Order Flow Boot Camp

Why Trend Following Works

Keeping it simple to stay profitable

Wise men once said that you can use any logical approach to trade the markets, as long as you're consistent with it. While this makes sense from certain points of view, we want to show you some of the most logical and time-tested ways of confronting the markets.

1. What is Trend-following and Momentum?

Trend-following strategies and momentum strategies essentially work on the basis of continuation: if YM, for example, has been performing well over the past 3-6-12 month period, then it is rational to expect some continuation. Momentum styles buy recent winners and sell recent losers.

It's hard to argue with Trend and momentum in this context

"Chasing Returns has attracted negative publicity, but it turns out that using suitable lengths over which to measure performance, trend/momentum style strategies have been historically successful in almost any asset class, but more so in commodities and currencies.

2. What academics say

Academics are smart people. They crunch numbers like we crunch potato chips. So if they say something has worked for a long time, and has a good chance of working in the future, then we should listen and see what they are studying. As we will see later, it also applies to shorter term trading.

The most common trend-following rules are based on moving averages and we can tie this into the success of the Commitment of Traders report, establishing the 3month window, the 6month window and the 12month window. The rationale is that we know that the current market price is the most important relevant data point, but we do not know whether the most appropriate comparison is the price of a week, a month, a quarter , or a year ago! So it makes sense to use a moving average.

What the lesson can be, for those that attempt to leg into the fast-moving intraday momentum moves, is to make sure there is some substantial trend or momentum play already in action. For example, does it make more sense to play a trend following strategy in chart A or B?

Chart A showing EurUsd weekly and 1H charts

Chart B showing UsdCad weekly and 1H charts

I hope we can all agree that the EurUsd has better trend following capacity to it, because the longer term frames are strongly trending whereas UsdCad is still a little choppy on the weekly, even though the 1H frame already looks like the trend is under way.

And this is the key point: intraday players need to make sure they have larger participants beind them before they interact with the market. It's best to "run with the wind in your favour". In this case, the wind is a metaphor to indicate larger players that are stacking their bets in the same direction.

3. Sentiment and Trend

Trend following and momentum strategies work over a vast amount of asset classes and time frames. What do we have to add? A few tweaks!

a) Poorly anchored asset prices allow for greater trending, because they give more scope for sentiment-driven changes. For example, stocks have various measures of "fair value". Currencies and energy prices do not. A lack of clear fair-value anchors means that there is more potential for long trends and exaggerations. George Soros also spotted this. So Sentiment is very important in the short term, and even more so with assets that do not have clear fair value anchors.

b) Volatility influences the profitability of trend-following methods. Trend-followers need volatility. Low volatility kills trend-following. This is why we follow a number of asset classes with Order Flow Trading. To constantly skate where the "puck" is.

c) Trend-following strategies tend to work well in the run-up to predictable "events" like economic announcements. Be it Non-Farm Payrolls, or Central Bank meetings, or OPEC announcements. Traders become more risk-averse prior to such announcements, so liquidity starts to dry up and the potential for larger moves increases. Hence, the"weak hand" playing counter-sentiment is more easily wiped out - thereby accentuating the recent trend.

To sum up: trend following/momentum strategies are simple and naive, but they have worked in the past and will work in the future. The important thing to remember is that it takes some heavy duty money to start a trend on the larger time frames, which then can be played via the shorter (even intraday) time frames so long as momentum continues to push forward. Sentiment is the main filter for these short-term forays into the market, as players push & pull the market price around based on emerging fundamentals and their own perceptions of value…since value doesn't oscillate that much in the short term.

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