Trend Following Systems

Chapter 3 - Trading Strategies and Systems: The Trader Mastery Series

In trading, the trend is often referred to as "your friend," and for good reason. Trend following systems are among the most popular and effective trading strategies used by traders to capture large market moves. These systems capitalize on sustained price movements in one direction, enabling traders to profit from prolonged trends in both rising and falling markets. This article, part of Chapter 3 of The Trader Mastery Series, explores how trend following systems work, the tools and indicators used to build them, and how traders can implement these strategies to increase profitability.

Additionally, we will examine a real-world case study to illustrate how a well-designed trend following system can be employed in live market conditions to generate consistent returns.

What is a Trend Following System?

A trend following system is a technical trading strategy that seeks to identify and follow existing market trends. The idea behind the strategy is simple: when prices are trending in a certain direction—whether upwards (bullish) or downwards (bearish)—the trend is likely to continue for some time, providing profitable opportunities for traders who can ride the trend. The system operates by using technical indicators to detect trends and generate buy or sell signals accordingly.

Unlike mean-reversion strategies that assume prices will revert to their historical averages, trend following systems aim to capitalize on the continuation of market trends. These strategies can be applied to a wide range of asset classes, including stocks, commodities, forex, and cryptocurrencies.

Key Components of Trend Following Systems

Successful trend following systems rely on a combination of technical tools and indicators to determine the direction of a trend and signal the right time to enter or exit a trade. Some of the most commonly used components include:

Moving Averages: Moving averages (MA) are one of the foundational indicators in trend following systems. They smooth out price data over a specific period to identify the overall direction of the market. Traders often use the 50-day and 200-day moving averages to identify long-term trends. When the shorter-term moving average crosses above the longer-term moving average, it signals a buy, and when it crosses below, it signals a sell.
Breakouts: Breakouts occur when the price of an asset moves outside a predefined support or resistance level. Trend followers look for breakouts to signal the start of a new trend. For example, if the price breaks above a resistance level, it may signal a bullish trend, and if it breaks below a support level, it could indicate a bearish trend.
Relative Strength Index (RSI): While trend following systems primarily focus on identifying the trend direction, momentum indicators like RSI can help confirm the strength of the trend. A high RSI indicates a strong upward trend, while a low RSI suggests a strong downward trend.
Averaging Down: Some trend following systems involve averaging down, which means buying more of an asset as its price decreases (in the case of a bullish trend) or short-selling more as the price increases (in the case of a bearish trend). This strategy can amplify returns if the trend continues but also increases risk if the trend reverses.
ATR (Average True Range): ATR measures market volatility and helps traders adjust their position sizes or stops based on how volatile the market is. Higher ATR values indicate higher volatility, which means wider stops to account for price fluctuations.

Building a Trend Following System

To build a trend following system, traders need to define clear rules for entering and exiting trades. These rules are based on technical indicators that help identify the start and end of a trend. Here’s a step-by-step approach to building a basic trend following system:

1. Identifying the Trend

The first step in a trend following system is to identify whether a trend exists. Traders can use moving averages, trendlines, or channels to determine the direction of the trend. For example, a trader might use the 50-day and 200-day moving averages to identify trends. If the 50-day moving average is above the 200-day moving average, this indicates an upward trend. Conversely, if the 50-day moving average is below the 200-day moving average, it indicates a downward trend.

2. Entry Signals

Once a trend is identified, the next step is determining when to enter the trade. Entry signals are usually triggered when the price breaks above a key resistance level (in an uptrend) or breaks below a key support level (in a downtrend). Breakouts are particularly important in trend following systems because they confirm that the price is moving in the direction of the trend.

3. Exit Signals

Knowing when to exit a trade is equally important. Most trend followers use trailing stops to lock in profits as the trend continues. A trailing stop adjusts the stop-loss level as the price moves in favor of the trader. For example, a trader might set a stop-loss at 10% below the highest price achieved during the trade. If the price rises, the stop-loss moves up with it, but if the price falls, the stop-loss remains fixed, protecting the trader from further losses.

4. Risk Management

Risk management is crucial to the success of any trading strategy, including trend following systems. Traders should never risk more than a small percentage of their account on any one trade. Additionally, they can use the ATR indicator to set stop-loss levels that adjust to market volatility, ensuring that their positions are protected in volatile markets.

Benefits of Trend Following Systems

Trend following systems offer several advantages for traders:

Simple yet effective: Trend following systems are easy to understand and implement. They rely on straightforward technical indicators and clear rules for entry and exit.
Profitable in strong trends: These systems can generate substantial profits when the market is trending strongly, as traders can ride the trend for an extended period.
Works in both bull and bear markets: Trend following systems are not limited to bullish markets. Traders can use them to profit from both rising and falling trends, making them versatile in all market conditions.
Reduces emotional trading: By relying on technical indicators and predefined rules, trend following systems reduce the emotional element of trading, helping traders avoid impulsive decisions.

Challenges of Trend Following Systems

Despite their benefits, trend following systems also come with some challenges:

Choppy markets: Trend following systems do not perform well in sideways or choppy markets, where prices do not follow a clear trend. During these times, traders may experience multiple false signals and small losses.
Late entries: Because trend following systems wait for confirmation of a trend, traders may enter the trade later than they would with other strategies, potentially missing some of the early profits.
Volatility risks: High volatility can lead to wider stop-loss levels, which can increase risk and potential losses if the market reverses suddenly.

Case Study: Applying a Trend Following System in Forex

Let's consider the case of David, a Forex trader who uses a trend following system to trade the EUR/USD currency pair. David relies on the 50-day and 200-day moving averages to identify trends, and he uses breakout signals for trade entries.

Step 1: Identifying the Trend

In March 2022, the EUR/USD pair began to show a strong upward trend, with the 50-day moving average crossing above the 200-day moving average. David recognized this as a potential buying opportunity, confirming the trend using additional indicators such as the RSI and ATR to measure momentum and volatility.

Step 2: Entry Signal

David waited for a breakout above a key resistance level at 1.1200 before entering the trade. Once the price broke through this resistance level, David opened a long position in EUR/USD, confident that the trend would continue upward.

Step 3: Managing the Trade

As the trade progressed, David used a trailing stop-loss to lock in profits. He set the stop-loss at 2 ATRs below the highest price achieved during the trade, ensuring that he would capture profits while protecting against a sudden price reversal.

Step 4: Exiting the Trade

In early June, the EUR/USD pair began to lose momentum, and the price dipped below the 50-day moving average. David’s trailing stop-loss was triggered at 1.1750, allowing him to exit the trade with a 5.5% profit. By following his trend following system, David was able to ride the trend and capture substantial gains during the strong uptrend.

Final Remarks

Trend following systems are powerful tools that enable traders to capture large price movements in both rising and falling markets. By using technical indicators like moving averages, breakouts, and trailing stops, traders can build robust trend following strategies that provide consistent returns. However, traders must also be aware of the challenges, such as false signals in choppy markets and increased risk during volatile periods. By combining clear entry and exit rules with sound risk management, trend following systems can be a valuable addition to any trader’s toolkit.

This article is part of Chapter 3 of The Trader Mastery Series, which explores trading strategies and systems to help traders improve their market performance and maximize profits.