Trend following systems emerge as a popular and robust solution for traders and investors, offering a structured methodology to identify and capitalize on market trends. Although they present notable advantages, it's important to consider their limitations and use them complementarily with other analysis strategies to make informed decisions in the complex world of investments.

What are Trend Following systems?

Trend following is an investment approach based on the idea that financial assets tend to move in established directions over certain periods of time. These systems seek to identify and follow bullish or bearish trends, leveraging market movements in the same direction rather than attempting to predict the future direction of the market. Many investors have exploited this type of strategy to generate incredible returns. A notable example is the legendary Paul Tudor Jones, known for using a strategy based on moving average crossovers to identify long-term trends in futures and forex markets. Larry Hite, co-founder of Mint Investment Management Company, is known for using the ADX as part of his trend-following approach. Another well-known example is the turtle experiment, conducted by Richard Dennis and William Eckhardt in the 1980s, where a random group of individuals was recruited and trained to apply a trend-following system. The results of the turtles were impressive, with some members of the group, such as Jerry Parker and Curtis Faith, generating significant returns using this system. Parker, for example, founded Chesapeake Capital and has had a successful career as a hedge fund manager. Many people use these types of strategies, but it's not for everyone. If you want to learn how to design such a strategy, you can read the following article: Designing Trend Following Strategies.

Advantages of Trend Following Systems

1. Simplicity: Trend following systems are usually based on simple and easy-to-understand rules, making them accessible even for novice traders.

2. Trend Identification: They allow for easy identification of prevailing market trends, facilitating buying or selling decisions.

3. Exploitation of Sustained Movements: By following trends, these systems allow for the exploitation of prolonged market movements in a specific direction, thus maximizing profit potential.

4. Market Noise Reduction: By focusing on long-term trends, these systems help filter out market noise and avoid impulsive decision-making based on short-term fluctuations.

Disadvantages of Trend Following Systems

1. Delayed Trend Identification: Trend following systems may take time to confirm a trend, meaning traders could miss out on part of the initial market movements.

2. False Signals: In volatile or transitioning markets, these systems can generate false signals, resulting in losing trades.

3. Difficult in Sideways Markets: In markets without a clear trend, trend following systems may generate incorrect signals or incur losses due to the lack of a defined market direction.

4. Long Periods of Losses: One of the main characteristics and challenges of employing this methodology are the long periods of losses. Some investors implement different strategies to minimize their impact, such as reducing position size during these periods.

Absolute or Relative Trends?

The main difference between an absolute trend and a relative trend is how prices are considered. In the case of absolute trend, only the price of the asset is taken into account, while in relative trend, the relationship between two assets is considered with the aim of seeing which one has better performance. The main reason for choosing one methodology or another is the type of management intended. Absolute trend is usually employed more in discrete management where individual operations are considered instead of always having open positions, while relative trend is used more in the latter case, where one wants to always be in the market and maintain positions in assets that are showing the best performance. But it doesn't have to be just one system used; both can be used together to find investment opportunities according to the absolute trend in assets that have a good relative trend, thus using the relative trend to filter only the assets with greater strength. Interestingly, Kent Daniel gave a lecture at Columbia University in 2010 on this type of asset selection and how selecting those with the worst relative performance during crisis periods could significantly increase returns.

It is worth noting that when investing in assets that are quoted in currencies other than one's own, this should be taken into account in the calculation of the asset's price, thus turning it into a system of relative trends. This is because if you have an account in Euros and intend to trade in the American market, in Dollars, assuming that the Euro is growing against the Dollar, the final return of the operation will be lower due to the devaluation of the Dollar against the Euro. It may be more convenient to invest in some European asset that shows a slightly lower absolute trend but relatively higher. The same case could occur in reverse, where the Dollar appreciates against the Euro and investment in the US market takes advantage of both the asset trend and the currency trend, this case will be seen later.

If we follow this line of thought, technically speaking, we all have open positions in different assets permanently, with that asset being your local currency (money in the bank account), your vehicle, your house, etc. Each position will depreciate or appreciate, with your assets constantly fluctuating. You may buy a table at one price and sell it at a higher price, yielding a profit, or buy a car and sell it at the same price but due to maintenance costs (tire changes, oil, filters, etc.), it becomes a losing position. This approach demonstrates that absolute trend does not actually exist but is simply a special case of relative trend in which a variable is deliberately ignored or considered constant.

Calculation of Relative Trends

The calculation of this type of trend is not complex and mainly depends on the relationship between assets. The main issue arises when it is intended for comparison, in which case a prior standardization should be performed so that the scale difference does not affect such comparison. The most common approach is to select a reference asset and divide the prices of the assets being studied by those of the reference asset. In the case of currency exchange, it may vary depending on the pair being dealt with. For example, given the price of a stock A that is worth €2 and an exchange rate for EUR/USD of 1.1. If the intention is to change the price to dollars, it should be noted that the exchange rate is interpreted as 1 Euro equals 1.1 Dollars, so it should be multiplied (2 x 1.1 = 2.2), while if the conversion is the other way around, it should be divided.

In the following example, we will compare the performance of AAPL, MSFT, GOOG, AMZN, TSLA, META, NVDA, and BRK-A. BRK-A has been chosen instead of BRK-B to better appreciate the effect of not applying standardization to the time series in a more obvious manner. The following graphs will use a logarithmic scale to make comparison easier.

In this first graph, you can appreciate the relative values of each asset compared to the SPY without prior standardization. As you can see, BRK is superior by a significant margin due to its much higher price, even though its return has not surpassed that of the benchmark asset. Conversely, TSLA is in the lower zone, although its performance has been considerably higher. When standardization is carried out (lower graph), BRK becomes the lowest and TSLA the second highest. Additionally, it can be seen that in 2022 the relative performance of all assets decreased compared to that of the SPY, making investing in the SPY the most advisable, except for BRK.

In this case, the only thing that has been done to standardize is to calculate the return of the time series relative to its first value, so that the relative value actually considers returns instead of the asset price. Additionally, currency conversion has not been applied since the relationship between assets would remain the same because all are quoted in dollars. Applying currency conversion would make sense when comparing investments with different currency units. By way of example and to clarify the explanation, if currency conversion is applied to AAPL because an investment in a European asset is being considered and the currency used by the investor is Euros, the price at the end of the period would be 164€ instead of 176$, and its total return would be 1300% instead of 1100%, because during that period the Euro has depreciated against the Dollar. In this way, if compared with an asset that has achieved a return of 1200% in Euros during the same period, if currency conversion is not applied, it would appear that the return of the second asset is higher when in reality the investment in AAPL would have gained 100% more than the European asset thanks to exposure to USD.

In reality, more concepts should be considered to compare assets since the entry and exit costs of the market and the maintenance costs of positions probably differ, these should be reflected to make a more accurate comparison.

Conclusion

It is very important to consider that all material possessions are positions and some may be more profitable than others, from the house you live in or the car you buy to where you keep your money. The main advantage of considering absolute trends is the lesser need for market data and the greater simplicity of systems, allowing for simpler strategy development. The main disadvantage is exposure to risks that are not taken into account and the opportunity cost.