A Step-by-Step Guide Towards a Trend-Following Trading Strategy by Sofien Kaabar, CFA The Startup

The first principle of risk management is not to risk a disproportionately large amount of your total capital. Some traders will limit their risk to less than 2% on any one trade – meaning, for example, that they will not risk more than $2000 if their total capital is $100,000. Because of this, it’s very important to limit the amount you lose on trades that don’t work out. It’s worthwhile to remember that trends are also tied to investor behaviour. For example, investor enthusiasm can drive stocks to extremes without any fundamental underpinning.

Alternatively, trend followers can switch to shorting stocks when the regime has changed to a bear market. Other systematic traders use different types of risk management. Some traders https://forexhero.info/paquete-de-optimizacion-lineal-de-python/ will use ATR or other indicators in order to size positions. The Kelly Formula provides the optimal position size when you have information such as win rate and expectancy.

Using Donchian Channels to follow the trend

In empirical tests it performs as good as the other types of moving
averages. Similarly, there are in principle not very big differences between
various trading rules. Hence, a trend-following strategy can be implemented as
10-month MOM, SMA, or MAE rule.

However, if too many traders start to try to take advantage of a particular strategy, that strategy will cease working as well as it did previously. You want systems that can handle the unpredictable, not those that are fitted to a specific market regime. The Average True Range indicator (ATR) is a very popular trading indicator that can be used in many different trading situations. For this strategy, we’ll use Bollinger Band indicator (BB), the technical indicator created by John Bollinger about four decades ago. We’ll also add an Exponential Moving Average (EMA) with the period 50, which will play the same role as the 50 MA in our previous strategy.

What Do New Traders Get Wrong About Trend Following Strategies?

This strategy is suitable for beginners because it’s simple and provides objective signals. Also, it uses the most popular technical indicator, which is the Moving Average (MA). Remember that MAs are lagging indicators, i.e., they reflect the historical price movements rather than magically predicting the future. Multiple timeframe analysis should be at the core of every trading strategy.

• While not typically considered a trend-following indicator, chart patterns can be used to determine entry and exit points.
• The MACD line is the most important part of the indicator, and is the difference between the shorter and longer period exponential moving averages.
• You can track the performance of the trend following strategies by looking at CTA and managed future funds.
• Using 1% of a 100,000 portfolio value would give us an account risk of 1,000.

A downtrend is the opposite – an asset’s price reaches lower low pivots and lower high pivots. This simple trend following system holds 25 stocks at a time and buys a stock whenever it makes a new 252-day high. It also incorporates a market regime filter which allows it to take new positions only when the S&P 500 is above it’s 90-day moving average.

Ending remarks about trend following strategies

Prices of securities are volatile, making it harder to see trends. The moving average creates a smooth line of price data, limiting the impact of price fluctuations that occur randomly. There are a few different ways to use this smoothed line of price data to inform trend following decisions. It can be incredibly challenging to know when to exit when that happens.

This was a buy signal because the trend was bullish while the Tenkan Sen line crossed above the Kijun Sen line in the senkou span area (Kumo). This chart is the best time frame to use because it gives you a good overall picture of how the last few days have gone as far as it trending. Just like the Donchian channel indicator, Bollinger bands fall into the category of price channels.

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By using technical tools and indicators, traders can improve their analytical process and remove a lot of subjectivity from their trading. The top-down approach is important and can often make a big difference in a trend trading approach. When the price is trending and the price keeps trending close to the outer Bands, it signals trend strength. As long as the price moves close to the outer Bands, the trend is still intact. It’s rare to see an immediate reversal when the price is moving close to the outer Bands. This knowledge can help trend following traders remain confident during their trades.

Although medium to very short-term trends are exploitable, most trend-following strategies ride long-term price movements. Trend following is one of the most popular approaches to trading, and in this guide, we will explain step-by-step what a trend-following strategy is and how it works. We’ll also show you, with practical examples, how you can use it to properly trade different markets. According to Zakamulin (2017), the MAE rule must be preferred to all other
rules with daily trading. For example, a trend-following strategy can be implemented as a 10-month
SMA with 1% envelope.

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When you spot that the ascending triangle is in the process of formation, it shows you the uptrend finds strong resistance from bears, which is reflected by the flat resistance line. Impatient traders will often get in too soon but waiting for a confirmed breakout may provide a more robust trading approach. Besides using technical indicators, there are some great strategies that rely on chart patterns. For me, the simplest and most powerful trend continuation patterns are the triangles, although not the symmetrical ones. Some traders prefer to simply go long when the price fluctuates above the BB’s mid-band and go short when the currency pair keeps moving below it. However, we’ll add more confluence factors to get more robust signals.