The concept of trend following is often one of the first strategies new traders learn when discovering the financial markets. Several well written and convincing mass market books preach strongly about the superiority of the trend following method.
On the surface it appears that nothing could be easier than catching a trend. The basic premise of trend following is that stock strength begets strength and stock weakness leads to more weakness. A series of higher highs and higher lows identifies an up trend. And a series of lower highs and lower lows is a sure sign of a downtrend.
The strategy, as defined in the books by the same name, teaches that once the investor identifies the trend, trades are placed in the direction of the trend. In other words, one would buy a stock that has exhibited an uptrend on the price chart. A stock downtrending would be shorted.
While this is definitely a feel good investing method and it appears to work for some large, well diversified hedge funds, trend following can spell disaster for the investor.
First, it is a non-quantified, unspecific trading system. For example, just how many up moves increase the odds that the next move will be in the same direction? My personal favorite example of why trend following makes little sense when examined is as follows. If you flip a coin and heads comes up 6 times in a row, are you in heads trend?
Secondly, when the trend following criteria is tested it fails miserably. We tested the S&P 500 over a 15 year period to determine if an edge actually exists going with the perceived trend. What was discovered is quite the opposite of what the proponents of trend following teach.
The SPY and NDX were used as the test vehicles. The market actually lost money within one week after 3 or more consecutive days of higher highs. The opposite was also proven true. 3, 4, and 5-days in a row of lower lows leads to outperformance over 1-day, 2-days and 1 week time frames. In fact, multiple day lows FAR outperformed multiple day highs.
Similar results were found when the Nasdaq 100 was tested. In other words, we clearly discovered that there is no edge whatsoever to trend following when trading stocks. Remember it’s often the ideas that make the least sense at first glance that are proven edge providers when investing.
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David Goodboy is Vice President of Business Development for a New York City based multi-strategy fund.