How to Trade Using Trend Following Strategy Complete

Trend following is a trading strategy. It seeks to profit from sustained price movements. Traders identify a trend and follow it until it reverses. This strategy does not attempt to predict market tops or bottoms. It reacts to market action. Trend following applies to various markets: stocks, commodities, forex.

Prerequisites

Successful trend following requires specific tools and a disciplined mindset.

Capital Allocation: Determine your risk capital. This is money you can afford to lose. A common guideline is to risk no more than 1-2% of your capital on any single trade. If you have a $100,000 trading account, your maximum risk per trade is $1,000 to $2,000.

Trading Platform: You need a reliable trading platform. The platform must provide real-time data, charting tools, and efficient order execution. Examples include MetaTrader 4/5, TradingView, or proprietary broker platforms. Ensure your platform offers backtesting capabilities.

Charting Software: Advanced charting software is essential. It helps identify trends and entry/exit points. Look for features like multiple timeframes, various indicator overlays, and customization options. TradingView is a popular choice.

Indicators: Trend following relies on specific technical indicators. These include moving averages, Average True Range (ATR), and sometimes momentum oscillators. Understand how each indicator works and its limitations.

Risk Management Plan: Develop a comprehensive risk management plan. This plan defines position sizing, stop-loss placement, and overall portfolio risk. Adhere to this plan without exception.

Discipline: Trend following demands discipline. You must follow your rules, even during drawdowns. Emotional decisions undermine the strategy.

Patience: Trends develop over time. You may experience periods of flat performance or small losses. Patience is crucial for waiting for significant trends to emerge.

Step-by-Step Guide

This guide outlines a systematic approach to trend following.

Step 1: Define Your Market and Timeframe

Choose the markets you will trade. Focus on liquid markets with clear trends. Examples include major currency pairs (EUR/USD, GBP/JPY), large-cap stocks (AAPL, MSFT), or popular commodities (Crude Oil, Gold).

Select your preferred timeframe. Trend following works on daily, weekly, or even monthly charts for longer-term trends. Shorter timeframes (e.g., 4-hour) can also be used, but they generate more signals and potentially more noise. For this example, we will use daily charts.

Step 2: Identify the Trend

Use moving averages to identify the trend. A common setup involves two moving averages: a shorter-period moving average (e.g., 20-period Exponential Moving Average - EMA) and a longer-period moving average (e.g., 50-period EMA).

• Uptrend: The shorter EMA is above the longer EMA. Both EMAs are sloping upwards. Price is generally above both EMAs.
• Downtrend: The shorter EMA is below the longer EMA. Both EMAs are sloping downwards. Price is generally below both EMAs.
• Sideways/No Trend: The EMAs are intertwined or flat. Avoid trading in sideways markets.

Example: On a daily chart of AAPL, if the 20-EMA is above the 50-EMA and both are rising, an uptrend is present.

Step 3: Determine Entry Points

Enter a trade once a clear trend is established. Wait for a pullback or a retest of a moving average. This offers a better risk-reward entry.

• Long Entry (Uptrend): After identifying an uptrend, wait for price to pull back towards the 20-EMA or 50-EMA. Enter a long position when price bounces off this moving average and resumes its upward movement. Look for a bullish candlestick pattern (e.g., hammer, engulfing) at the moving average.
• Short Entry (Downtrend): After identifying a downtrend, wait for price to pull back towards the 20-EMA or 50-EMA. Enter a short position when price is rejected by this moving average and resumes its downward movement. Look for a bearish candlestick pattern (e.g., shooting star, engulfing) at the moving average.

Example (Long Entry): AAPL is in an uptrend. The 20-EMA is above the 50-EMA. Price pulls back from $180 to $175, touching the 20-EMA. A bullish engulfing candle forms at $175. Enter a long position at $176.

Step 4: Set Stop-Loss Orders

Place a stop-loss order to limit potential losses. Use Average True Range (ATR) for dynamic stop-loss placement. ATR measures market volatility.

• Long Position: Place the stop-loss below a recent swing low or 1.5 to 2 times the current ATR below your entry price.
• Short Position: Place the stop-loss above a recent swing high or 1.5 to 2 times the current ATR above your entry price.

Example (Stop-Loss for Long Entry): For the AAPL trade, assume the ATR is $2. Your entry is $176. A conservative stop-loss would be $176 - (2 * $2) = $172. Alternatively, if the recent swing low was $173, place the stop at $172.90.*

Step 5: Determine Position Size

Calculate your position size based on your risk capital and stop-loss distance.

Position Size = (Risk Capital * Percentage Risk) / (Entry Price - Stop-Loss Price)*

Example (Position Size): Account size: $100,000. Risk per trade: 1% = $1,000. Entry Price: $176. Stop-Loss Price: $172. Risk per share: $176 - $172 = $4. Shares to buy: $1,000 / $4 = 250 shares.

Step 6: Trail Your Stop-Loss

Do not set fixed profit targets. Trend following aims to capture large moves. Trail your stop-loss to protect profits as the trend progresses.

• Moving Average Trailing Stop: Use a shorter moving average (e.g., 10-EMA) as a trailing stop. Close the trade when price closes below the 10-EMA (for a long position) or above the 10-EMA (for a short position).
• ATR Trailing Stop: Adjust your stop-loss by a multiple of ATR. For a long position, move the stop up by 1 ATR each time the price moves significantly in your favor. Maintain the stop 2 ATRs below the highest close since entry.
• Swing Point Trailing Stop: Move your stop-loss below the most recent swing low (for long positions) or above the most recent swing high (for short positions).

Example (Trailing Stop): For the AAPL trade, if price moves to $190, and the 10-EMA is at $185, move your stop-loss to $184.90. If price closes below the 10-EMA, exit the trade.

Step 7: Exit the Trade

Exit the trade when your trailing stop is hit. Do not second-guess the exit signal.

• Long Exit: Price closes below your trailing stop-loss.
• Short Exit: Price closes above your trailing stop-loss.

Example (Exit): AAPL price closes at $184, which is below your trailing stop of $184.90. Exit the long position.

Common Mistakes

Avoid these pitfalls when trend following.

Trading Against the Trend: This is a fundamental error. Always trade in the direction of the established trend. Counter-trend trading is a different strategy.

Lack of Discipline: Deviating from your trading plan leads to inconsistent results. Stick to your entry, stop-loss, and trailing stop rules.

Premature Exits: Closing trades early to lock in small profits limits your ability to capture large trend moves. Let your winners run.

Over-Leveraging: Using too much leverage amplifies losses. Adhere to your position sizing rules.

Ignoring Risk Management: Failing to set stop-losses or risking too much capital per trade can wipe out your account.

Chasing Price: Entering a trend late after a significant move reduces your risk-reward ratio. Wait for pullbacks.

Trading Sideways Markets: Trend following performs poorly in choppy or range-bound markets. Wait for clear trends to emerge.

Emotional Trading: Fear and greed cause irrational decisions. Maintain a logical approach.

Pro Tips

Enhance your trend following strategy with these professional insights.

Diversify Across Markets: Apply trend following to multiple uncorrelated markets. This reduces portfolio volatility and increases the probability of catching a strong trend somewhere.

Use Multiple Timeframes for Confirmation: Identify the primary trend on a longer timeframe (e.g., weekly chart). Then, look for entry signals on a shorter timeframe (e.g., daily chart). This provides a higher-probability setup.

Focus on Strong Trends: Not all trends are equal. Look for trends with strong momentum and clear separation of moving averages