In all of trading, the quickest way to make a lot of money is to latch onto a trend in a futures market and ride it. This approach has two catalysts. First, futures trading involves leverage (i.e., you only put up a small fraction of the value of the contract when entering a trade) and second, when a market soars or swoons a lot of money can be made quickly. Of course, that's the good news. The bad news is that things can also go in the other direction, so strong risk control is an essential element to successful futures trading.

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This piece will not get into the nitty-gritty of risk control and money management. Rather, it will simply make the case for identifying and trading in tune with the primary trend of a given market.

In the Beginning

A long time ago, about the time personal computers came into being, trend-following systems that were "always in" - i.e., always holding either a long or short position at all times - were fairly popular and could be useful. Back then a market could trend a good ways before a lot of people caught onto what was going on. Today market information is so readily available and gets disseminated so quickly that simplistic trend following is not necessarily a viable alternative as a standalone approach to trading.

Likewise, the numerous "whipsaws" and long stretches of non-trending price action make a pure "always in" trend-following approach less than optimal from a rate of return perspective. And then there is always the emotional "wear and tear" that comes with taking a lot of losing whipsaw trades along the way while waiting for a few truly big winning trades to generate the bulk of overall profits. As a result, very few traders still rely very heavily on "always in" trend-following methods.   

Still, as it turns out, there are strong benefits to using trend-following methods, particularly when they are used primarily as a filter. Applying a trend-following method as a filter can allow a trader to keep his or her capital focused in the areas that have the greatest likelihood of maximizing returns.

Distinguishing a "Trend Filter" from a "Trading Signal"

The purpose any trend-following indicator is simply to be able to objectively designate the current trend as up or down, or in some cases, possibly as trendless. There really is no prediction built into any given trend-following indicator. A given method does not tell us that the trend will be up (or down) tomorrow, only that it is up (or down) as of right now. So investors must still be aware of the potential for whipsaws.

When viewed in this manner, the act of designating a given security as being in an uptrend or a downtrend is different from generating a specific "buy" or "sell" signal. As such, just because a trader designates the trend as "up" does not necessarily imply that he should be holding a long position. It does, however, mean that he should not be holding a short position. In other words, the primary function of a trend-following filter may not be so much in telling you what to do, but in telling you what not to do.

Trend-Following Filters in Action

Let's look at one example of a simple trend-following filter in the futures markets. We will designate the trend as "up" if the following two conditions are met:

   1. The 10-day moving average is greater than the 30-day moving average and;
   2. The latest close is above the 200-day moving average.

If both conditions are met, then a trader in this example would only consider taking a long trade and would completely eschew trading from the short side.

On the flipside, we will designate the trend as "down" if the following two conditions are met:

   1. The 10-day moving average is below the 30-day moving average and;
   2. The latest close is below the 200-day moving average.

If both conditions are met, then a trader in this example would only consider taking a short trade and would completely eschew trading from the long side.

Figure 1 displays one example of a market using this filter. The chart presented is actually an exchange-traded fund that emulates a futures market. This type of ETF can act as a good proxy for a given futures market since there are no contract expirations as there are in the futures markets.

Figure 1 - Using Simple Trend-Following Tools to Filter for Market Trend
Source - ProfitSource by HUBB

The first filter indication marked on Figure 1 notes that the 10-day moving average is above the 30-day moving average and also that the closing price is above the 200-day moving average. At this point the trend is designated as "up" and until further notice a trader can consider entering into a long position but should absolutely not consider entering into a short position since this would mean "fighting the trend."

The second indication ("No Trend; No Positions") simply points out the lack of an objective primary trend. At this point the trader would simply stand aside this market until a new trend is established.

The next new trend is established once again to the upside a few weeks later. The next "no trend" indication after that did not occur for roughly five months. During this entire time the trader would have been focused solely on the long side of the market. As all price dips during this time were relatively shallow and short-lived, most traders who attempted to play the short side of the market during this time would have most likely ended up experiencing a string of losing trades. The trader who focused solely on the long side of the market based on a simple trend-following filter not only enjoyed the greatest likelihood of making money by virtue of focusing on the primary trend, but also avoided the emotional and financial drain of any countertrend losing trades.

The Bottom Line

The "rules" used in our example are not intended to comprise a complete trading system. The only purpose of these rules is to keep a trader focused on the price direction which is presently showing the greatest strength. In other words, trend filtering is only one - albeit, a highly useful - piece of the trading puzzle. A trader using a filter like the ones in our example still needs to incorporate specific buy and sell rules, must determine how many contracts to buy or sell short and must determine where to place stops, etc.

Nevertheless, in the end, the trader who can focus his or her capital and attention on strongly trending situations stands a greatly enhanced probability of profiting in the futures markets over the long run.

Other articles in this week's newsletter

18 Share Tips - 10 May 2010

Why Australia suffers a housing affordability crisis

Aussie dollar has everything to lose

How Corporate Events Affect Stock And Bond Holders

Using Pivot Points In Forex Trading

Master Futures Trading With Trend-Following Indicators