**Trend Following in Forex Trading: A Comprehensive Review**
Trend Following is one of the foundational strategies in Forex trading, rooted in the basic principle: “the trend is your friend.” This approach capitalizes on the directional movement of the market by identifying established trends and riding them until signs of reversal appear. Rather than attempting to predict market tops or bottoms, trend followers aim to enter trades during the middle of a trend and exit once the momentum begins to wane.
This article provides an in-depth look at the Trend Following strategy, breaking down how it works, outlining the steps traders use to implement it, and exploring its key advantages and disadvantages. This review will equip traders, both novice and experienced, with a clear understanding of what trend following involves, and how to determine whether it aligns with their trading goals and personality.
Understanding Trend Following
Trend Following is a strategy based not on predicting market moves but on reacting to them. When a currency pair starts moving consistently in one direction — either upward or downward — trend-following traders look for confirmation of that trend and enter positions in the same direction.
Typically, trends develop when there is a sustained imbalance between buying and selling pressure over time. This could be due to macroeconomic developments, interest rate changes, political events, or prolonged investor sentiment. The underlying belief guiding trend followers is that large-scale market forces take time to fully play out, and trends can last days, weeks, or even months, allowing ample opportunity to ride the wave of momentum.
Key Characteristics of Trend Following
Trend following strategies are typically medium to long-term in nature. Unlike scalping or day trading, which focus on quick moves and small pip gains, trend following targets larger moves. This strategy relies on technical indicators and historical price action to identify trends and determine entry and exit points.
Importantly, trend followers accept that they will never buy at the bottom or sell at the top. Instead, they focus on catching the bulk of a trend’s movement, which, while it may lack precision entries, seeks to profit from the overall market direction.
Steps Involved in Trend Following
Implementing a trend-following strategy involves several sequential steps. Below, we break down the core components that traders follow when using this technique:
1. Identifying the Trend
The first and most critical step is to identify whether a trend exists. Trends can be upward (bullish), downward (bearish), or sideways (ranging). To recognize a trend, traders typically rely on the following tools:
– Moving Averages (Simple and Exponential): Common settings include the 50-day, 100-day, and 200-day moving averages. A rising average suggests an uptrend, while a falling average points to a downtrend.
– Trendlines: Drawing straight lines connecting higher lows in an uptrend or lower highs in a downtrend can help visualize the trend.
– Price Action: Traders often scrutinize higher highs and higher lows (in an uptrend) or lower highs and lower lows (in a downtrend) in price charts.
– Directional Movement Index (DMI) or Average Directional Index (ADX): These indicators help quantify the strength of a trend.
2. Entry Point Determination
Once a trend is identified, the next step is to find a suitable entry point. Traders may wait for:
– A pullback to a moving average or key support/resistance level.
– A breakout from a consolidation phase or chart pattern (e.g., flag, pennant).
– Confirmation signals like candlestick patterns or a crossover of indicators (such as a shorter MA crossing above a longer MA in an uptrend).
Patience is essential at this stage. Entering too early can lead to losses if the trend hasn’t been confirmed, while entering too late can reduce potential profit margins.
3. Stop-Loss Placement
Risk management is paramount in Forex trading, and trend following is no exception. Traders usually place stop-loss orders:
– Below recent swing lows in an uptrend or above recent swing highs in a downtrend.
– At a specific ATR (Average True Range) multiple, like 2x ATR, to accommodate normal market volatility.
– Based on technical levels such as previous support/resistance or pivot points.
Proper stop-loss placement helps to prevent large losses when a trend unexpectedly reverses or a false breakout occurs.
4. Position Sizing
Because trend following usually involves wider stop losses and longer holding periods, choosing the correct position size is crucial. Traders often use a fixed percentage of their trading capital (e.g., risking 1-2% per trade) to ensure they remain solvent through a series of trades, especially during choppy or transitioning markets.
5. Holding and Monitoring the Trade
Once in a trade, the biggest challenge for trend followers is not cutting the trade too early. Letting winners run is one of the key principles of this strategy. Traders monitor trend strength and may use:
– Trailing stops to lock in profits while allowing the trade room to grow.
– Continued analysis of price action and indicators to confirm the trend remains valid.
– Break-even adjustment, where the stop-loss is moved to the entry point once the price has moved in favor.
6. Exiting the Trade
Exiting too early can cut off potential profits, while exiting too late can lead to giving back gains. Common exit strategies include:
– A trendline break or moving average crossover in the opposite direction.
– A close below or above a significant support/resistance level.
– Deceleration signals such as a drop in momentum or divergence in oscillators like RSI or MACD.
Pros of Trend Following
There are several benefits that make trend following a popular approach among both institutional and retail traders.
1. Simplicity and Clarity
Trend following is straightforward. There is no need to predict tops and bottoms. The system works by observing established market behaviors and making calculated participation in that flow.
2. Proven Historical Success
Many legendary traders, such as Richard Dennis and the Turtle Traders, have demonstrated the effectiveness of trend following. Its principles are rooted in statistical robustness and market behavior theories like the Efficient Market Hypothesis.
3. High Reward Potential
Long-trending markets can produce substantial gains, especially in the Forex market, where currency pairs can trend for prolonged periods due to macroeconomic fundamentals.
4. Reduced Emotional Trading
Once a trend is established and a position is entered with a pre-set stop and take-profit plan, much of the emotion is removed from decision-making. This increases discipline, especially with the help of automated or rule-based systems.
5. Fits Multiple Timeframes
Trend following can be implemented across daily, weekly, and even monthly charts, offering flexibility to traders with different styles and schedules.
Cons of Trend Following
Despite its many strengths, trend following has drawbacks that traders must be wary of.
1. Not Suitable for All Market Conditions
Trend-following strategies underperform in sideways or range-bound markets. During these periods, traders may face a series of small losses or stop-outs that can be emotionally draining and financially taxing.
2. Late Entries and Exits
Due to the nature of confirming a trend before participation, traders often enter the market after a trend has already begun and exit after signs of a reversal. This lag can result in missed portions of the move and reduced profit potential.
3. Requires Patience
Trends take time to develop and produce results. This strategy is not ideal for traders seeking quick returns or who are uncomfortable with holding positions for long periods.
4. Whipsaws and False Breakouts
Markets can produce false signals, especially around key levels or during news events. These whipsaws can lead to