Trend following: buying strength, selling weakness
What a trend following system does, what its rules tend to look like, the shape of its results, and why it spends so much of its time being wrong.
By Baris Demirci · · Rev00
The idea
When prices start to move in one direction, they often keep going for longer than anyone expects. A trend following system does not try to guess where a move will start or end. It waits until a move is already under way, joins it, and stays in until the move turns.
It never buys at the bottom or sells at the top. It gives up the first part of every move to confirm the trend, and the last part to confirm the turn, and aims to catch the middle.
That is close to the opposite of mean reversion, which buys weakness and sells strength. Trend following buys strength and sells weakness.
What the rules look like
Almost every trend following system has three parts:
- A measure of trend. Price above a long moving average, a move over several months, or a new high over a set number of days.
- An entry when the trend begins. For example, price breaking above its recent high.
- An exit when the trend ends. Price falling below an average, a new low, or a trailing exit that follows price up and is never lowered.
Trend systems usually hold for weeks or months, not days. Many are built to run across many markets at once, such as stocks, bonds, commodities and currencies, because each market trends at different times.
The shape of the results
Trend following has the mirror image of mean reversion’s pattern:
- It is wrong often. Many breakouts fail, and the system is stopped out for a small loss. It is common for well under half of all trades to make money.
- The losses are small. A failed trend is cut quickly.
- The gains are rare but large. A real trend is held for as long as it lasts, and a few of those carry the whole record.
Where it works, and where it struggles
- It does well in long, sustained moves, up or down, and in some markets during crises, when prices fall far and for a long time.
- It struggles in choppy markets. Price breaks out, the system buys, price falls back, the system sells, and it happens again. Each round trip is a small loss, and they pile up.
- It can spend years behind simply holding the market. A trend system on one stock index sits out some of every rise while it waits for confirmation. Our trend overlay study shows a long stretch of exactly that.
What it asks of you
- Living with being wrong. Most trades lose. That is normal for the system and says nothing about whether it still works.
- Letting winners run. The urge to take a gain early is strong. A trend system that takes gains early cuts off the rare large wins that pay for everything else.
- Watching gains given back. Every trend ends with a turn, and the exit only comes after the turn. Part of each big gain is always handed back.
Mean reversion and trend following side by side
| Mean reversion | Trend following | |
|---|---|---|
| Buys after | a fall | a rise |
| Right | often | under half |
| Gains | small | large, rare |
| Losses | large, rare | small |
| Suits | choppy markets | long moves |
| Feels | easy most days | hard most days |
Because each tends to do well when the other struggles, many traders run both. Why that can matter more than perfecting either one is the subject of The Holy Grail is uncorrelated systems.
The short version
A trend following system buys strength and sells weakness. It is wrong often, loses small and wins rarely but large. It does well when markets move far and badly when they chop sideways, and it asks you to sit through long runs of small losses for the few trends that matter.
Written for people building their own systematic portfolio management process. Nothing here is a recommendation to buy or sell anything. See the disclaimer.