How to Choose a Trend-Following System

"Imagination is more important than knowledge. Knowledge is limited. Imagination encircles the world." -- Albert Einstein

Like the candy in Willy Wonka's Chocolate Factory, there is a seemingly endless variety of trend-following flavors in the marketplace. There are trend-following systems that deal with individual stocks, and those that use index funds as their investment vehicle. There are programs that generate signals on a daily or weekly basis, and those that issue signals only a few times a year. Some are based on very complex technical models, while others are quite simple.

How do you find the trend-following system that is right for you?

Look Inside

First and foremost, consider your investment style. Are you an investor or a trader? The traditional definition of a trader paints someone who is focused on exploiting shorter-term market starts and stops, while investors hold a view of the longer-term market direction and prefer to trade infrequently.

Traders and aggressive investors often favor trend-following systems that focus on individual stocks. It can be more dangerous to play with individual stocks, but for some, the potential high returns are worth the higher risk. Other systems use broad market trends as represented by major stock market indices like the Nasdaq Composite index and the Russell 2000, and the index funds or exchange-traded funds (ETFs) that track them.

There are trends within trends, from those visible one-minute charts to patterns that develop over months or years. More aggressive traders and investors also seek to exploit short-term imbalances. Just keep in mind the shorter the time frame, the more trading begins to resemble gambling. When you focus on short-term trends, it's very easy to get whipsawed.