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Intermediate4 min readTrading and Investing Strategies · 1/10

The Trend-Following Strategy

A trend follower does not try to call the bottom or the top. They wait for a trend to show itself, enter a little late, exit a little late, and accept leaving the start and the end to someone else.

What you will learn

  • Understand the idea behind the strategy and its basic rules.
  • See with numbers when it tends to work and when it tends to lose.
In this lesson
  1. The idea in one sentence
  2. Four rules written before the trade
  3. A worked example
  4. When does it lose?
  5. Check yourself
  6. Summary
  7. Related terms

The idea in one sentence

The strategy rests on an observation: a price moving in a clear direction sometimes keeps going for a while before it turns. There is no guarantee it continues, which is why the whole strategy is built around a clear exit rule for when the trend breaks.

Four rules written before the trade

  1. Define the trendFor example: higher highs and higher lows, or price above a chosen moving average. What matters is that the definition is fixed and does not bend with your mood.
  2. Entry signalYou enter after the definition is met, not before in the hope that it will be.
  3. Exit ruleUsually a trailing exit: each time the price makes a higher low, the exit level moves up behind it.
  4. Position sizeSet from the distance between entry and exit, so a loss, if it comes, stays within a limit you accept.

A worked example

OlderNewer
Move starts at 10
Entry after confirmation 11.5
Exit after the break 13.1
The move ran from 10 to 14; the follower captured only the middle part.
An invented stockShares of Al Wadi Food Industries (an invented company) start rising from EGP 10. The follower does not jump in. They wait for a higher high and a higher low, then enter at 11.5. The stock reaches 14, then falls below the last higher low at 13.4, so they exit at 13.1. The whole move was EGP 4; they captured only 1.6 of it, and that is normal for this style.

When does it lose?

The biggest enemy of this strategy is a sideways market. The price rises a little and looks like a trend, you enter, it slips back, you exit with a small loss, and that repeats several times in a row. So results often look like this: many small losses and a few larger gains. If you cannot sit through that run of small losses, you will probably abandon the strategy before the big move that makes up for them.

Watch outThis strategy lags by nature. In a sudden drop, such as a price gap after news, the stock can open far below your exit level, and the loss can be larger than you planned.

Look for trends yourself

Open the screener, pick a simple condition such as price above a moving average, and look at the charts of the results. The aim is to practise the definition, not to pick a stock.

Stock screenerAll stocks

Check yourself

1. In what kind of market does trend following usually struggle?

A sideways market produces many false entries, each ending in a small loss.

2. The stock rose from 10 to 14; you entered at 11.5 and exited at 13.1. What did you make per share?

13.1 − 11.5 = 1.6. A follower gives up the start and the end of the move.

Summary

  • Trend following enters after a trend shows and exits after it breaks; it does not try to predict tops or bottoms.
  • Its rules are written before the trade: trend definition, entry, exit and position size.
  • It struggles in sideways markets, and its results are often many small losses and fewer, larger gains.

Related terms

Moving averageStop lossSupport and resistance

Related lessons

Technical IndicatorsMoving Averages: SMA vs EMAReading ChartsTrendlines and Price Channels: How to Draw ThemRisk and Portfolio ManagementPosition Sizing: How Much to Put in One Trade
Previous · 11Rebalancing a PortfolioNext · 02The Mean-Reversion Strategy

Educational content only, not investment advice. Companies and figures in the examples are invented for illustration.