Secrets of Trend Following

Trend Following was my eight-year "hazardous journey" for the truth about trend-following trading. This book was meant to fill a void in a marketplace inundated with books about finance and trading, but that lacked any resource or reference to the best strategy to make money in the markets: trend-following trading.

I have come to learn over time that trend following is a confusing term. The best definition I have seen comes from trading psychologist Van Tharp: "Let's break down the term 'trend following' into its components. The first part is 'trend.' Every trader needs a trend to make money. If you think about it, no matter what the technique, if there is not a trend after you buy, then you will not be able to sell at higher prices.

"'Following' is the next part of the term. We use this word because trend followers always wait for the trend to shift first, then follow it."

Trend following quite simply seeks to capture the majority of a trend, up or down, for profit. It trades for profits in the major asset classes of stocks, bonds, currencies and commodities.

That's the simple part. Now for the controversial part of trend following.

Lao Tzu, a philosopher from the 6th century B.C., once said, "Those who have knowledge don't predict, and those who predict do not have knowledge." Trend followers do not predict market direction. They can't predict the next big trend, and they can't predict their performance. People have a hard time accepting those simple truths in a world where CNBC makes it seem like the next bit of news will be crucial to your trading account.

Probably the most-asked question I get on the subject is not directly related to trend-following trading. People want to know, "Have the markets changed?" The short and sweet answer is, "No, the markets have not changed." Markets behave the same as they did 300 years ago. They are the same today because they always change.

Trend followers believe that if you have a trading system that's sound -- meaning its principles are designed to adapt -- you can take advantage of market changes and make money. Changes in markets are no different from changes in the business world or in other areas of life. They will not hurt you if your strategy for handling them is based on reality, flexibility and responsibility for making your own decisions.

Consider the wisdom of John W. Henry, owner of the Boston Red Sox and a legend in the field of trend following:

If you have a valid basic philosophy, the fact that things change turns out to be a benefit. At least you can survive. At the very least, you will survive over the long term. But if you don't have a valid basic philosophy, you won't be successful because change will eventually kill you.

I knew I could not predict anything, and that is why we decided to follow trends, and that is why we've been so successful. We simply follow trends. No matter how ridiculous those trends appear to be at the beginning, and no matter how extended or how irrational they seem at the end, we follow trends.

Still others are unconvinced of Henry's logic. They argue that technology has erased any trading edge found by trend followers, thereby changing the markets.