Trend Following Trading
Trend trading can be highly profitable for methodical traders who can correctly identify them and then properly manage their position—and their emotions—for the duration of the trade.
Forex appears to be a good market for the trend following strategy. Long term directional movements are obvious in the major currency pairs and trend following traders can capitalize on these moves.
Do not read too much into the analysis of intraday price reactions that are tied to short-term news releases. Instead, trust that at the end of the day, week, etc., price action will have gotten it right.
Trend Following Trading Rules
There are not a whole lot of different ways that trend following can be done.
How to easily identify the trend:
Draw a trend line between successive highs or lows and observe whether it has a positive or negative slope , also determine what period of time the trend covers. Another simple method is to use the Moving Average indicators.
Make yourself familiar with the behaviour of the currency pairs and their trends
Some currency pairs tend to move slow but steady in one direction; though occasionally they may still spring a surprise. Fast-moving, highly volatile currency pairs are more exciting, but also more difficult, to trade. Expect larger numbers of false starts, shakeouts and trend reversals.
Identifying the tendencies of a specific currency pair. Different exchange rates can have very different paces. A good comparison can be drawn between AUD/JPY and EUR/GBP. The former has a historically wide carry differential (the difference between the economies’ respective interest rates) which makes it extraordinarily sensitive to even subtle changes in underlying risk appetite. That being said, this is a pair that would have a penchant for erratic behaviour and would not be good identifying steady trends or defined ranges unless the underlying market conditions are fully supportive of just such an arrangement. Alternatively, EUR/GBP is comprised of two currencies whose underlying economies are heavily dependent on each other. This acts like something of a stabilizer between the exchange rate as fundamental changes in one currency is oftentimes mirrored in the other. In turn, such a link helps smooth out trends and preserve ranges.
Don’t Try to Pick the Top or Bottom
If you are going to trade trends, no matter what the time frame, you are likely to encounter three major problems: false starts, early shakeouts and late exits. Let’s analyse these in a bit more detail below.
False Starts (enter too early)
Also known as whipsaws, false starts occur when your setup gives a positive signal, immediately followed by a reversal. You are no sooner stopped out of your position when the setup gives another buy signal. This is frustrating; and expensive. Many traders lose heart and fail to take the second entry, only to find that the trend spikes sharply upward, leaving them ready to throw their PC (or themselves) through the window.
Trend-following systems either suffer from a large number of shake-outs or are slow to exit when the trend reverses; and often both. You can’t have your cake and eat it.
Taking profits too early
Must learn to set and forget.
Some currency pairs are inherently more volatile than others. To give each position an equal chance to impact the bottom line, positions must be larger for less volatile markets. This can be achieved many different ways. One popular strategy uses Average True Range (ATR) for this purpose. ATR measures the average daily price movement of a market. This can serve as a proxy for volatility. Set a target desired daily impact per position. Then calculate how many contracts you need to trade to achieve that based on the ATR. This naturally assumes that volatility remains roughly the same. This is not always the case of course. It’s an approximation and as such it does the job.
Apart from systemic problems we also need to consider the human aspect. There is no amount of advice that can prepare traders for the temptation of exiting a trade too soon, or conversely, ignoring money-management rules in order to maximize profits. Trading is the most intense self-examination there is, and no matter how prepared you think you are, there’s always room to learn and grow. A trend trading system builds psychological pressure as the trader witnesses repeated gains followed by significant retracements and frequent late exits at trend reversals. Pressure can build to such an extent that the trader overrides his system, attempting to take profits at a perceived high point in the trend. At this point he/she is following their emotions rather than a system — a recipe for disaster.
Managing psychological pressure will be dealt with in a later article.
Trend Trading obviously works in the Forex market, however it’s harder than it looks. Large draw downs are an inherent part of the strategy. The Forex market has severe intraday swings that will knock out all but the very convicted, disciplined trend trader. Determining what drawdowns are actual changes in trend can’t be known until after the fact. Therefore, a strict set of rules and strong discipline are a must to make money Trend Following.