The Trend: Is it Your Friend?

Much has been made in the financial literature of the advantages of trend trading, but what exactly is it? Although trend trading, also known as trend following, systems have been around for almost fifty years, many investors don't have a clue as to what they are or how trend trading can help increase the size of their porfolios. Most if not all trend trading systems are comprised of two crucial components: the trading algorithm itself which dictates when to enter and exit trades (timing), and how to enter and exit positions along with how much to trade (portfolio management). To completely understand trend trading, we must first look at its historical roots.

Richard Donchian--The Father of Trend Trading
Richard Donchian is considered the father of trend following and is still considered to be one of the most respected technicians on Wall Street. He started life working as an assistant in his family's oriental rug business after graduating with a degree in economics from Yale. But it was after reading uber-trader Jesse Livermore's fictionalized biography Reminiscences of a Stock Operator* that Donchian became hooked on studying the financial markets. His interest in technical analysis bloomed after he suffered losses following the market crash in 1929, shortly after which he began his career on Wall Street. During this time, he developed a system of trading commodity futures which he termed "trend following", and wrote numerous articles pertaining to it.

One of Donchian's students, Barbara Dixon, outlined his trend following philosophy in the December, 1974 issue of Commodities Magazine which can be summarized as follows:

1. The trend follower makes no attempt to forcast the extent of a price move.
2. Once a trend begins, it has a tendency to persist in the same direction for some time.
3. The trend follower studies the trend and devises precise rules when to enter and exit trades. He or she then acts on these rules to the exclusion of other market factors, thus eliminating emotion from the equation.

In short, trend trading is a mechanical system. The reason that you may not have heard the term used for a while is that it has been replaced by other terms such as momentum trading, mechanical trading, systematic trading, or algorithmic trading. (Agorithmic trading is sometimes referred to as program trading which is a slightly different beast--it's a way for institutions to trade large blocks of stock without (hopefully!) disrupting the normal flow of the market.)

Characteristics of Trend Trading Systems
Any trend trading system is characterized by the following set of four components:

Price: The price of an instrument, be it commodities futures, stocks, bonds, etc., is of primary concern. Other indicators are of minor importance as it is only price that tells you what the market is doing at the moment. (A side note: Donchian noted that even in his day the Transportation Index (back then it was just called "the rails") was a leading indicator of overall market direction and that factored into his set of rules.)
Risk Control: Positions are downsized according to market volatility and strict rules are applied to cut losses. Preservation of capital is the key to trend following systems since in most cases, there are a greater number of losers than winners.
Money Management: What size positions to take and when to take them is a key factor here.
Trading Rules: Trend trading is systematic, based on a technical determination of the trend. A trend following scheme must answer the following five questions:
1. How do you determine what market to buy or sell at any given time?
2. How large a position should you take at any given time?
3. How do you determine when to enter a market?
4. How do you determine when to exit that market if the trade is profitable?
5. How do you determine when to exit that market if the trade is unprofitable?

You can see that any trend trading system follows precise rules of trade timing and risk management. In order to develop a viable trend trading system, one must apply the scientific method.**

The Advantages of Trend Trading
The real advantage to a trend trading system is that it removes the emotional component from the equation which is usually the downfall of many investors. But it does require discipline to stick to the rules and not chicken out when the market moves against you. How successful are trend trading schemes? Very. Consider the track records of the following four trend following firms:***

Abraham Trading: 1988-Present: +5,524% vs S&P500 +429%
EMC Capital: 1985-Present: +19,871% vs S&P500 +696%
Campbell & Co.: 1983-Present: +2047 vs S&P500 +771%
Winton Capital: Late 1997-Present: +579% vs S&P500 41%

The reason that trend trading is effective is that it capitalizes on market inefficiences, but that is the subject of another discussion. Note that although trend trading schemes are most often applied to commodities futures, one can apply them to other markets, including equities, with similar success.

The Downside of Trend Trading
The most obvious downside to this type of investing is what if the market is trading sideways? Two things could occur: The trend trader will rarely if ever get a trade signal, or else will get whip-sawed. (Whip-sawing occurs during fluctuating markets.) The result of this is that the investor will either not even have the opportunity to make any money or worse yet will suffer a string of losses.

Another disadvantage is that for the rules to work, a trend must already be in place. In this instance, the investor loses out on the initial movement which can result in an overall decrease in profits. If, instead, an investor uses indicators such as a breakout from a cup and handle formation that we looked at a while back, he or she will be able to participate in price movements much sooner.

The other major disadvantage is that any trend trading system requires strict discipline on the part of the trader. Following the rules can at times be nerve-wracking especially if the position is temporarily moving against you. An investor must be able to weather sizable draw-downs to his or her portfolio which requires nerves of steel. If a large draw-down happens to occur at the beginning of an investor's trading career, he or she may never be able to fully recover from the loss.

Conclusion
I hope I've shown you that trend trading can be a viable way for you to trade your portfolio. If you're new to trading and afraid of making your own investment decisions, then having a strict set of rules to follow may just be the ticket. In upcoming blogs we'll be going into the trading system used by the most successful trend follower in history--Richard Dennis, the founder of the Turtles.

* Reminiscences of a Stock Operator, by Edwin LeFevre (1923). This book gives a fictionalized biography of legendary trader Jesse Livermore's rise on Wall Street. Still in print with updated editions, this book is required reading for any trader but I must confess that I had a tough time reading it and ultimately had to put it down because of the stilted writing style. But that was years ago and I should probably give it a try again.

**The Rules of the Scientific Method:
1. Define the question, such as “How do I make money in a trending market?”
2. Gather information, such as looking at charts of trending markets and noting the best times to enter and exit trades
3. Form an hypothesis, such as “If I buy this stock (or commodity or whatever) ten days after it hits a new high, what type of profit, on average, can I expect to make and when is the best time to exit?”
4. Look at many trending charts and collect the appropriate data
5. Analyze the data and draw conclusions. If your initial hypothesis doesn't work, go back and modify it and test it again. Repeat until you have a viable model.
6. Test out your theory in real-time by paper-trading first.

***Data obtained from the following article in May, 2008 issue of Stocks, Futures, and Options Magazine: Trend Following: It Works!, by Michael Covel. (www.sfomag.com)