Why Trend Following Can Work for Stock Picking

There's no shortage of tactics for picking stocks. In fact, if you're managing your own portfolio, chances are you've explored everything from detailed fundamental analysis to fast-paced short term technical trading. So how do you know which approach is best?

Well, unfortunately the answer seems to change depending on who you ask! And in reality, it most likely comes down to your own individual situation: your risk tolerance, investing time frame and other personal preferences.

But the good news is, no matter what stock picks you're hunting for, trend following trading strategies can really help you tilt the scales of risk and reward in your favor. Before I show you though, let's quickly take a step back and review one of the most important (and obvious) aspects of stock picking: making money!

How Do You Really Make Money Picking Stocks?

This might sound a little bit basic, but it's important to understand: picking stocks is all about making money. And going a step further: if you're planning to realize profits from buying stocks, you simply must sell your stock for a higher price than you bought it! Seems easy, right?

Well, over the years I’ve met many self-directed traders and investors who seem more interested in feeling smart, or being right, than making money! I know it might sound hard to believe. But there are examples everywhere you look, from the StockTwits message stream to the talking heads on CNBC. It can be helpful to follow Motley Fool recommendations.

In fact, it's not uncommon to see investors and traders alike expressing their conviction for an under-valued and out-of-favor equity. But in my experience at least, this collective obsession with justifying an underwater position does much more harm than good to your portfolio's performance.

And intriguingly, this is where trend following is different. But be warned: While the ideas are pretty simple, they aren't exactly intuitive. So let me show you what I mean.

Why Trend Following Trading Strategies Can Help Your Stock Picking:

In case you aren't familiar, trend following investing strategies originally started in the managed futures industry, but the underlying ideas can be applied to any liquid asset class, including stocks. So how does it work?

Well, unlike the well-known investment idiom of “buy low, sell high” trend following traders tend to buy high, and sell higher! They wait for a stock or security to start trending up in price. At that point, they jump on and ride the trend until it starts to reverse. Then it's on to the next opportunity.

And although this concept of following price momentum is pretty simple in theory, it can be emotionally difficult in practice. It's as though our egos are afraid to buy a stock that's already gone up 20%; probably because we fear it will reverse and we’ll feel dumb.

But look at it this way: shares of AMZN have gone up up over 55,000% since going public. And if you think about it, a stock has to go up 20% if it's ever going to go up 50%, 100% or yes, even 55,000%. It's just a basic mathematical fact!

So that’s why trend following can work so well for stock pickers. Because instead of trying to catch falling knives, or tying up your money in underperforming equities, trend followers go with the market’s momentum. And when you find the right stock at the right time, these trends can run for months, quarters of even years on end.

Plus, trend following traders are incredibly disciplined about risk management and stop losses. They always have a plan for when to sell. So even though trend followers are only right about 50% of the time, they maximize profits by keeping losses small and letting winners run.

It's this emphasis on risk management and capital protection that's responsible for impressive trend following performance track records. And individual stock pickers can learn a lot from this momentum-based approach.

However, in case you’re still wondering what this looks like in practice, let me share a few more tips I use to apply trend following tactics to my stock picking.

Tips to Get Started Trend Following With Stocks

I'm not suggesting that you give up your equity positions for the fast-moving and highly-leveraged world of futures trading. Instead, I think you can take some of these trend following concepts and potentially apply them to what you're already doing.

For example, if you're a value investor trying to pick under-priced bargain stocks, you could add a trend following filter to only focus on opportunities that have started trending higher. While waiting for price to cross above a longer-term moving average might cost you a couple percentage points, it can keep your money working harder by putting the market’s momentum in your favor.

Another example would be to consider using a pre-set stop loss to ensure you don't lose too much money (or time) if you're wrong in your analysis. Because at the end of the day, it doesn't matter what your analysis says: If the market doesn't agree, you won't make money.

Remember: If you want to make capital gains, you simply need your stock pick to go up in price. So by definition, hanging around in losing stock picks hoping for a reversal is not a viable strategy for success. Instead, you can act like a trend follower who's always focused on the opportunities presented by uptrends by cutting your losses quickly and consistently.

As for me, I'm still an avid stock picker. But adding trend following rules to my FinViz stock screener has really helped me hone in on breakout stock picks with more potential to make a fast move. And at the end of the day, this capital appreciation is what a stock picker relies on to make money. So why not give it a try for yourself? Can you see how you might add some trend following strategies to the mix in order to improve the performance of your stock picking?