Trend-Following

Trend-following is a trading strategy that seeks to profit from market momentum by buying assets that are rising in price and selling short assets that are falling in price. It's a purely reactive approach, meaning it doesn’t try to predict market tops or bottoms. Instead, a trend-follower waits for a trend to establish itself and then “hops on for the ride.” The core philosophy is encapsulated in the old trading adage, “The trend is your friend.” This strategy relies heavily on technical analysis, using price data and various indicators to identify the direction and strength of market trends across different asset classes like stocks, commodities, and currencies. A key characteristic of trend-following is its systematic nature; decisions are based on predefined rules and signals, removing emotion and guesswork from the trading process. While it can generate substantial profits during long, sustained market moves, it often struggles in choppy, sideways markets where clear trends are absent.

Imagine the market as a river. A trend-follower isn't interested in predicting where the river will change course. Instead, they identify which way the current is flowing and simply float along with it. This means they are agnostic about an asset's fundamental worth. The only thing that matters is its price direction. If a stock's price is consistently making new highs, a trend-follower buys it, assuming the upward momentum will continue. Conversely, if it's consistently making new lows, they might sell it short. This strategy is built on the behavioral finance observation that price movements often persist, driven by herd behavior, fear, and greed.

Trend-followers use a variety of technical indicators to signal when to enter and exit a trade. These tools are designed to filter out market “noise” and confirm the existence of a trend. The goal is to be systematic and avoid emotional decisions. Common tools include:

• Moving Averages: These are one of the most popular tools. A trader might buy when an asset's price crosses above a long-term moving average (e.g., the 200-day average) and sell when it crosses below. A “golden cross” (short-term average crossing above a long-term one) is a classic bullish signal.
• Breakouts: This involves entering a position when a price moves above a previous high (a resistance level) or below a previous low (a support level). A breakout from a long period of consolidation is often seen as the start of a new, powerful trend.
• Channel Breakouts: A famous example is the Donchian Channel system, which buys when the price hits a 20-day high and sells when it hits a 20-day low.
• Directional Movement Indicators: Tools like the ADX (Average Directional Index) help measure the strength of a trend, not just its direction. A rising ADX suggests a strengthening trend, giving the trader more confidence to stay in the position.

This is the holy grail of systematic trading and the absolute mantra for trend-followers. The strategy's success hinges on capturing large, infrequent gains that more than offset the many small, frequent losses. To achieve this, a trader must have iron discipline.

1. Cutting Losses Short: Every entry is paired with a pre-determined stop-loss order. If the market immediately reverses after a trade is initiated, the position is closed for a small, manageable loss. There is no “hoping” for a recovery.
2. Letting Profits Run: This is often the harder part. When a trade is working, the trend-follower resists the urge to take profits early. They ride the trend for as long as it continues, often using a “trailing stop” that moves up with the price, only exiting when the trend shows clear signs of reversal. This discipline allows for outsized returns from a single trade.

The Achilles' heel of trend-following is a ranging or sideways market. In these conditions, the market lacks a clear direction, causing prices to “whipsaw” up and down. A trend-following system will generate repeated buy and sell signals, each resulting in a small loss as the anticipated trend fails to materialize. This period of “death by a thousand cuts” can be psychologically brutal and is the primary reason why many aspiring trend-followers give up. A successful practitioner must be prepared to endure long periods of flat or negative returns while waiting for the next big trend to emerge. A whipsaw is when a security's price heads in one direction, but is then quickly followed by a movement in the opposite direction.

For us at capipedia.com, this is the most crucial comparison. Value investing and trend-following are not just different strategies; they are opposing worldviews.

A trend-follower believes that price is reality. All available information, hopes, and fears are reflected in the current price, and its direction is the only truth that matters. They buy high, hoping to sell even higher. A value investor, in contrast, believes that price is what you pay, and value is what you get. They are laser-focused on calculating a business's intrinsic value—what it's truly worth based on its assets, earnings power, and future prospects. A value investor's goal is to buy an asset for significantly less than its intrinsic value, creating a “margin of safety.” For them, a rising price is often a sign of decreasing opportunity and increasing risk, not a signal to buy.

From a value investing perspective, trend-following is seen as a form of speculation, not investment. It's an attempt to profit from the market's psychological whims rather than from a company's underlying business performance. Legendary investors like Benjamin Graham and Warren Buffett have built their fortunes by being contrarians—buying when others are fearful (and prices are low) and selling when others are greedy (and prices are high). Trend-following does the exact opposite. Buffett famously said, “Be fearful when others are greedy, and greedy when others are fearful.” A trend-follower is, by definition, greedy when others are greedy and fearful when others are fearful. While this may work for short-term traders, the value investor believes that long-term wealth is built by owning excellent businesses, not by chasing price charts.

Trend-following is a disciplined, rule-based strategy that aims to capture profits from major market movements. It requires immense patience to endure the inevitable small losses in choppy markets and steel-willed discipline to let profitable trades run. However, it stands in stark opposition to the value investing philosophy. While a trend-follower chases price, a value investor seeks to understand and buy business value. For the long-term investor focused on building wealth through ownership of great companies, trend-following is a siren song best ignored. The real, enduring “trend” to follow is the growth in the intrinsic value of a well-run business purchased at a reasonable price.