DIYQuant experience with Trend Following

As promised at the start of the year, I am going to share with everyone a series of posts on my experience in trading. For the first post let's start from how I take on trend following. I will not share my exact strategy because that would be proprietary (black box) but it would be the general idea of it.

If you have been to my strategy page, you'll know that the system that I built is adopting a trend following strategy. Below is a definition of trend following adapted from Investopedia:

Trend following is a trading strategy that attempts to capture gains through the analysis of an asset's momentum in a particular direction. The trend trader enters into a long position when a stock is trending upward (successively higher highs). The trader exits the position when the trend reverses. Conversely, a short position is taken when the stock is in a down trend (successively lower highs) and the trader exits the position when the trend reverses.

Successful traders always follow the line of least resistance. Follow the trend. The trend is your friend

-Jesse Livermore

I was inspired to use trend following after reading the 2 books below and by what Jesse Livermore mentioned above.

1. How I Made $2000000 In The Stock Market by Nicolas Darvas
2. The Original Turtle Traders’ Trend Following System

There will always be trends

Additionally, I believe in the scalability of trend following strategy and its potential to apply to many other asset classes other than stocks. In fact, trend is everywhere. Not only in the investing world. Fashion, media, culture, we tend to be attracted to what is popular and current. And many of us like to follow what everybody else is doing (think #Bitcoins, #iphone and #Facebook). So, my belief is it is human nature to follow trends. Trend will never go away. And the other thing that helps to boost trends is fear and greed, at least in the investment world. Greed pushes trends into bubbles. Fear bursts the bubbles and reverses the trend. Fear and greed will never go away as long as we are still human (let's not go into the topic of spirituality here). And trend following strategy takes advantage of that by taking position when the trend starts to form and exit when the trend loses its steam.

There are many different indicators used to identify possible trends. A classic one being the Simple Moving Average cross over. Others include EMA, breakouts, MACD, Darvas Box Theory among others. The one currently included in my system is the breakout strategy. My current algorithm only focuses on long. Long means it generates a buy signal when the price of a stock pushes through a determined resistance level. A sell signal would be the opposite - when the price of the stock being held fell below the support level.

Few big wins, many small losses,

One thing I learnt from my experience with trend following in stocks is that most of the time, it doesn't work. This is one of the characteristics of trend following. Approximately 70% of the trades are losing trades if trend following strategy is used alone. But trend followers keep the losses small by exiting when the trend doesn't materialize. But the remaining 30% of winning trades are so large that, theoretically it can cover all the small losses and bring in a net profit. That's why trend followers generally do not set target price. They keep losses small and let profit run which occasionally produces multibaggers (check out this 370% return KEMET Corporation). It is not easy to trade trend following strategy due to the high percentage of losing trades and it is easy to give up before you see a winning trade. I would say you need to have traded 20 stocks before you would start seeing profit (also depends on the current market conditions) And if you are trading only a few stocks per year, you may only start seeing profit after a few years!

Trend following works well on this group of stocks

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