Trend Following is a popular trading strategy that involves identifying and trading in the direction of the prevailing market trend. The core idea behind trend following is relatively straightforward: “the trend is your friend.” Traders who use this approach seek to capitalize on sustained price movements, whether upward or downward, by entering positions aligned with the current market momentum.

At its essence, trend following relies on the assumption that asset prices tend to move in persistent trends rather than random fluctuations. By identifying these trends early and holding a position until the trend shows signs of reversal, traders aim to capture significant portions of a price move. This strategy applies across various markets, including forex (FX), contracts for difference (CFDs), indices, and stocks.

One common method to identify trends is through moving averages. For example, a trader might use a 50-day moving average (MA) and a 200-day MA to determine the trend direction. When the shorter-term MA crosses above the longer-term MA, it signals a potential uptrend; conversely, when it crosses below, it indicates a downtrend. This is often referred to as the Moving Average Crossover strategy.

Formula:
Simple Moving Average (SMA) = (Sum of closing prices over n periods) / n

For example, SMA50 = (Sum of last 50 closing prices) / 50

A real-life example of trend following can be observed in the stock market with Apple Inc. (AAPL). Suppose a trader noticed that Apple’s 50-day MA crossed above its 200-day MA in early 2020, signaling a strong uptrend. The trader then bought shares and held them as the price continued to rise for several months, riding the trend and realizing substantial gains before the trend reversed or momentum slowed.

In the FX market, trend following is also prevalent. For instance, during the period when the EUR/USD pair was in a downtrend from mid-2014 to early 2015, trend followers who shorted the pair based on moving average or momentum indicators profited from the prolonged depreciation of the euro against the dollar.

Despite its straightforward premise, there are several common mistakes and misconceptions associated with trend following. One frequent error is entering trades too late, after much of the trend’s profit potential has already been realized. Since trends can sometimes be visible only in hindsight, distinguishing between a genuine trend and a short-term price swing can be challenging. This leads to the risk of “chasing the market,” where traders buy at or near peak prices.

Another pitfall is failing to use proper risk management. Trend following often involves holding positions for extended periods, exposing traders to the risk of sudden reversals. Without setting stop-loss levels or position size limits, traders may suffer large losses when the trend abruptly changes.

Some traders also mistakenly believe trend following guarantees profits. Like any strategy, it has periods of drawdowns and false signals. It tends to perform well in trending markets but struggles during sideways or choppy conditions. Therefore, many trend followers incorporate filters or combine trend indicators with momentum oscillators to improve signal reliability.

Common related queries include: How do you identify a trend in trading? What are the best indicators for trend following? How long should you hold a trend following trade? What is the difference between trend following and trend trading?

In summary, trend following is a time-tested trading strategy focused on capitalizing on sustained market movements by trading in the direction of the prevailing trend. It requires patience, discipline, and effective risk management. While simple in concept, success demands the ability to accurately identify trends early, avoid false signals, and manage trades prudently.