What is meant by trend following?

The great majority of commodity traders are trend followers. Commodity markets frequently move in trends, during which the price continues in either an upward or downward direction for long periods.

With stocks, it is usually a bad sign if the price enters a falling trend. Stocks are supposed to reflect the progress of the companies they represent and are expected to rise and rise as the company prospers. When a stock price falls, it is hardly ever a good sign.

But this is not the case with commodities. Commodity prices trend naturally as conditions dictate - and it is just as normal for the price of a commodity to progress downwards – perhaps as supplies of the commodity are increased to satisfy demand, as it is for the price to rise as demand outstrips supply.

The natural tendency of commodity prices to ‘trend’ provides opportunities for traders to make money. Dealings in the commodity futures markets are of enormous size compared to equities and the majority of trades are commercial ones that are made in order to provide ‘financial certainty’ rather than speculative positions.

The popular picture of traders playing a ‘zero sum game’ is largely false. Speculative trades have their place but they are only a part of the big picture.

Most trading system rules are designed to catch trends and keep the trader in the trend as long as possible. There are all sorts of variations on rules that do this. To be of use to a trader, the rules must show that over a period of time they are likely to be profitable and this is done by testing against past market prices.

Markets do not trend all the time – they can be whipsawing around or they can be flat and moving very little. At these times, there are no trends to follow and profitable trading is not possible. Traders want their systems to keep them out of markets like these.

Much of what is written here is from the point of view of day trading. When seen in larger or smaller time intervals, market moves look different. For example, a choppy daily market could reveal trending markets when viewed on an ‘intra day’ basis, using perhaps one minute time intervals between price bars.

Commodity trading on small time intervals introduces a large element of artificiality and the trading is different in ways that are not easy to explain.

When daily markets close, there is a temporary resolution of the price, and some meaning attaches to the closing price. However, when markets are traded, say on five minute time intervals, there is no closing in the true sense and the closing prices have no real meaning other than the fact that they are ‘snapshots of a moving market’. The same trading concepts do not necessarily apply to these markets, which are not traded on a market day basis or multiples of days.

Successful systems traders do not trade these artificial time intervals.

 

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