Trend following is an algorithmic trading strategy that combines the strengths of mathematical models and statistics to take advantage of market trends. Rooted in the principle of momentum, trend-following methods generally seek to identify and take part in prevailing price asset trends.
Today, it is widely used by large financial institutions to generate profits for clients in both falling and rising markets. Man Group, an active investment management firm listed on the London Stock Exchange (LSE) with over USD 143 billion in assets under management (AUM), uses trend following as one of their algo trading strategies for generating returns.
The key to a successful trend-following strategy is the use of technical analysis to identify prevailing trends in markets. In-depth technical analysis can help you gain a good understanding of an asset’s historical price movements. And identify patterns that could indicate the direction of future price movements.
Say you found a trend. The trend-following algorithm will enter a position in the same direction as the trend. The algorithm holds strong to this position until it detects signals that the trend is about to end. Or until such point that the risk-reward ratio exceeds its pre-programmed parameters.
The Conceptual Framework of Trend Following
A trend-following principle is that asset prices tend to follow a particular trend over a certain time frame. Traders whose strategies are built on these principles are much less concerned about “tops” or “bottoms”. And are instead focused on analyzing whether a price trend has taken hold of an asset market. By adopting this non-contrarian position, trend-following traders align with the dominant momentum instead of seeking to time the market.
The Advantages of Trend Following
Traders use trend-following strategies on different time frames today, from intra-day to long-term. Across a wide variety of assets. Including stocks, commodities, bonds, and currencies. This is due to the inherent benefits of trend following as an algorithmic trading strategy, such as:
- Profitability in both upward and downward-trending markets: Trend following can take advantage of rising or falling asset prices, as it identifies trends and executes trades in the direction of the trend.
- Relatively low-risk exposure: Trend following is considered to be a relatively low-risk algorithmic trading strategy, as it does not rely on short-term price movements nor is it dramatically affected by market volatility.
- Low-technical barrier: Compared to other algorithmic trading strategies, trend following is a relatively simple concept, which makes it ideal for traders who have limited technical knowledge or are new to the practice of algorithmic trading.
Final Thoughts
Trend-following lines up with dominant market forces. Which steers it away from the pitfalls of highly contrarian or counterintuitive positions. By following the momentum principle, trend following gives traders an effective tool for identifying market trends and capitalizing on the resulting price action. Combined with risk management practices such as position sizing, stop-loss orders, and risk reward-ratio analysis, traders can generate positive returns while also protecting their capital from significant losses.
