trading
As computer technology becomes more advanced and easily accessible, more and more traders start to resort to mechanical or even fully automated trading strategies. This has resulted in a major shift, where discretionary trading is becoming much more scarce, and replaced with rules-based systems that only rely on specific conditions being met and nothing more.
This, largely, is a good development if you ask us. With rules-based trading strategies and even automated trading strategies, more people will stand a chance in the markets. However, it also has the effect of making markets more efficient and harder to trade, as competition tightens.
So what has this got to do with trend following?
Well, as you might remember, many trend following trading strategies rely on very simple rules such as 20-bar high breakouts and similar conditions. And with rules of this kind being easy to quantify and hand over to a computer, a lot more people will be able to execute these signals. And as soon as too many make use of an edge, it generally starts to fade away.
Thus, the advent of and increase in automated and rules-based trading leads to more efficient markets, which makes trend following harder.
How do you survive in this environment?
Well, the most important thing you need to start doing, is becoming creative and building your own trading strategies. In essence, you have to come up with something that’s not commonplace and practiced by most market participants.
If you’re interested in learning more about creating your own trading strategies, we recommend that you have a look at our guide to building a trading strategy. Our complete guide to algorithmic trading may also suit you well!
Should You go for Trend Following
Having covered some of the biggest benefits and disadvantages of trend following trading strategies, you might wonder if trend following suits you. As you have learned, trend following comes with some quite significant advantages, and we really think it’s a trading form you should consider.
Here we have listed a couple of points that might be good to consider before deciding if trend following is something for you!
So, if most of the following points resonate with you, you should perhaps give trend following a try:
- You want a trading style where you hold positions for longer periods of time, profiting from the prolonged swings in the market
- You don’t mind taking trades less often
- You understand that you’ll be wrong most of the time, and think you can manage it.
- You can cope with having long losing streaks
- You don’t want to spend all your time in front of the computer monitoring your systems
Trend following is one of the most popular trading styles and has been used extensively for a long time. However, as technology moves forward and the markets become more easily accessible, the simple concepts of the past may not work that well anymore. In order to stand a chance in the increasingly fierce competition, you must come up with your own unique concepts that most other market participants haven’t yet discovered.
Despite all this, trend following is a trading style that will continue to work for a long time going forward, albeit in a somewhat altered form.