Practical Trend Following Strategies:
Let’s say you’re sitting on some big winners in your portfolio and wondering if you should sell. What should you do?
What I offer is a Trend Following perspective that is unique because it is 100% technical (and 0% fundamental), systematic, mechanical and objective.
Here is an example of a Trend Following selling strategy: hold until price closes below the 20 day exponential moving average. If there is a close below the 20 day line, exit the next trading day.
For instance, with a popular stock such as NVDA, you would still be holding, since there have been zero closes below the 20ema:
For Trend Followers, the end of day closing price is more important than intra-day swings. When the dust settles at 4pm, day-traders and most algos are out of the stock and the closing price represents the point where committed traders are willing to hold.
This means the dip below the 20ema on February 21st wasn’t a sell signal.
But why does such a simple rule work? One interesting feature of using this strategy is that it always leaves your upside open. There is no point where the stock is “too high” or “overbought” and so it allows a winning trade to run wild.
At the same time, the rule is perpetually cutting off your downside as each day the 20ema ratchets a little bit higher, locking in more profits as the trend continues.
A rule like this is very simple, yet surprisingly hard to follow. I’ve explained this strategy to thousands of traders and I don’t think anybody really uses it.
I remember teaching this rule to a friend and when I checked back a few weeks later, he told he just had to sell because the stock was going to announce earnings and he didn’t want to take the risk. There are a million other excuses you could use to prematurely cut a winning trade short.
Every inch a stock rises, a little voice in your head will be urging you to sell, to lock in that profit. It’s human nature, as perfectly described in Daniel Kahneman’s best selling book.
The popularity of choice A illustrates that people like to “lock-in” gains. This trait has been hardwired into humans through millions of years of evolution.
The same applies to NVDA. You buy the stock at $500 and it goes to $550. Do you want to lock in that sure gain? Of course a new trader wants to lock that it, besides the stock could fall back down and you’ll lose all that profit.
Now the 20-day-rule is designed to resist that urge. Remember, the average trader will always quickly lock in winners. To achieve above average performance, you must behave in a way that is different from average. Holding on to a stock that is exploding higher, resting your temptations to sell, is a way to behave abnormally.
But, you may be thinking, what is so special about the 20 day moving average? The answer is that there’s nothing special about that number, but rather it just does a reasonable job of defining the trend based on my timeframe.
Back in 2013, I used to have wonderful Skype conversations with a trader named Jon Boorman. One thing he used to say was “it depends on your timeframe” and that most arguments on financial Twitter occur because different people have different timeframes.
And so the 20 day rule works based on my timeframe, but it may not work based on yours.
Nonetheless, regardless of your timeframe, you can develop a rules based systematic exit strategy that is right for you. Here are some examples:
Set a 2 ATR trailing stop
Sell after the price closes below the 50ma
Exit after a close below the 200ma
Exit once the 20ema crosses the 50ema
Sell after price prints a new 20 day low
Trend Following Podcasts:
Circling back to Jon Boorman, I recently listened to his interview with Michael Covel (episode #144).
In my opinion, the interview is pure gold and touches on many of the topics I’ve discussed today, including:
Trend following complexity, and why it can be "simple, but not easy"
Van Tharp, risk management and position sizing
Trend predicting vs. trend following
Mistaken emphasis on entries rather than exits
The fantasy of calling tops and bottoms
I recommend listening to the entire one hour interview, but if you’re pressed for time, here’s a valuable segment: