Getting to grips with trend following – part 2

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According to Wikipedia, trend following is an investment strategy that is based on the technical analysis of market prices, rather than on the fundamental strengths of the companies.

While that is true in part, it’s also correct that trend following is not merely technical analysis. Indeed, trend following is much more. It is a philosophy, a way of thinking about the world, and of course, it can be just as easily applied to forex as it can with stocks.

See the first part of Getting to grips with trend following

The long tail

What sets trend following apart from other methods of technical analysis is that it is grounded in an attempt to capture the long tail of a distribution.

The long tail is used in statistics to describe a distribution of numbers where a significantly large number of events occur away from the mean or central part of the distribution curve.

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The long tail occurs in many areas but it is a dominant feature in financial markets. To see this you need only to plot investment returns over a certain time period and count how many results do not fit into a normal distribution but expand further and further outwards.

Trend followers have more losers than winners

Because trend following attempts to capture the long tail, it makes sense that trend followers have more losers than winners. The trend follower’s aim is to follow trends as they appear and then to ride them to their conclusion but the majority of trades will not end up being long tail events. In this way, a trend follower will lose on many small trades before hitting the big one and that big trade will more than pay for all the other losing trades.

Price is everything

Another principle of successful trend following is that price is everything. Trend followers ignore other factors such as news or political events, since they believe that the price tells them all they need to know. Since information is absorbed and priced into the markets quickly, trend followers only need to look at the price of a security to know the real story.

Let your winners run

Since trend followers try to capture the long tail it is essential to their strategy to ‘let winners run’ and this goes hand in hand with ‘cutting losses short’. Indeed, if losses were not cut short, trend followers would find themselves capturing the long tail but on the wrong side of the trade, they would simply end up with huge losing trades, just like letting winners run leads to huge winning trades.

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