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What is Trend Following?

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  • Written By: Malcolm Tatum
  • Edited By: Bronwyn Harris
  • Last Modified Date: 08 November 2016
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In investing circles, trend following is the process of identifying the prevailing direction of the market, and conducting transactions that follow that direction. Proponents of this approach find that this strategy of following the current market trend results in a decrease in risk, while also allowing investors to quickly buy and sell to take advantage of the current direction of the market. The idea of trend following is relatively simple in comparison to other investment strategies, and is employed by seasoned investors as well as novices to the world of investing.

There are several indicators or factors that must be considered in order to apply a trend following approach. Price is normally the first indicator that the investor will address. By correctly identifying the trend as it relates to the unit price of the shares of stock, the investor can get an idea of whether the value of the stock is currently increasing, or shows signs of slowing down just before going flat or possibly experiencing a downturn. This one factor can help the investor determine if it is a good idea to look into acquiring the stock, or focus attention elsewhere.

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Assuming the current movement of the price is favorable, the investor will next want to consider how many shares to buy or sell. This factor will often be influenced by the financial goals of the investor, and his or her desire to devote a particular amount of the available assets to one investment. With trend following, this often involves projecting the return as long as the current trend continues, and deciding if the return is sufficient to warrant purchasing a larger number of shares, or going with a relatively small number of shares.

As with any investment strategy, the process of trend following must be tempered with some type of risk control strategy. Here, the idea is to generate the most revenue while following the trend, but being ready to make changes when the current trend begins to wane. By anticipating the downward movement of the trend, it is possible to minimize the potential for incurring losses. Even if the trend indicates a temporary slump followed by an upswing, the investor may choose to reduce the number of shares held just prior to the slump. This approach helps to keep the overall loss within reason while still being in a position to earn higher returns when the stock begins to increase in value once more.

Trend following requires that the investor understand how to read the trend and then act accordingly. To this end, the investor must know when to enter the market, and how many shares to acquire or sell. The investor must also know how to properly determine the amount of risk that he or she is willing to assume on any investment, and when to break away from the trend at just the right time to gain the most benefit. Keeping all these factors in mind makes it possible to ride the current trend and increase the value of the portfolio considerably.

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