How Long Term Investors Can Use Trend Following
To begin, I’d like to define what trend following is (for those who don’t know).
Trend following is an investment strategy where you use technical indicators to decide whether to buy or sell. Based upon the market’s recent price action, the technical indicators will give either bullish signals or bearish signals.
Trend following is exactly what it sounds – you hop on the bandwagon of a pre-existing trend. Now you’re probably wondering – isn’t that bad? Don’t you want to get into a position before a market has started a new trend? Trend followers see it in a different light. If a trend has started, then the trend is likely to continue. That means that if the market has been rising, I should probably buy now because the bullish trend will probably continue and push prices even higher.
That, in a nutshell, is trend following. On paper, trend following sounds like a strategy for active investors and traders, something that your typical mom-and-pop investor isn’t. Yes, on paper, that’s what it is. However, it is very possible for long term investors to use trend following to increase their investment returns.
How? It all comes down to how the technical indicators work.
An Example
Here is an example of how long term investors can change trend following to suit their needs.
A typical technical indicator that trend followers like to use is the moving average crossover. Essentially, a moving average is the average of a security’s price in the past X number of days. For example, a 50 day moving average for Microsoft will be the changing average of Microsoft’s stock price in the last 50 days.
Of course, there are many different moving averages, ranging from the 10 day to the 20 day to the 100 day and even the 200 day (a.k.a. the 1 year moving average). A shorter the time frame of a moving average, the more volatile it will be (the moving average will change more). The longer the time frame (e.g. 200 day), the less volatile it will be.
Now here’s the trend following use for moving averages. If the shorter time frame moving average crosses above the longer time frame moving average, then it is considered a bullish sign. Why? Because this shows that the previous bearish trend has now changed into a bullish trend – it’s short term average is higher than ti’s long term average.
The opposite is also true. If the shorter time frame moving average crosses below the longer time frame moving average, then it is considered to be a bearish sign.
How Long Term Investors Use This
We’ve already mentioned the ability of a moving average crossover to predict future price movements. How can long term investors use this?
Every technical indicator, including moving averages, can be adjusted based upon the time frame. You can choose whether you want a 10 day moving average, a 20 day moving average, or a 50 day moving average. All long term investors have to do is use longer moving averages.
For example, whereas a trader might use a 10 day and a 50 day moving average cross over, long term investors should use a 50 day and a 200 day moving average. Why?
Because the longer your moving average is, the less volatile it will be (meaning there will be fewer up and down spikes). Less volatility means that you will buy and sell less frequently – exactly what long term investors want to do.
Other Indicators
The same concept applies to all other technical indicators. All indicators can be adjusted based upon time frame. Long term investors just need to make their indicators longer in time length to fit their investing styles.
When indicators use longer dates (e.g. 50 day moving averages instead of 10 day moving averages), they fluctuate less. Fluctuating less means that these indicators make fewer decisions, meaning that (as a long term investor) you can buy and sell less frequently. It’s great for buying low, and also selling high. Although you won’t be able to pick off the exact bottom or the exact top, you will be able to get pretty close.
A frequent guest blogger, Troy also blogs at Technical Indicators Guy. Click here to check it out. He created this blog because the concept of technical indicators doesn’t fit too well with his blog about financial insight, The Financial Economist. Hope you enjoyed the post, and come back for more great guest posts!
Category: Investing
