Trend following - systematic or discretionary?

I have recently been re-reading Super Trader by Dr Van K Tharp, who has influenced my own approach (as well as countless others) to the markets over the years. While reading this I came across something which was the polar opposite of my own beliefs regarding two traders whose methods I used as a basis for my own system parameters.

According to Dr Tharp, Ed Seykota is classed as a systematic trader. As a comparison, Richard Dennis and the Turtle traders (who I considered to be extremely systematic in their approach) were deemed to be 'rules based discretionary traders'. 

The taking of stops - intra-day or end of day?

There is always a debate going on regarding whether you should take stops and exit trades on an intra-day move, or do you wait to see if price moves back in your favour before the end of the day.

This is somewhat similar to the argument about whether you should wait for an end of day close above a certain price level before initiating a position, or do you take it on an intra-day price move.

As a comparison, below are two infamous historic trading events, which caused price shocks - one of which you would have benefited by using intra-day stops, the other using end of day stops.

The psychology of opinions or predictions

The beauty about being a trend follower is that you are never bound to an opinion or prediction about which way a market is going to go. You simply let price show you and you then follow along. If price changes direction and starts a new trend, then your approach will reflect that.

Where people do struggle is when they have made some prediction about a certain market, and then price does start moving in the opposite direction. When that happens, those traders tend to start looking for new reasons (technical or fundamental) to support their original idea.

Learn to evaluate your trades in terms of R

Occasionally you will come across people who record their gains (and losses) expressed as a percentage movement in the share price. While this is great to know, does it add any value in terms of quantifying your method or profitability?

In my opinion, whether a stock moves 10% or 100% after you have opened a position is irrelevant. What IS of far more interest is your profit or loss expressed in terms of R.

Remember that R is the figure calculated when you divide the profit or loss generated by the initial amount risked. So, for example, a £2,000 profit on a trade where you originally risked £500 equals a 4R profit. A £250 loss while risking £500 equates to a -0.5R loss.

2014 so far - less has been more

While reviewing my trading performance today, I decided to do a comparison between those trades taken between the beginning of January to the end of May both for last year and for this. This is an interesting comparison as the general market conditions could not have been more different. Based on my preferred timeframe and system parameters, the indices last year were in a stable uptrend. This year, they have generally been in a non-trending volatile phase.

Trading and your locus of control

When I mentor a trader, I focus on three elements:

• The system of determining entries and exits;
• Risk management;
• Developing the correct mindset.

The system part concentrates on the trend following approach. The other two elements obviously can be applied to any type of trading. I will also say that, even if you had the best trading system out there, if you used poor risk control and/or had a poor mindset, then at best you struggle to make money, and at worst you will blow up your account. That's how important those elements are.

Some people you cannot help

Occasionally I receive emails or phone calls from traders looking for advice or guidance on how they can improve their own performance. I enjoy trying to help these people - even if they are not specifically interested in using a trend following approach, the other elements of risk management and trading psychology are critical factors that deserve more attention than they get.

An internal conflict

One of my students in the mentoring programme recently contacted me requesting advice on how to deal with an internal conflict. The situation was that a possible short set up had been identified on a forex pair. Price was moving in the opposite direction to what his economic understanding thought should happen.

However, as he put it "on virtually all the macro levels the trade ought to be the opposite to what is occurring. When I was trying to look at it my mind was just saying "no, no, no" to the idea of that trade working."

A simple approach to plotting trading improvement

Here is a basic business principle which can be directly applied to your trading.

If you don't like the results you are obtaining, then you need to change some element of your approach. If you don't, and you carry on in the same manner, then you will continue to achieve the same overall results.

Albert Einstein famously put it this way: "Insanity: doing the same thing over and over again and expecting different results."

Something that works in the long run

These are uncertain times in the markets at the moment, and I am currently in the highly unusual position (for me) of being fully in cash. The market conditions in 2014 have not been favourable towards my style of trading, and therefore the number of trades taken in the last few months is a lot lower than normal. That said, as the returns here show, they are still more than acceptable.

Two way markets, Jim Rogers and comparisons with 1987

The markets continue to be all over the place. The headline indices continue to remain close to new highs, yet under the surface the broader indices are showing a different position.

Below is the FTSE100, the headline index in the UK, the mid-cap FTSE250 and the AIM All-Share. As you can see, the differences are striking.

Thoughts on starting out with a small capital base

There is an old saying that "if you want to make a small fortune from trading, start with a large one!". Occasionally I get asked "What is the minimum amount of money I need to trade?". 

A trend bends at the end

Today my last surviving long trade triggered its stop. This trade had been in place since the middle of February, and ended up generating a +6R profit (chart below).

Unfortunately the last couple of days showed price action to the downside which eroded some of the profit. With trend following, you will never get out at the extreme of a price move - there is always an element of giving some of the profits back before the exit is triggered.

Keep your tuition fee as small as possible

The recent market action so far in 2014 will have been educational for the majority of traders who are relatively new to the markets.

This period should have told you that:

• risk control is everything - not only in terms of what you risk per trade, but also in terms of overall portfolio risk;
• you need to be cautious when the general market direction is unclear;
• you need patience and discipline to succeed in the markets.

Unfortunately, a lot of inexperienced traders will have found this period educational via the process of losing money, so there has been a tuition fee attached. In some extreme cases, this could have been expensive as they may have blown up their trading account.

My approach to blogging and tweeting

And now, in the words of Monty Python, for something completely different...

When I was at school, I always struggled with written exams. Not because I didn't know the subject, but because I was always very economical with the number of words I used. Examiners marked the answers down, simply because I didn't use the required minimum number of words, and the teachers were disappointed in the grades I got. It was a consistent theme throughout my school life.

My argument always was "why write 500 words when you can say the same in 50?"

Trend following in a nutshell

It's late 1999. Seemingly everyone is making money in the markets riding the dot.com bubble. Tech stocks are moving up $20 - $30 per day. New IPO's jump up 100% on their first day of trading. Trading is easy. Money is rolling in. Life is good.

A test of discipline and patience

As members of the mentoring programme will testify, the last few weeks have seen very little activity due to the condition of the general markets. It has been a test of patience and discipline for all concerned to wait for the picture to become clearer. When this will happen is anyone's guess - could happen tomorrow, could go on for a while longer.

Trend followers never predict what will happen - they wait for a potential trend to emerge and then follow the price action. If the trend quickly fails, no problem - a small loss is booked. If the trend develops, then we simply follow until such time that the trend finishes.

What is your preferred timeframe?

One question that pops up from time to time is the question of timeframe. As with all things trading, there is no one right answer that will suit everyone, but there will be a right answer for you.