Trend Following Explained

If there’s one thing I’ve learned through all my years of managing money and following the financial markets, it’s that no one can predict the future.

Of course, there have been cases in which an investor or analyst has been right once or twice. One famous example is Robert Prechter, who used the Elliott Wave Principle to correctly predict a long-term reversal lower in gold, and a “super bull market” in stocks in the early 1980s. But the long-term track records of these so-called “gurus” are often spotty at best.

In fact, anyone who tells you that he can predict with certainty what the market will do next is no better than a roadside fortune teller. I repeat: No one can see the future. If they could, every trader in the world would be after their signals.

There are also those who attempt to trade reversals. But this strategy has its drawbacks too …

First, you have to wait for the reversal point to be reached, and then move aggressively to take advantage of the new trend. If you’re right, it can pay off in a big way. But if you’re wrong, you’ll take a big loss and be forced to exit the trade and await the next reversal point.

To me, that still feels too much like fortune telling, and it’s a system that can only be employed effectively by short-term traders who are extremely nimble.

Any analyst who claims they can consistently predict where the markets are going is no better than a roadside fortune teller.

So you may be wondering, what options are left to us? Well, I’m here to tell you that there is a way of accurately being bullish during advancing markets and being bearish or in cash during declining markets. And that method is called Trend Following.

The Requirements and Advantages of Trend Following

In order to trade trends, you must first be able to identify an established trend. In other words, make sure you don’t get in too early. By the same token, you must also wait until after the trend ends before you can exit.

If you follow those two simple rules, you will NEVER miss any bull market, nor be hurt by ANY bear market. Ever! And all you lose is a few points at either the top or the bottom! I think most investors would happily sign up for those kinds of results.

In addition to timing your moves correctly, successful trend following strategies also require discipline.

Most investors are driven by greed and fear. Those emotions cause normally cautious individuals to jump into the markets during times of irrational exuberance, and to flee at the first sign of danger.

Greed and fear contribute to the herd mentality that can distort the markets. Granted, it is comforting to be moving along with the crowd. But it is NOT profitable.

The only way to consistently profit is by removing emotions from the equation. And the only way to do that is by strictly adhering to a trading plan using unemotional buy and sell signals, designed to capture the majority move of all major trends.

If you choose to become a trend follower, you will undoubtedly feel pressure to disobey the plan. You may be tempted to react to advice from friends, current events, or the extremely powerful emotions of fear and greed.

But if you ignore those voices and stay with the trading plan, you WILL profit over time.

Ignoring Short-Term Volatility

In order to be a successful trend follower, you must also ignore short-term volatility. You must realize that trends can last months, or even years. During those long-term trends, there will be corrections to the trend.

It’s human nature to want to act in the face of an adverse move. You might even rationalize that desire by telling yourself that you’re avoiding volatility. But volatility is not always bad, and trying to avoid it often inhibits your ability to stay with the current long-term trend. That’s why successful timing strategies depend on volatility to profit.

Trend Following Protects Against Losses

Trend following not only gives you the opportunity to profit in both up and down markets; it also helps you avoid large losses by protecting your capital.

There will always be occasional failed trends, or trendless markets. But if you keep your capital intact, you’ll be ready to jump on board when the next profitable trend begins, and ride it to the end.

Trend followers do not try to anticipate reversals or breakouts. We respond to them.

Trend followers are not prognosticators. We just identify and follow trends.

Trend followers believe the markets are smarter than any of us. We make it our business not to try to figure out why the markets are going up or down, or even where they are going to stop.

We simply identify trends, trade those trends, and patiently allow them to play out while our profits grow.

Predicting the markets is a fool’s game. The way to beat the financial markets year after year is by following trends, and by sticking with your trend-trading strategy through thick and thin.

Remember, no one can consistently predict where the markets are going, or when the next trend will begin. But by employing our trend-following strategy, we don’t even need to try.

Sincerely,

Douglas