Trend following is probably the single-most successful method I have used in stock speculation and it can be an easy strategy once the necessary research has been conducted. I believe that our results in practically any endeavor in life are directly proportional to the amount of effort we are willing to expend. Get ready for trend following for beginners.
Editor’s Note: This is a guest contribution by David Reiner.
What is trend following? According to wikipeida.com, trend following is an investment strategy based on the technical analysis of market prices, rather than on the fundamental strengths of the companies. In financial markets, traders and investors using a trend following strategy believe that prices tend to move upwards or downwards over time. (https://en.wikipedia.org/wiki/Trend_following). In this article I’m going to cover some basic ideas for trend following for beginners.
Something you probably won’t hear a lot about regarding trend following is what sets off the actual trend. This is something I call a “trigger event” and could be anything from proposed legislation, a new oil discovery or innovation in technology. Yes, it is great to ride a trend, but it is better to be one of the first to discover a trend or anticipate a trend – I have found this to generate the highest returns for me.
However, the risk also increases with this method, because it is difficult to do sometimes. There are times where my money will sit idle or I may even lose money should a trend not materialize that I had anticipated. When the trend did materialize however, I made some very impressive returns, because I was one of the first in line. The early bird gets the worm.
An example of this was when I caught on to the marijuana equity boom very early, buying shares in a few small companies that were looking to capitalize on the idea of the increased adoption of marijuana related businesses. There were some well-known industry leaders heading these companies and I recognized them right away. I had a good hunch there would be money flowing into the sector but I wasn’t sure when.
Luckily, it didn’t take much time for my money to quadruple or more in these companies, and again even more than that in late 2014, when some huge returns were generated. Venture capital, investment funds and the average investor all wanted a piece of the action. There were also some nice recent returns recently this year with several progressive marijuana-related ballot measures.
Another issue with trend following I should highlight is leverage. My expertise has been focused on small companies which allowed me an inherent leverage based on a low share price or valuation. This was important for me starting out in my speculative endeavors because I didn’t have a great deal of money to invest. It is more difficult to generate above average returns buying a $100 stock compared to a $.10 stock.
During the recovery of the 2008/2009 stock market crash I was able to turn roughly $2000 into $180,000 by following the overall market trend that was formed by monetary stimulus from the Federal Reserve and economic bailout/stimulus policies put in place by the U.S. Government. So this highlights an important issue with trend following, which is there are different types of trends we need to follow – macro trends and micro trends. Macro trends have to do with monetary policies, fiscal policies and industry changes where micro trends might be more hidden in the form of innovation or a new oil discovery, so it pays to be attentive to both.
I take a liberal approach to trend following. For me, trends can be intra-day, a week, a month, a year, or more. For day-traders, there can be an intra-day trend that can be found practically every day. Everyone has their niche. Some people like to day trade only while others take more of a long-term investing approach. I think it is good to do both. Have a long-term fund and a short-term fund to keep you on your toes and keep your mind sharp.
Something I can probably highlight in a future article is the use of intuition in selecting the stocks you purchase on your trend following quests, something that has saved me a considerable amount of money and frustration. This aspect starts to get a mystical but there are some scientific studies that have been conducted.
Trend Following author Michael Covel states, “As science looks closer, it is beginning to acknowledge that intuition is not a gift, but a skill. Like any skill, it is something you can learn.” (Michael Covel. Trend Following: How to Make Millions in Up or Down Markets, P.187) John W. Henry and Co., an alternative asset manager and one of the largest managed futures advisors in the world, uses “fast and frugal decision-making with a bias toward trend following.
John Henry’s philosophy is founded on the premise that prices, not fundamentals are the key to making decisions, because they contain people’s expectations and the expectations are manifest in price trends. Henry’s computer systems are designed to remove the human emotional bias in the trading process, and is built around a model that will sell out losers quickly and hold on to winners as long as possible. The company believes that humans tend to hang onto losers too long and sell winners too soon, and that complex computer models are susceptible to a greater potential for errors.
Furthermore, John W. Henry does not believe he can predict the future, “I don’t believe that I am the only person who cannot predict future prices. No one consistently can predict anything, especially investors. Prices, not investors, predict the future.” (www.jwh.com – quote and information no longer available on the website – I saved this quote years ago as part of my own research – I guess they figured it wasn’t wise of them to divulge their secrets to the masses anymore).
John Henry and Co. states, “Our understanding of the nature of markets is based on the hypothesis that people’s expectations adjust slowly and manifest themselves in long-term price trends. These trends can be analyzed and exploited in our investment decision process.
A second hypothesis is that prices eventually will reflect all relevant information. That is, anything that could possibly affect the market price of a commodity or financial instrument – including fundamental, political, or psychological factor – will be reflected in the price over time. Initially, prices may over or under react to new information. In addition, price signals can be noisy and may have to be filtered to discover the underlying true information. Nevertheless, a study of market price, rather than market fundamentals, is the foundation for our analysis. Finally, we have observed hat prices move in trend that are highly complex and difficult to indentify. As a corollary to that premise, trends often last longer than most market participants foresee.” (www.trendfollowing.com)
I hope this article about trend following for beginners has piqued your interest – there is much more to discuss on this topic such as psychology, decision-making and stock selection that we can talk about in later articles.
Good luck out there and happy hunting! – Dave Reiner