Trend Following Strategy
A trend-following strategy that works on any market and timeframe
What is Trend Following?
Trend Following is a trading strategy based on the principle that once a trend is established, it is more likely to continue than to reverse. Instead of trying to predict where the market will go, trend followers wait for a clear trend to form and then ride it for as long as possible.
The philosophy is simple: "The trend is your friend."
Why Trend Following Works
1. Markets Trend
Financial markets spend a significant portion of their time in trending conditions. While exact percentages vary, studies suggest that major currency pairs trend meaningfully 25-35% of the time. When they do trend, the moves can be substantial and sustained.
2. Behavioral Finance
Trends persist because of human psychology:
- Herding behavior - Traders follow other traders
- Anchoring - People adjust slowly to new information
- Momentum - Positive feedback loops create self-reinforcing trends
- Institutional flows - Large institutions deploy capital gradually, sustaining trends
3. Historical Track Record
Trend following has been one of the most consistently profitable systematic strategies over decades. Many legendary traders and funds have built their success on this approach.
Identifying a Trend
Method 1: Market Structure
The most fundamental way to identify a trend:
- Uptrend: Price is making Higher Highs (HH) and Higher Lows (HL)
- Downtrend: Price is making Lower Highs (LH) and Lower Lows (LL)
- No trend: Price is moving sideways with no clear structure
Method 2: Moving Average Direction
- Price consistently above the 200 SMA = Uptrend
- Price consistently below the 200 SMA = Downtrend
- Price whipsawing around the 200 SMA = No clear trend
Method 3: ADX (Average Directional Index)
The ADX measures trend strength on a scale of 0-100:
| ADX Value | Trend Strength |
|---|---|
| 0-20 | No trend or very weak |
| 20-25 | Emerging trend |
| 25-50 | Strong trend |
| 50-75 | Very strong trend |
| 75-100 | Extremely strong (rare) |
ADX only measures strength, not direction. Use it in combination with +DI and -DI (directional indicators) or price action to determine direction.
Method 4: Multiple Moving Averages
When short, medium, and long-term MAs are aligned (not crossing), the trend is clear:
- Bullish alignment: 20 EMA > 50 EMA > 200 SMA (all sloping up)
- Bearish alignment: 20 EMA < 50 EMA < 200 SMA (all sloping down)
Trend Following Entry Techniques
1. Pullback Entry (The Preferred Method)
Rather than chasing price, wait for the price to pull back within the trend before entering:
In an uptrend:
1. Identify the uptrend on the daily chart
2. Wait for a pullback to a key level (50 EMA, Fibonacci 38.2-61.8%, support zone)
3. Enter long when the pullback shows signs of ending (bullish candle, Pin Bar at the MA)
4. Stop loss below the pullback low
5. Target the previous high or use a trailing stop
In a downtrend:
1. Identify the downtrend
2. Wait for a rally to a key resistance level
3. Enter short when the rally shows rejection
4. Stop loss above the rally high
2. Breakout Entry
Enter when price breaks to new highs (in an uptrend) or new lows (in a downtrend):
Advantages:
- Catches the momentum early
- Clear invalidation level (the breakout level)
Disadvantages:
- Higher risk of false breakouts
- Worse risk-reward ratio compared to pullback entries
3. Moving Average Crossover Entry
Enter when a faster MA crosses a slower MA in the trend direction:
- Buy: 20 EMA crosses above 50 EMA while both are above 200 SMA
- Sell: 20 EMA crosses below 50 EMA while both are below 200 SMA
4. Retest After Break of Structure
1. Price breaks a previous swing high (confirming uptrend continuation)
2. Price pulls back to retest the broken level
3. Enter long when the retest holds
Exit Strategies for Trend Following
Knowing when to exit is equally important as knowing when to enter.
1. Trailing Stop Loss
Move your stop loss to lock in profits as the trend progresses:
Methods:
- Swing point trailing: Move SL below each new higher low (uptrend) or above each new lower high (downtrend)
- Moving Average trailing: Trail the SL below the 20 EMA or 50 EMA
- ATR trailing: Set SL at 2x ATR below the most recent swing point
- Fixed pip trailing: Trail by a fixed number of pips (less recommended)
2. Take Profit at Key Levels
Close all or part of the position at significant support/resistance levels:
- Previous swing high/low
- Fibonacci extension levels (127.2%, 161.8%)
- Round numbers
- Major weekly/monthly S/R
3. Trend Reversal Exit
Exit when the trend structure breaks:
In an uptrend, exit when:
- Price breaks below the most recent Higher Low
- The 20 EMA crosses below the 50 EMA
- A clear bearish reversal pattern forms (Head and Shoulders, Double Top)
4. Partial Take Profit
A balanced approach:
1. Close 50% at the first target (e.g., 1:1 risk-reward)
2. Move stop to breakeven on the remaining position
3. Trail the remaining 50% with a moving average or swing points
4. Let the remaining position ride the trend until stopped out
A Complete Trend Following System
Here is a complete system you can use as a starting point:
Setup Rules
Timeframe: Daily chart for trend direction, 4H chart for entries
Trend Identification:
- 200 SMA on the daily chart defines the trend
- Price above 200 SMA = only look for longs
- Price below 200 SMA = only look for shorts
Entry Conditions (Long):
1. Daily trend is bullish (price above 200 SMA)
2. Price pulls back to the 50 EMA on the daily or a key support level
3. On the 4H chart, a bullish price action signal appears (Pin Bar, Engulfing, Inside Bar breakout)
4. RSI is not in overbought territory (below 70)
Entry Conditions (Short):
1. Daily trend is bearish (price below 200 SMA)
2. Price rallies to the 50 EMA or a key resistance level
3. On the 4H chart, a bearish price action signal appears
4. RSI is not in oversold territory (above 30)
Risk Management
- Risk 1% per trade
- Stop loss beyond the pullback extreme or price action signal
- Minimum 1:2 risk-reward ratio for initial target
- Trail stop using the 50 EMA on the daily chart
Trade Management
1. Enter full position at the signal
2. When price reaches 1:1, move stop to breakeven
3. At 1:2, close 50% of the position
4. Trail the remaining 50% with the 50 EMA
5. Exit when price closes below/above the 50 EMA
Dealing with the Challenges of Trend Following
Challenge 1: Whipsaws in Ranging Markets
Trend following strategies lose money in sideways markets because price repeatedly triggers entries and then reverses.
Solutions:
- Use ADX to filter: only trade when ADX is above 25
- Reduce position size during uncertain periods
- Accept that some losing trades are the cost of catching the big trends
Challenge 2: Giving Back Open Profits
Trailing stops mean you will always give back some profit before exiting. This can be psychologically difficult.
Solution: Accept that giving back 30-40% of open profits is normal and necessary. Exiting too early means missing the biggest moves, which is where trend followers make most of their money.
Challenge 3: Low Win Rate
Trend following typically has a win rate of 35-50%. You will have more losing trades than winning ones.
Why it still works: The winners are significantly larger than the losers. A single winning trend trade can make up for 3-5 small losses.
Challenge 4: Long Periods Without Profit
There will be stretches of weeks or even months without meaningful profit, especially during ranging markets.
Solution: Trust the process. Backtest your system to understand its historical drawdowns and ensure you can handle them emotionally and financially.
Famous Trend Followers
Studying successful trend followers can provide inspiration and confidence:
- Richard Dennis and the Turtle Traders - Proved that trend following can be taught
- Ed Seykota - One of the most successful systematic trend followers
- John Henry - Used trend following to amass a fortune and buy the Boston Red Sox
- Dunn Capital Management - Decades of trend following success in managed futures
Key Takeaways
- Trend following is based on the principle that established trends are more likely to continue than reverse
- Identify trends using market structure, moving averages, and ADX
- The preferred entry is on pullbacks within the trend, not chasing momentum
- Use trailing stops to ride trends for maximum profit
- Accept a lower win rate because winning trades should be significantly larger than losses
- Filter for trending conditions (ADX > 25) to avoid whipsaws in ranging markets
- Combine trend following with price action for the best entry timing
- Patience and discipline are essential; the biggest profits come from holding positions through the trend
Next Lesson: In the next lesson, we will bring everything together by learning how to Build a Trading Plan - your comprehensive blueprint for trading success.