What is Trend Following?
Trend following is a technique that allows traders to minimize their risk when entering a trade. It also significantly increases the odds of having a highly profitable trade. Why? Trend following is exactly what the name of the strategy suggests: it is following the trend. All a trader has to do is successfully identify the direction of the trend. Next is to jump in at the right time to ride it out. Trend following minimizes risk for traders because they do not have to guess what direction the market is heading in. This is because they have already established that it is either going up or down.
People choose trend following because of the lower risk involved. Many traders are skeptical when it comes to trend following. They believe the odds of a highly profitable trade are much lower. They believe they would gain more if they catch the trend when it first starts. Entering a trade at the beginning of a new trend means that a trader has to perfectly time the end of a prior trend. Then they have to enter at a point where they think the reversal is likely to take place. Reversals are extremely hard to spot and it requires a lot of speculative intuition. Whereas trend following is not speculative because traders are following a trend that is already established. Trend followers do not try to bet against the trend and hope for a reversal; that is extremely risky and much more than the average trader can stomach.
What are Continuation Patterns?
Continuation patterns are what traders use to determine whether or not a trend is likely to continue. I use the word “likely” because nothing in the market is ever guaranteed. More information about this will be found at the end of this article. Continuation patterns are high probability signals that tell traders it is likely safe to enter into a trend as it is breaking previous highs/lows. Many traders are afraid to enter into a trade new highs/lows. Most traders think that there is a higher probability of trends reversing at new highs/lows. This is one of the biggest misconceptions in trading. Think about it- if trends failed and reversed at new highs/lows, how would it be possible for market to move higher or lower? If new highs/lows caused reversals, the market would forever trade sideways.
Continuation patterns are merely a configuration (pattern) of market structures that show strength in one direction and weakness in the other direction. For example, in an uptrend, you would expect to see market structures signaling that buyers are stronger than sellers. The opposite is true for a downtrend, you would expect to see market structures signaling that sellers are stronger than buyers. It sounds harder to identify than it actually is. To spot that buyers or sellers are stronger, you first need to understand basic market structure.
Why Trend Following and Continuation Patterns Work
Trend following and continuation patterns work because of market psychology. Traders make them work. Traders make them work because many traders believe that these principles work. This is because there are tons of sites, videos, and books on how to trade them. Many traders are looking for the same spots in the market to enter and exit trades. With enough money influence from traders thinking the same thing, trends and continuation patterns work. Trading is so much easier when you know there are many other traders out there that are thinking the same thing you are.
Expect Some Degree of Failure
You may be wondering why so many traders still lose money following this strategy. There are a few reasons why this strategy can fail. One of the biggest reasons is that many traders are not patient enough to what for continuation patterns to fully develop. Some patterns look like others while they are in the process of forming. Jumping into a trade before a continuation pattern fully forms can lead to huge losses. Another reason for failure is that traders sometimes interpret market choppiness as continuation patterns. Remember, continuation patterns only work when a lot of other traders recognize them. So if you recognize market choppiness as a pattern and other traders do not, then the strategy will fail.
Only one reason causes this strategy to fail that is entirely out of our control. Overall market sentiment can cause this strategy to fail. If overall market sentiment changes in the middle of a trend, it is likely to fail. When market sentiment is bad, traders tend to panic sell. When market sentiment is good, traders tend to buy hopefully. Therefore, a change in market sentiment can cause a change in trend direction. This is usually rare and requires major political/economic news.