Are you frustrated in finding a good trading strategy that brings you a consistent profit? Many traders are stuck in a vicious circle and unable to break it, whereby they keep trying to predict market tops and bottoms only to face frustration and losses. This may leave them less confident in executing their trading decisions.
This article takes you into the realm of trend following strategies, and it focuses on capturing extended moves in the financial markets: up or down. Since it does not predict where or when there will be reversals in the market, this approach captures existing trends and lets you ride waves of momentum.
Let’s focus on three specific trend following strategies and their historical performance, along with the trading rules. And by the end, you will have a good understanding of these types of systems and their potential downsides and rewards.
What is Trend Following?
Briefly, trend following is an endeavor that relies on the pursuit of and sowing capital on major market movements. In this view, traders can enjoy upward and downward price moves without the agony of making complex forecasts. Rather than trying to predict the market timer, trend followers will wait for clear signals showing when they should enter or leave trades on the basis of existing trends.
Strategy 1: Monthly Moving Average Cross
Overview
The first strategy we’re going to consider plots the S&P 500 as monthly bars and utilizes a simple moving average crossover system.
Trading Rules
- Long signal: On crossing to above the 12-month moving average at the close of the current bar long.
- Short signal: Exit and go to cash on closing price cross down below the 12-month moving average.
Historical Performance
We backed this strategy on the S&P 500 from 1960 to date. Results are as follows:
- Annual Return: 6.6% (excluding reinvested dividends).
- Buy and Hold Comparison: marginally lesser than the 7% returns given by buy-and-hold strategies.
- Drawdowns: very much lesser at 26%.
This strategy, that tracks SPY ETF since its inception in 1993, shows the ability to evade extreme drawdowns. Due to being invested only 68% of the times, the risk-adjusted return is on an impressive 9.6%.
Strategy 2: Golden Cross
Overview
The second strategy used is Golden Cross. This strategy is based upon the use of moving averages so that bullish and bearish trends can be determined.
Trading Rules
- Long Position Signal: Bullish breakout happens when the 50-day moving average crosses above the 200-day moving average.
- Short Position Signal: Bearish breakout takes place if the 50-day moving average crosses below the 200-day moving average.
Past Performance
When this strategy was backtested on the S&P 500 since 1960, here are its results:
- Annual Return: 6.6%. Its annual returns looked like that of the previous strategy.
- Drawdowns: Smaller compared to buy-and-hold strategies, holding only for 69% of the time.
- Risk-Adjusted Return: 9.5%
A trade example illustrates its efficiency; the 50-day moving average crossed above the 200-day in July 2020, thus positioning to buy at 2867 and sell in March 2022 at 4173, thereby achieving a gain of 32.4%.
Strategy 3: Super Trend Indicator
Overview
The third method is based on using the Super Trend Indicator in terms of weekly bars and trending into reversals.
Trading Rules
- Entry: Buy long, when the closing price is above previous value of Super Trend Indicator.
- Exit: Sell, when the closing price crosses below previous value of Super Trend Indicator.
Backtesting in the S&P 500 results in:
- Annual Gains: Virtually 6%, a little behind buy-and-hold.
- Time Invested: The system is invested only 62% of the time and returns 9.5% risk-adjusted.
For example, there was one trade that worked extremely well and generated the kind of returns that, at first, seemed fantastic; however, it must be remembered that not all trades will pay in equal amounts. Good trend following requires patience because winners must be allowed to run.
Advantages of Trend Following
Now, let’s outline the advantages of trend following.
- Universality: These strategies are pretty easy to implement and are less demanding in terms of management.
- Purely Market-Driven Strategy: Trend followers do not try to time the market; buy and sell indications are instead taken from real market action.
- Much Lower Draw-Downs: Trend following strategies mostly have lower draw-downs than buy-and-hold strategies, which keeps things stable during market flow.
Disadvantages of Trend Following
While trend following has several benefits, it also has its disadvantages:
- Whipsaw Effect: Trends can turn in a very short time, and the trader receives many false signals and whipsaws.
- Lower Win Rate: Many of the trades are losers, and normally only a few of the winners earn most of the profits.
- Patience: A trader should resist the temptation to close winners early and let profitable trades run their course.
Summary In summary, trend following strategies present a relevant approach for the traders who wish to take advantage of market movements without the sophisticated procedures associated with predictive trading. Of the three strategies that we discussed—monthly moving average cross, golden cross, and the super trend indicator, which are very clear in terms of when there would be entry and exit signals based upon the established trend.
If you’d like to learn more about any of these other strategies, or even other trend following techniques, do visit our website and download your treasure trove of resources and proven trading strategies.
Enjoyed this video? Hit like and subscribe for more insight, and don’t forget to watch our video on swing trading, one strategy that is perfectly complementary to the trend following strategy. Thanks for watching and happy trading!