The Assumptions behind Trend-Following Systems

The basic assumptions behind a simple trend-following system are as follows:

1. Markets trend smoothly up and down, and trends last a long time.

2. A close beyond a moving average signals a trend change.

3. Markets do not have large countertrend price swings.

4. Prices do not move too far away from an intermediate moving average.

5. Whipsaws are relatively few and do not cause large losses.

6. Significant price moves last many weeks or months.

7. Markets are predominantly in a trending mode.

The reality of a trend-following system is that:

1. Markets are often in ranging mode with choppy swing moves, so losses in trading ranges are significant.

2. There are large swings in trade equity, since the model "gives back" a large proportion of profits before signaling an opposite trend.

The 65sma-3cc Trend-Following System 75

3. These systems need a relatively "loose" stop in order to avoid missing about 5 percent of trades that account for major profit­able moves.

4. These systems often enter the market on strength or weakness, so that they can be stopped out during short but vicious coun-tertrend moves.

The advantages of simple trend-following systems are:

1. They provide guaranteed entry in the directions of the major trend.

2. They are profitable over multiple markets and multiple time frames, as long as time frames are 6 months to 5 years in hori­

zon.

3. These systems are usually robust.

4. These systems have well-defined risk-control parameters.