Does “Trend Following” The Stock Market Really Work?

Stock market trends seem to obey Newton’s Laws. The Law of Inertia states that a body will tend to stay at rest or in constant motion along its present trajectory, unless any other force acts upon it to change its current state. Stock market trends tend to maintain their momentum and follow the current trend unless an external factor powerful enough to change their course, interrupts their path.

Stock prices can move in the upward direction, or downward direction or even sideways. Investors can use the direction from technical analysis to identify the current trend of a particular stock, mutual fund or index. This is known as trend following. The price of the stock would normally continue to follow the current trend as long as there is no powerful influence to change its course. The ability to spot tendencies could put investors at a tremendous advantage over others who do not use this powerful strategy for investing.

A simple way to identify the trend is to use a straight line to indicate the direction. In order to identify a particular trend, investors need to mark at least three successive points on a graph. A series of three consecutive higher highs and higher lows would indicate an up-trend. And a series of three consecutive lower highs and lower lows would indicate a down trend. When the upper and lower points travel along horizontal and parallel lines, it indicates a sideways movement.

The tendency for the stock, mutual fund or index to follow the same direction in the future would be stronger when the stock has been following that trend for a longer period of time in the past. In other words, the longer the stock price has been following a particular direction, the stronger the likelihood of that stock following the same trend. Therefore, taking a long-term look at trends would offer a more reliable indication of future movements. Normally, trends over a period of weeks or months are used in this type of analysis. This approach is more suited for long-term investors. Short-term investors can use daily, hourly or minute-wise data to do their analysis, although trend following using short-term data can be less reliable.

Trend following is therefore a technique where data of stock price movements from the past are used to predict the future movements of the same stock. When the volume of past data is considerably large, the prediction of future price movements would be more reliable.

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