We receive the question regularly: How do you pinpoint or find a trend? First, put away the microscope. It will not help locate trends.

Some people seem to think there must be some one precise way to determine when a trend starts. Identifying the exact trend starting point is their single unreachable objective. It’s the same as picking a top or bottom. If you find yourself attempting to peg the exact beginning of a trend, get ready to start losing money. The holy grail can’t be had.

What can you do? What do trend followers do? First, you must have a system that covers all system trading issues including money management (or bet size). A complete trend trading system will establish rules for entry, exit, how much to buy and how much to sell. Regardless of the particular day, week, month, year or current market condition, the rules are universal.

But, still how do you determine a trending market? Wrong question! The question is how do you make money. The answer involves taking small bets early on in a market (that is starting to move) to see if the trend does indeed mature and get big. Trend followers enter markets long before the nightly news is reporting new 13 year highs and long before a trend is ever evident. When the financial news starts talking about high gas prices or a stock at record lows or highs, trend followers have long since established their positions (and profits) and may be exiting when the late to the party amateurs start taking their positions based on a David Faber news report.

When trends begin they often arise from a flat market that doesn’t appear to be trending in any direction. That’s when trend followers are establishing their positions based on their entry rules. There are usually small signs early that signal trend follower’s entry into a market. These signs, coupled with money management, are the keys.

The Wrong Way to View a Trend

“If a speculator is correct half of the time, he is hitting a good average. Even being right 3 or 4 times out of 10 should yield a person a fortune if he has the sense to cut his losses quickly on the ventures where he is wrong.” — Bernard Baruch

It was reported that a trading fund had still not seen major redemptions even though the fund was down 95%! Think about that. Your position is down 95% and you are still sitting there holding on hoping for it all to come back. This is a great example of following the trend the wrong way. And for those that think we are simply being 20/20 hindsight, you are dead wrong. Trends are trends and they will continue to behave the same in the future as they have in the past. You just need rules to trade them. More.

Why the Entry Point Question Is the Wrong Question

The “how do you find a trend?” question produces the search for the perfect entry indicator because it frames the goal incorrectly. Finding the exact beginning of a trend is not the goal. Capturing a profitable portion of the trend is the goal. These are different problems with different solutions.

The search for the exact trend beginning produces two failure modes. First, it leads to premature entries in markets that show early signs of movement but do not develop into sustained trends. These false starts accumulate as small losses. Second, it leads to missing the early portion of real trends because the entry signal requires more confirmation than a simple breakout provides. By the time the trend is “confirmed” to the satisfaction of the confirmation-seeker, much of the move has already occurred.

The correct framing is Baruch’s: being right 3 or 4 times out of 10 yields a fortune if losses are cut quickly and profits are let run. The entry timing does not need to be perfect. It needs to be early enough in the trend that a multiple of the initial risk is available before the exit fires. A breakout entry at the 20-week high is early enough in most sustained trends to capture a large multiple of the initial stop distance. The position is wrong more than half the time. The position is profitable when the winning positions run to many multiples of the initial risk.

The 95% drawdown example is the clearest available statement of what happens when the entry frame is reversed: when a participant holds a losing position hoping for it to come back rather than cutting the loss at the defined stop level. The fund that remained 95% down without seeing major redemptions was being held by investors who had made the same mistake as the original position manager. Treating the position as something to hold through the decline rather than something to exit when the exit rule fired. The trend was down. Following the trend would have meant being short or flat. Being long and holding was following the trend the wrong way.

Frequently Asked Questions

Why is pinpointing the exact start of a trend the wrong goal?

Because it requires picking a top or bottom, which is precisely what systematic trend following avoids. The goal is not to enter at the exact beginning of a trend but to enter early enough to capture a profitable portion of the trend when it develops. A breakout entry that occurs after a small portion of the trend has already developed is still early enough to capture a large multiple of the initial risk if the trend continues. The search for the perfect entry point is the search for the holy grail that cannot be had.

When do trend followers establish their positions relative to the news cycle?

Long before the news cycle identifies a trend as significant. When financial news begins reporting multi-year highs in gas prices or record lows in a stock, systematic trend followers have already been in their positions for weeks or months based on breakout signals that fired before the trend became obvious. By the time the news is reporting the trend, trend followers may be approaching their exit levels while retail investors are establishing their initial positions based on news-driven conviction.

What does the 95% drawdown example teach about exit rules?

That holding a losing position through the full extent of a decline while hoping for recovery is following the trend the wrong way. The investor in a 95% drawdown has refused to exit at the defined stop level and has watched the loss compound to catastrophic size. Systematic exit rules prevent this by defining the maximum acceptable loss before the position is established. The exit fires at a small loss. The 95% drawdown is the result of having no exit rule, or of repeatedly overriding the exit rule when it was time to act.

Trend Following Systems
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