In trend following, the trader attempts to capitalize on large price movements over the course of several months. Trend followers enter trades when markets are at historical highs or lows and exit when a market reverses and sustains that movement for a few weeks. Traders spend a lot of time developing methods to determine exactly when a trend has begun and when it has ended; however, all the approaches that are effective have very similar performance characteristics. Trend following generates excellent returns and has done so consistently for as long as anyone has traded futures contracts, but it is not an easy strategy for most people to follow for several reasons. First, large trends occur fairly infrequently; this means that trend following strategies generally have a much higher percentage of losing trades than winning trades. It may be typical for a trend following system to have 65 or 70 percent losing trades. Second, in addition to losing money when there are no trends, trend-following systems lose when trends reverse. A common expression that the trend followers use is “The trend is your friend until the end when it bends.” The bends at the end can be brutal both on your account and on your psyche.
Traders refer to these losing periods as draw downs. Draw downs usually begin after a trendy period ends, but they can continue for months when markets are choppy, and the trend-following strategies continue to generate losing trades. Draw downs generally are measured in terms of both their length (in days or months) and their extent (usually in percentage terms). As a general rule, one can expect draw downs for trend-following systems to approach the level of the returns. Thus, if a trend following system is expected to generate a 30 percent annual return, you can expect a losing period in which the account may drop 30 percent from its highs. Third, trend following requires a relatively large amount of money to trade using reasonable risk limits because of the large distance between the entry price and the stop loss price at which one would exit if the trade did not work out. Trading with a trend-following strategy with too little money greatly increases the odds of going bust.