Trend Following in the Currency Markets
Trend following analysis examines price action to determine if a trend is in place. This type of analysis is considered a lagging indicator as it alerts an investor once a trend is already moving, as opposed to the beginning of a market move. Investors who use trend analysis are comfortable with the idea that the market is already moving and want to jump on the train while it’s in the middle of its run, as opposed to the very beginning.
A trend of a financial instrument is a specific direction that continues to perpetuate. The most efficient way to determine that a trend is in place is to analyze moving averages.
A moving average is the average of a financial instrument over a specific period of time. Moving averages calculate the average over a specific period and drop the earliest period, when a new period is added. For example, the 20-day moving average of the EUR/USD index will average the last 20 days. On the 21st trading day, the first trading day will be dropped from the average.
One of the most popular trend following strategies is the moving average crossover strategy. In this style of trading, an investor is looking for the middle of a trend to initiate a position. A moving over crossover strategy initiates a position when a short term moving average crosses above or below a longer term moving average.
When a short term moving average (for example the 10-day moving average) crosses above a medium term moving average, a short term trend is considered to be in place. The reverse is true for a down trend. When a short term moving average crosses below a medium term moving average, a downward short term trend is considered in place. Longer moving average equate to longer periods of time which reflect longer term trends.
Most short term trend following strategies, which include the moving average crossover strategy generate signals that are wrong more than they are right. The key for those strategies is solid risk management. Trend strategies are designed to catch a good portion of a trend which should make more on winning trades than is lost on losing trades.
If a strategy is profitable 40% or the time and unprofitable 60% of the time, but makes 20 dollars on winning trades and losses 10 dollars on losing trades the strategy will be profitable. Trend following strategies generally has a robust risk reward profile that allows traders to catch relatively large moves when a trend is in place.
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