Are You a Trend Follower or a Contrarian?

March 20, 2013

in Investing

By Alvin Chow (guest contributor)

Law I: Every body persists in its state of being at rest or of moving uniformly straight forward, except insofar as it is compelled to change its state by force impressed. ~ Sir Isaac Newton

I have always adhered to the trading mantra – follow the trend and do not try to fight it. All the trading courses I have attended taught me trend following strategies. So it was quite ingrained in me that to make money in the market, I need to be trading in the right direction and then capture the price movement as much as possible.

Trend following as a trading strategy

The central idea of trend following is that price has momentum – what goes up, continues to go up; and what goes down, continues to go down. Of course, we do not decide how long the trend will last. We will keep shifting our stops to protect profits until the trend reverses.

The advantage of the trend following strategy is that you can make a nice profit with a small amount of capital. But opportunities do not come easy. You do not know when the market will have a large movement so you have to dip into the market whenever you have a signal. The challenge in trading is to be wrong most of the time which results in cutting losses. Despite repeated small losses, you must continue to get in when the signal comes. Because missing a big trend will make a big difference to your profit and loss statement and the next big trend may take a while to come by again.

Even in a strong trending market, prices do not go up in a straight line. It is always a three steps up and one step back movement. Trends have various degrees of strength. When the trend is intact, the pullback may only be momentary before it resumes again. When the trend is exhausted, it will become a reversal. Trend followers will be happy to take the profit at this point.

Being a contrarian

On the opposite side of the trend followers are the contrarians who pick tops and bottoms. Instead of subscribing to trends, they believe in mean reversion – what goes up must come down; and what goes down must go back up. Of course, this not always the case as companies can go bankrupt.

The essence is that prices cannot trend forever. Mean reversion traders look for weakness in the trend and place a trade in the opposite direction. They are not interested in capturing a large price movement. They are more interested to take many little profits along the way. In fact, research shows that markets revert to the mean most of the time.

The weird thing is both kinds of traders can make money. In general, trend followers would need a longer time frame (days to weeks to months) while a mean reversion trader can open and close trades within a day. If you are trading for income, mean reversion strategies are more suitable. If you are trading to grow your money, trend following would be more appropriate.

 

By guest contributor Alvin Chow, who blogs at Big Fat Purse, a Singapore personal finance blog.

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