Trend following has become a popular allocation in many investment portfolios, and is one of the largest alternative strategies with over $300 billion in assets under management.
The trend following strategy is grounded in the idea that once a trend is established, whether upward or downward, it is likely to continue for a certain period.
“Trend following is usually a medium to long term strategy,” says Marco Santanche, a quant strategist and author of the newsletter Quant Evolution. “Traders often deploy time series models to discover trends for individual assets and to build the final portfolio.”
Historically, the strategy has displayed low correlation with stocks and bonds, and has the potential to perform in both bull and bear markets. In this guide, we set out the basics of trend following and the investment considerations for incorporating the strategy into an investment portfolio.
What is Trend Following
Trend following is a systematic investment strategy designed to capitalize on price trends, with the expectation that upward trending will continue to rally, and downward trends will continue to decline.
It can be deployed across various financial markets, including stocks, government bonds, interest rates, commodities, and currencies.
White trends are an established concept in the financial market, the timing and prediction of it are not straightforward.
“Anticipating trends is difficult,” says Santanche in the newsletter Quant Evolution. “Jumping on trends while they have been running for a while can result in reversals and losses. Trending following works best for long-term trends persisting over multiple market cycles, although they can still be exposed to a number of risk factors and short term reversals.”
Identifying Trends
Traders often identify trends using a variety of methods:
Moving Averages: Calculating and analyzing moving averages of different periods. Moving averages smooth out price fluctuations and provide a general indication of the trend direction. A crossover between two moving averages can signal a trend change.
Technical Indicators: Utilizing technical indicators like MACD (Moving Average Convergence Divergence), RSI (Relative Strength Index), and Bollinger Bands. These indicators provide additional insights into momentum, trend strength, and potential trend reversals.
Volume Analysis: Analyzing volume bars or volume indicators to assess the strength and conviction behind price movements. Higher volume during uptrends suggests stronger buying pressure, while higher volume during downtrends indicates stronger selling pressure.
Fibonacci Retracements: Applying Fibonacci retracement levels to price charts. Fibonacci retracements are based on the Fibonacci sequence and identify potential support and resistance levels, which can indicate potential trend reversals.
Trending Following ETFs
For investors seeking a simplified way to incorporate trend following to their portfolios, ETFs could present a viable option.
“Rather than trying to build our own trend following strategy,” says Santanche. “Investors can focus on identifying ETFs that provide them with ready-made solutions for trend following.”
These ETFs typically employ systematic strategies to identify and follow trends, either up or down. While there are not many ETFs explicitly labeled as "trend-following," some ETFs use quantitative models and rules-based approaches to capture trends.
Examples of these ETFs include (Source: Quant Evolution):
Potential Benefits of Trend Following
Profit Potential in Strong Trends: In markets characterized by strong trends, the trend-following strategy has the potential to yield substantial profits by allowing traders to ride the trend until signs of reversal emerge. For example, trend followers had an average gain of 27.3% in 2022, according to a report by Alternative Fund Insight.
Long-Short Positions: Trend following strategies engage in both long positions during uptrends and short positions in downtrends. This stands in contrast to traditional investments, which can only benefit from rising prices.
Diversified Exposures: Trend following strategies offer exposure not only to stock and bonds but also currencies and commodities. This makes it suitable for diverse market conditions.
Systematic Approach: Trend following strategies do not predict market movements. Instead, a trend following strategy adjusts the portfolio based strictly on rules and price movements. This systematic approach proves particularly valuable in instances where market behavior deviates from forecasts made by traditional forecasters and analysts.
Risks of Trend Following
Whipsaw Movements: Trend followers may encounter whipsaw movements, where the market quickly changes direction. This can lead to false signals and potential losses.
Choppy or Sideways Markets: In markets with no clear trend, the trend-following strategy may result in frequent trades with minimal profits, as it is most effective in trending conditions.
Market Regime Changes: Trend-following strategies may struggle during significant market regime changes, such as shifts from trending to range-bound conditions.
Related Reading
Trend Following ETFs: A Deep Dive
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
