Trend following at work

It should be clear to anyone who has read my blog, or knows anything about trend following that:

• Trend followers do not buy into long positions on retracements - we only go long on new highs, and short on new lows;
• Trend followers by definition do not get in at the low, or exit at the high of a move up, as we cannot predict what the extremes of such a move will be;
• By definition trend following achieves a win percentage of between 40% and 50% historically;
• By cutting our losses, and letting our profits run, the gains from winning trades far outstrip our losses from the losing trades.

As it happens this week has seen short signals given on silver, gold and now the FTSE100 (not really surprising given the number of large cap miners in the index). There appears to be a certain amount of disbelief around as to why precious metal prices are falling, particularly silver. If you read the fundamental story, it would appear to be very bullish. However, prices are falling, and there are people acting upon that fact.

My own system first gave the signal a couple of days ago, as shown in the chart below.

I do not trade commodities, but the vast majority of trend following systems in use solely trade a basket of currencies, commodities, indices and interest rates. Trend following systems, in their purest form, are very simple, almost crude, systems that respond solely to price - their beauty is in their simplicity. These systems embrace the volatility that comes with trading these instruments, can withstand a pre-determined level of volatility, and only exit when that level is exceeded, bringing the existing trend into question. My own system is based upon these well known systems, however I have incorporated a couple of additional filters as I prefer to trade stocks.

So, these trend followers then - potentially who are we talking about here?

• John W Henry (who's made enough from trading to buy the Boston Red Sox baseball team for $700m, and is also now the owner of Liverpool FC);
• David Harding of Winton Capital, the UK's most successful hedge fund;
• Ed Seykota, trading legend and Market Wizard;
• Highly successful traders such as Jerry Parker, Paul Rabar, Liz Cheval who were some of the famous Turtle Traders from the 1980's.

These are just the tip of the iceberg - thousands of other successful CTA's and private trend followers who use similar systems, dotted around the globe will have got the same signals, and will have acted in the same manner. These traders have hundreds of millions of dollars at their disposal, and as soon as their systems give a signal, those funds are put to work, regardless of the fundamental story.

(edit: I do not know if these traders are actually short silver, simply that, based on their historical performance and the nature of the systems that they employ, at some point they will get a short signal, and these people tend to act without hesitation on receiving such a signal).

The exact timing on their entry signal will be determined by the parameters specified in their own system, as well as looking at intra-day or an end of day basis, however it is safe to assume that the longer-term trend following systems will no doubt be getting short signals over the coming days if the price of silver continues to fall.

As I have mentioned before, these traders do not trade AT ALL on fundamental data - they simply follow price. Indeed, some of the best trades are when the fundamentals seemingly suggest one thing, and the price suggests going in the opposite direction.

In my own trading, these trend reversals have caused an erosion of open profits, and for a number of positions to be exited as my stops have been hit. Trend following profits tend to arrive in streaks, followed by the inevitable drawdown as existing trends finish. However, as one door closes, another one opens - new trends start to appear, giving more opportunities. Time to look at the short side?

A couple of excellent trends

I have been pleased to hear from some of the people who have purchased 'The Trading Triangle' and have enjoyed helping discussing with them some points raised in the book. The response from those who have read it has been positive, and it appears that some are already enjoying some profitable trends.

Here are a couple of charts of set ups identified and traded by readers - trades which I would have loved to have taken myself!

Here we go again

I see that some traders and market commentators are predicting the top of the market again, and even in one or two cases I've seen pieces stating that a market crash is coming. As you know, trend followers do not predict, they follow, so any attempt to 'pick' the top or bottom of a move goes against the basic methodology.

Market tops and subsequent crashes also frequently follow a period of euphoria (remember the magazine cover theory). I cannot recall seeing any sign of euphoria occurring since early 2009, so it is quite possible that we will continue to climb this 'wall of worry' until we reach that state. As always, we will let the markets tell us when the time is right to look to the short side.

For those of you who fall into this predicting mode, I will let you consider this quote from Market Wizard Ed Seykota, who said "It can be very expensive to try and convince the markets you are right". Think about it.

What are you looking for?

It always slightly amuses me that, when the price of a stock starts moving, the trading and investing herd are trying to found out exactly what the reasons are for the move. A great swarm of sleuths converge, trying to nail down the elusive piece of data. 99% of the time, they are looking at news releases, fundamental data or other related titbits of information. Their findings are frantically and endlessly discussed in internet forums and on websites, fair values hurriedly recalculated and so on.

I read a piece recently about a trend following UK based hedge fund which predominantly trades Forex - they have been consistently successful, generating profits for their investors for a number of years, however their investors are repeatedly calling up wanting to know the reasons WHY the markets have moved. In the end, for their monthly reports the fund has had to 'create' a fundamental story to give to investors to 'back up' why they've taken the trades!!!

I will give you my take on why prices move - people buying and selling, and the price at which they are prepared to buy and sell. That's it - no more, no less.

And of those people buying and selling, you have NO idea of any other person's rationale for those decisions, (of which there can be tens of thousands of traders and investors, dotted around the globe) - they could be based on fundamental or technical reasons, based on different timeframes and outlooks, directors buys and sells, or a multitude of other reasons that necessitate an opening or closing of a position.

As I've stated here on more than one occasion, I focus solely on the price of a stock, and open and close positions as determined by my trading rules and criteria. All of the other stuff I ignore.

There are no doubt some people reading this who scoff that anybody can make money in the markets simply by looking at price. Yet there are simply too many stories of successful trend followers, who have made millions by following the price, for it not to be a fluke, or a series of lucky trades.

This is a collary of anther maxim about trading - "Do you want to be right, or do you want to make money?". The herd fall into the first category. The real winners fall into the second category.

I'm fully aware that there is more than one way to skin a cat. However, I'm more than happy to be judged on my trading performance, which is there for all to see, as detailed on the trades log. The rules that I adhere to are pretty simple, and I think the performance proves that simplicity in trading can work. I think I'll leave the hours of pouring over fundamental and economic data to others.

Mind the gap(s) - negative surprises

If you read a book like Market Wizards, you will note that these successful traders' most traumatic experiences occurred when price went against them significantly, and they were unable to exit their positions at their desired exit point.