How to Use Trend Following Strategies for Long-Term Investing

When it comes to investing, there’s an age-old debate between two camps: fundamental analysis and technical analysis. While fundamental analysis focuses on valuing securities based on their intrinsic value, technical analysis focuses on the price movements and patterns of assets. One of the most popular and time-tested strategies within technical analysis is trend following.

Trend following is a strategy that seeks to capitalize on the momentum of an asset by riding the trend—be it upward or downward—until there's a clear signal that the trend has reversed. While often associated with short-term trading, trend following can also be a powerful tool for long-term investors. In this article, we’ll break down how trend-following strategies work, their benefits and risks, and how you can incorporate them into your investment approach.

What Is Trend Following?

At its core, trend following involves identifying the direction of the market or an asset’s price movement and taking positions that align with the trend. If an asset is in an uptrend, a trend follower buys and holds; if it’s in a downtrend, they may sell or short the asset. The goal is not to predict price movements but to identify existing trends and act accordingly.

Characteristics of Trend Following

• Long-term focus: Trend following often involves holding positions for weeks, months, or even years, as long as the trend persists.
• Rules-based approach: Decisions are typically based on clear, predefined rules rather than intuition or emotions.
• Works across markets: Trend following can be applied to stocks, commodities, currencies, and bonds.
• Reactive, not predictive: Trend-following strategies react to market data rather than attempt to forecast future price movements.

One of the most famous proponents of trend following was Richard Dennis, who, along with his partner Bill Eckhardt, trained a group of novice traders known as the "Turtle Traders." Using a simple set of rules, these traders managed to achieve remarkable success in the financial markets.

How to Identify Trends

To implement a trend-following strategy, you first need to identify whether an asset is in an uptrend, downtrend, or no trend at all. This can be achieved using various tools and indicators:

1. Moving Averages

Moving averages smooth out price data to help you identify the overall trend. Two popular types are:

• Simple Moving Average (SMA): The average price over a specific period, such as 50 days or 200 days.
• Exponential Moving Average (EMA): A weighted average that gives more importance to recent prices.

An asset is considered to be in an uptrend if its price is above a certain moving average (e.g., the 200-day SMA) and in a downtrend if it’s below it.

2. Trendlines

Trendlines are drawn on price charts by connecting consecutive higher lows in an uptrend or lower highs in a downtrend. These lines provide a visual representation of the trend.

3. Relative Strength Index (RSI)

The RSI measures the speed and change of price movements, helping traders understand whether an asset is overbought or oversold. While RSI is often used for mean-reversion strategies, it can also confirm trends in conjunction with other indicators.

4. Average Directional Index (ADX)

The ADX measures the strength of a trend, regardless of whether it’s up or down. A high ADX value generally indicates a strong trend, while a low value suggests a weak or nonexistent trend.

Implementing a Trend-Following Strategy

Once you’ve identified a trend, how do you act on it? Here’s a step-by-step guide to implementing a simple trend-following strategy for long-term investing:

Step 1: Define Your Rules

Your strategy should include specific entry and exit criteria based on technical indicators. For example:

• Entry Rule: Buy when the 50-day EMA crosses above the 200-day EMA (a golden cross).
• Exit Rule: Sell when the 50-day EMA crosses below the 200-day EMA (a death cross).

These rules should be strictly defined to remove emotion from your decision-making process.

Step 2: Diversify Across Markets

While trend following can be applied to individual stocks, it’s often more effective when diversified across multiple asset classes, such as commodities, currencies, and indices. This diversification helps to reduce risk and increase the likelihood of capturing trends in at least some assets.

Step 3: Risk Management

Trend following can lead to significant gains, but it also comes with the risk of sharp reversals. Protect your portfolio by implementing risk management techniques, such as:

• Setting a maximum percentage of your portfolio that can be allocated to any single position.
• Using stop-loss orders to exit losing trades before the losses become too large.
• Rebalancing periodically to ensure that no single position dominates your portfolio.

Step 4: Monitor and Adjust

While trend-following strategies are largely mechanical, they still require regular monitoring to ensure that trades are executed according to plan. Additionally, you may need to adjust your strategy over time as market conditions change.

Benefits and Risks of Trend Following

Like any investment strategy, trend following has its advantages and disadvantages. Understanding these can help you decide if it’s the right approach for you.

Benefits

• Simplicity: Trend following relies on a set of straightforward rules, making it accessible even for novice investors.
• Versatility: The strategy can be applied to various asset classes and market conditions.
• Potential for high returns: By capturing long-term trends, investors can generate substantial profits.
• Emotion-free investing: A rules-based approach helps remove emotional biases from decision-making.

Risks

• Whipsaw losses: In choppy or sideways markets, trend-following strategies can generate multiple false signals, leading to losses.
• Lagging indicator: By design, trend-following relies on historical data, which means there may be a delay in identifying trend changes.
• Drawdowns: Trend followers can experience significant drawdowns during periods of market volatility or sudden reversals.

Practical Example: Applying Trend Following to the S&P 500

Let’s consider an example of using a simple moving average crossover strategy to invest in the S&P 500. The rules are:

1. Buy SPY (an S&P 500 ETF) when the 50-day SMA crosses above the 200-day SMA (golden cross).
2. Sell SPY when the 50-day SMA crosses below the 200-day SMA (death cross).

Over the last 20 years, this strategy would have helped investors avoid major drawdowns during bear markets like the 2008 financial crisis and the 2020 COVID-19 crash. While the approach may underperform during bull markets due to its lagging nature, it can provide solid risk-adjusted returns over time.

Backtest Results

Here’s a simplified comparison of the hypothetical performance of a trend-following strategy using the 50-day and 200-day SMA crossovers versus a buy-and-hold approach for the S&P 500:

As the table shows, the trend-following strategy sacrifices some return in exchange for significantly lower drawdowns and higher overall risk-adjusted returns.

Is Trend Following for You?

Trend following isn’t for everyone. It requires patience, discipline, and a willingness to stick to your rules even during periods of underperformance. However, for investors who are comfortable with a systematic approach and want to limit drawdowns, trend following can be a valuable strategy, especially when combined with other investment styles.

Questions or thoughts? Find me at shrutinarmeti.github.io.