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Trend Following as an Investment Tool Coursework

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Updated: Dec 4th, 2020

Introduction

Trend-following has a rich historical background, which can be traced to more than 200 years (Hurst et al. 2). David Ricardo and Jesse Livermore are among pioneer scholars who examined trend-following as an important investment tool that could yield positive returns to companies. The basic theory of this business approach involves venturing into markets that have recorded profits in the recent past while disregarding those that have witnessed negative returns. It is crucial to examine the concept of trend-following as an investment method. A critical discussion of its use and implementation reveals the probability of its past success continuing into the future.

Concept Description

More than two centuries ago, David Ricardo, a classical economist, persuaded investors to focus on eliminating losses while allowing their profits to be consistent. This scholar demonstrated how the concept of trend-following could be deployed as an investment strategy. According to Szakmary and Lancaster, the model involves taking market advantages that emerge from long, intermediate and short-range trends or moves observed in different markets (238). Traders who apply this business framework do not emphasise the need for conducting market predictions before making investment decisions. Rather, they target any emerging trend based on their peculiar rules and reasons that support the perception that a trend in a particular market emerges with a likelihood of continuing.

Under the trend-following business strategy, investors wait for a trend to be well established. They anticipate the trend to persist to the extent that they are willing to forego the initial profit margins (Smith et al. 182). Whenever turns occur contrary to what is expected regarding the trend, investors exit trading in a particular market asset until the pattern shifts in the opposite direction.

When a peculiar rule raises an exit alarm, the trend-following business strategy requires traders to exit immediately and wait until the appropriate pattern re-emerges. Failure to follow this rule subjects any interested shareholders to losses. This strategy is in line with Jesse Livermore’s proposition that the amount of money earned is directly proportional to investors’ ability to seize a whole market. They need to be aware of the underlying trend while at the same time taking measures for addressing any individual market variations (Sun et al. 2215). However, when betting using a positive edge, it is critical to consider some possible risks as indicated by variables, including the number of shares held, the prevailing market price and market volatilities.

Critical Consideration of the Use and Implementation of Trend-Following

Investors need to be careful when using and executing the trend-following business strategy. According to Lempérière et al., observing all market rules is sufficient to earn significant returns on investment in the long, medium and short-term (6). This claim may be misleading because all markets have unique characteristics that require businesspeople to overlook some rules. In a study by Li et al., futures markets differ from one country to another, hence implying the possibility of the use of trend-following yielding profits in the U.S. and not in China (1227).

Hence, since the strategy involves following unproven guidelines that vary based on the level of advancement in a given nation, care should be taken to avoid over-optimism. When implementing this strategy, the majority of the traded volumes may end up resulting in low profits or even losses against a trader’s expectations. The above studies do not address a mechanism for avoiding risks when executing the trend-following investment plan. Clare et al. seal this gap by introducing the CAPE ratio strategy that has been proven effective in boosting withdrawal levels, hence enhancing the profitability rates of the respective investor (91). Overall, when using this method, trend-following becomes a profitable approach to business.

It is also crucial for traders to focus on using the strategy in commodity markets as opposed to stock bazaars. According to Szakmary and Lancaster, when a trend starts in a commodity market such as the U.S., chances are high that the pattern will continue due to feedback, trading and confirmation bias (221). However, when prices stretch above some underlying critical and fundamental values, trends are discontinued.

At this point, traders may witness huge losses if they do not revert to the elementary trend-following principles as presented in the study by Clare et al. (93). Hence, although trend-following may be profitable, investment decisions made should demonstrate an investor’s understanding that one state of affairs cannot continue forever. For instance, in some investments such as managed futures, risks are highly probable to the extent that trend-following may fail to work (Leles et al. 2). However, this study fails to address the huge financial losses that a managed futures strategist can incur in case of an abrupt reversal of trends. Therefore, applying the trend-following strategy in this area of investment becomes a high-risk endeavour. Hence, an investor should occasionally invest in managed futures strategies.

The Possibility of Past Success Continuing into the Future

According to Szakmary and Lancaster, trend-following has been confirmed to be an effective investment strategy for over a century (240). This situation has boosted investors’ confidence as evidenced by a rise in the number of assets invested based on the trend-following strategy. The impact of an unforeseen competition among these assets raises concerns regarding the consistency of future returns.

For instance, as Ayed et al. argue, this decade alone has been characterised by assets, which have demonstrated incoherent trends following abrupt reversals of business patterns (374). Such incidents reveal the need for examining whether or not the success of trend-following as an investment strategy will continue into the future.

Evidence from the study by Lempérière et al. indicates that trend-following has been successful since its introduction to the market (8). Its performance has not only been significant but also remarkably constant. Hence, amid the rise in the number of assets invested, trend-following has remained profitable. Any increase in capital invested under this investment strategy has been accompanied by a corresponding market size expansion.

Therefore, trend-following activities are not likely to produce any significant effects on market dynamics, hence implying that past success may continue into the future. According to Szakmary and Lancaster, market trends are dependent on issues such as interventions by governments or central banks, existing market frictions, traders’ biases and hedging pressures (223). The unavoidability of these elements only sets the pace for trend-following investment to remain a viable venture.

Conclusion

Trend-following requires traders to buy investments when prices begin to rise and sell when they start falling. Despite the simplicity of this rule, critical considerations have to be made using appropriate rules that help to mitigate risks, including over-optimism and the effects of market volatilities. The paper has indicated the possibility of trend-following experiencing challenges such as competition. Nevertheless, this situation does not imply that past success cannot be replicated into the future.

Works Cited

Ayed, Ahmed B. H., et al. “Forecasting Trends with Asset Prices.” Quantitative Finance, vol. 17, no. 3, 2017, pp. 369-380.

Clare, Andrew, et al. “Reducing Sequence Risk Using Trend Following and the CAPE Ratio.” Financial Analysts Journal, vol. 73, no. 4, 2017, pp. 91-103.

Hurst, Brian, et al. “.” Capital Management. 2017. Web.

Leles, Michel C. R. M., et al. “A New Trend-Following Indicator: Using SSA to Design Trading Rules.” Fluctuation & Noise Letters, vol. 16, no. 2, 2017, pp. 1-16.

Lempérière, Yves, et al. “Trend-Following. 2014. Web.

Li, Bin, et al. “Do trend following strategies work in Chinese futures markets?” Journal of Futures Markets, vol. 37, no. 12, 2017, pp. 1226-1254.

Smith, Peter N., et al. “Breaking into the Blackbox: Trend Following, Stop Losses, and the Frequency of Trading: The Case of the S&P500.” Journal of Asset Management, vol. 14, no. 3, 2013, pp. 182-194.

Sun, Zheng, et al. “Only Winners in Tough Times Repeat: Hedge Fund Performance Persistence over Tough Different Markets Conditions.” Journal of Financial and Quantitative Analysis, vol. 53, no. 5, 2018, pp. 2199-2225.

Szakmary, Andrew C., and Carol M. Lancaster. “Trend-Following Trading Strategies in U.S. Stocks: A Revisit.” Financial Review, vol. 50, no. 2, 2015, pp. 221-255.

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IvyPanda. "Trend Following as an Investment Tool." December 4, 2020. https://ivypanda.com/essays/trend-following-as-an-investment-tool/.

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IvyPanda. 2020. "Trend Following as an Investment Tool." December 4, 2020. https://ivypanda.com/essays/trend-following-as-an-investment-tool/.

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IvyPanda. (2020) 'Trend Following as an Investment Tool'. 4 December.

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