How to Choose a Trend-Following System

When narrowing down your choices, start by taking a look at yourself.
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"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.

At the other extreme is a system with a longer-term focus. This is the approach I favor. It's the closest thing to buy and hold, but with downside protection. My trend-following style is geared toward the long-term investor who intends to build substantial wealth by applying disciplined, nonemotional technical analysis to all, or most, serious money available. Obviously, you want to be invested in the market most of the time. But you want to be able to protect yourself against downtrends by being able to step out of the market when necessary. Or better yet, benefit in downtrends by shorting the market.

Look at What You Follow

Another way to differentiate trend-following systems is to look at what indicators they track. Michael Covel and the traders he profiles in his book,

Trend Following,

focus purely on price. They contend that this can be applied to anything that's traded: stocks, bonds, currencies and commodities. Other systems focus solely on the stock market and measure additional indicators such as volume.

Regardless of whether a system focuses on price only or price and volume, its model can range from very simple to exceedingly complex.

With the more complex systems, you may be getting more information than you really want or need, and the model may have been overly optimized or fitted to the observation period. When you start factoring in too many indicators, it starts to become emotion-based trading again. Which of the dozens of indicators do you favor? Which moving average do you use -- 20-day, 50-day? The problem with overly complicated trend-following models is that you begin to lose sight of the forest because there are too many trees.

Look Back

It may sound obvious, but one of the most important considerations in choosing a system is its track record. Is it backtested? Does it have a live track record as well?

Backtesting is key; it reconstructs trades within certain parameters using historical data. A strategy that worked well in the past over long periods and varied market conditions is likely to work well in the future. What's important to understand is that there are many approaches to backtesting -- some that are very credible and some that are dubious. So you want to double-check any history with a live track record.

Look for Advice

Any company can tell you how great their system is and can slice and dice the way it presents its results. Check out the credibility of the service and people who run it. Who are the people behind the system? Are they known and respected in the investment community? There are some systems on the Internet that don't include even basic information like who runs them and where they're based. If you are going to trust somebody's investment advice, you need to be fully able to trust the individuals making the recommendation.

But you don't have to rely on your own gut instinct. That's where the value of independent verification comes in. Both

Hulbert and

TimerTrac are independent investor subscription services that monitor and evaluate investment newsletters and market-timing systems in the marketplace.

Look for More

As you consider your options, see what value-added services the various systems provide. I think one of the most important is investor education. Invariably, an educated investor makes better choices.

If you are not typically highly disciplined, you might want to find a system that will do the trading for you. Some people find it's just too hard to follow through on the buy and sell signals issued. They just can't help second-guessing the system because at times it seems so counterintuitive. In that case, it may be better to simply close your eyes, tune out the noise and have the service make your trades for you.

At the end of the day, with careful research and evaluation, you can find a trend-following system that suits your investment style and -- like the Chocolate Factory -- provides you with sweet returns.

Frank Minssieux is president and co-founder of

TimingCube

, a broad market trend-following model, and originator of its Trend Timing newsletter. Minssieux invites your questions and will answer as many as possible in future columns.

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