Richard Dennis, the founder of the turtle traders, made $400 million trading the futures market.
Ed Seykota, possibly the best trader of our time, achieved a return of 250,000%, over a 16 year period.
Now you’re probably wondering:
What is their trading approach?
It’s Trend Following.
What is Trend Following?
Trend Following is a trading methodology that, seeks to capture trends across all markets, using proper risk management.
Why does Trend Following work?
The reason is simple.
Markets are driven by emotions, greed, and fear.
When either side is in control, there will be a trend, and Trend Followers can take advantage of this phenomenon.
Behind this trading methodology lies 5 trading principles that every successful Trend Follower must follow.
And I’m going to reveal them to you, right now…
Buy high and sell low
You walk into a supermarket and you see apples being sold, 3 for $1. So, you get some apples for a nice healthy snack.
The next day…
You go back to the supermarket and, realize the same apples are now being sold, 3 for $5.
Would you buy it?
Probably not because the price is too high. You’d rather wait for the price to drop, or find other alternatives.
Now you’re wondering:
What does buying apples have anything to do with trading?
Because your attitude towards buying apples, is brought over to your trading endeavor.
Here’s what I mean:
The takeaway is this…
The market is never too high to long, or too low to short.
Just follow price
You want to be right.
It feels good to know you called the tops and bottoms in the market.
However, when you start making predictions in the market, it clouds your judgement, and you start losing objectivity of the markets.
This leads to fatal trading mistakes like:
- Refusing to take a loss because you want to be right
- Averaging into your losses because you can get it “cheaper” now
- Revenge trading because you want to make back your losses
Now, what should you do instead?
The best thing you can do as a trader is, just follow price.
Here’s what I mean:
What’s the takeaway?
If you notice the price is forming higher lows, with resistance constantly breaking, chances are it’s an uptrend. You should be looking to long.
If you notice price forming lower lows, with support constantly breaking, chances are it’s a downtrend. You should be looking to short.
Risk a fraction of your equity to allow your edge to play out
You have a trading system that wins 50% of the time with 1:2 risk reward.
And you have a hypothetical outcome of L L L L W W W W
It’s a profitable system, right?
If you risk 30% of your equity, you’d blow up by the 4th trade (-30 -30 -30 -30 = -120%)
If you risk 1% of your equity, you’d have a gain of 4% (-1 -1 -1 -1 +2 +2 +2 +2 = 4%)
Having a winning system without proper risk management isn’t going to get you anywhere.
You need a winning system with proper risk management.
And not forgetting…
The recovery from the risk of ruin is not linear, it could be impossible to recover if it goes too deep.
If you lose 50% of your capital, you need to make back 100% to breakeven. Yes, you read right. 100%, not 50%.
That’s why you always want to risk a fraction of your equity, especially when your winning ratio is less than 50%.
So, how much should you risk exactly?
This depends on your winning ratio, the risk to reward, and your risk tolerance. I would advise risking no more than 1% per trade.
And a quick training video on how to determine your position size…
No profit targets so you can ride massive trends
Although trend followers have no profit targets, it doesn’t mean we don’t exit our trades.
We exit our trades using a trailing stop mechanism, instead of having a profit target like support & resistance etc.
Here’re some examples:
Some ways to trail your stop loss are:
- Moving average crossover
- Price closing beyond moving average
- Break of price structure
- Break of trendline
- Number of ATR away from the peak/trough
If you want to learn more, here are 13 ways to exit your trades to reduce risk, and maximize profits.
The hardest part about Trend Following is riding your winners. Because you’ll watch many small wins turn into losses, while attempting to ride the trend.
This results in low winning rate but, high reward to risk.
Trade all markets to increase your odds of capturing trends
Markets spend more time ranging than trending. Thus, it makes sense to look at a variety of markets, to increase your odds of capturing trends.
Trend followers trade everything from currencies, agriculture, metals, bonds, energy, indices, orange juice, pork bellies, etc.
How does Trend Following have an edge in the markets?
A company called Orange has been trading higher over the last 6 months.
Orange currently trades at $100 and you think it’s overvalued. You decided to short 1000 shares of Orange, at $100 with a profit target at $90, using no stop loss.
You apply this trading principle across all markets you’re trading. A small profit target with no stop loss.
What do you think will happen?
You’ll win often but, eventually, there will be a trade that goes against you, till you blow up your trading account.
What if I’m on the opposite side of your trade?
I would lose often but, all I need is one trade to make it all back, and more.
And this is the same trade that caused you to blow up your account.
A few examples in real life:
- Fall of Long-Term Capital Management
- Destruction of Bear Stearns
- The 2008 financial crisis
These events caused investors and traders to lose tons of money. But in a zero sum game, someone loses and someone wins.
And the winner happens to be Trend Followers. This is our edge.
Trend Following trading strategy
Now you’ve learnt the 5 secrets of Trend Following. Let’s put the information to use and develop a trading strategy.
To develop a Trend Following strategy, it needs to answer these 7 questions:
- Which timeframe are you trading
- How much are you risking on each trade
- Which markets are you trading
- What are the conditions of your trading strategy
- Where will you enter
- Where will you exit if you’re wrong
- Where will you exit if you’re right
You must choose a time frame that suits your personality and schedule.
If you’re someone who holds a day job, trading the 4 hour and daily charts would suitable.
You must risk a fraction of your equity on each trade to survive the inherent draw downs. Keep your losses to no more than 1% on each trade.
You should be able to trade about 60 markets from these 5 sectors.
- Agriculture commodities
- Non-Agriculture Commodities
Trend Following Trading Strategy
If 200ma is pointing higher and the price is above it, then it’s an uptrend (trading conditions).
If it’s an uptrend, then wait for “two test” at the dynamic support (using 20 & 50-period moving average).
If price test dynamic support twice, then go long on the third test (your entry).
If long, then place a stop loss of 2 ATR from your entry (your exit if you’re wrong).
If the price goes in your favor, then take profits when candle close beyond 50ma (your exit if you’re right).
Vice versa for downtrend
And there you have it, the complete guide to Trend Following.
If you want to learn more, go download the ultimate guide to trend following (it's free).