Wednesday, February 01, 2012

The psychology of trend following

A well thought out trend following system adheres to the KISS method (keep it simple, stupid!) but, for a lot of people, it is not easy to follow. 

Ed Seykota, in his Market Wizards interview, referred to the fact that having a screen on your desk is like owning a slot machine. He simply ran his scans, on an end of day basis, and placed his orders accordingly. The gyrations of the market throughout the day were left for others to worry about. He simply identified a trend, and acted on it.

Given his stunning success over a sustained period of time, along with that of other famed trend followers, it makes you wonder why other traders give trend following such a bad rap.

People seem to think have achieving a 90% win rate is preferable to a 40% win rate (which historically is what a trend following system tends to achieve). The difference is that those 90% wins are very small, and the 10% losers are very large.

Very wide stops (if any) are used to catch very small profits - a classic case of cutting your winners short, and letting your losers run.  It only takes a slight dip in the win rate for those traders to suffer a significant drawdown or blow up. Lots of those automated short term FX systems that are promoted on the web, for example, suffer from this.

On the other hand, trend followers are quite happy to achieve a much lower win rate, yet they know that when a trend does take off, the size of their wins far outweighs the small losses accrued looking for those sort of moves, and follows the theory of cutting your losses short, and letting your profits run.

This is where the psychology of sticking to a trend following system is hard for many. People like to be proven right in their trading or investing activities, and will go to extreme lengths to achieve this - I've read on bulletin boards about people who have refused to take small losses, and have ended up holding positions in stocks for several YEARS with seemingly no prospect of prices recovering to their entry point.

Trend followers are quite happy to be wrong on a lot of trades. The inherent positive expectancy within their system means that they are quite happy to absorb those losses (taken in accordance with their exit and risk management rules) and wait for the profitable trades to come to them. 

Each losing trade brings them closer to a winner. And they also know that one big winner can cover all the small losses and still leave them in profit. All they need to do is act upon the signals provided and open new positions. You never know, the next signal may be the big winner...

I have called this process 'panning for gold' in the past. It's a bit like an entrepreneur who has 10 business ideas, or a movie scriptwriter who has written the screenplay for 10 films. Perhaps 6 of those will be total washouts, 2 or 3 maybe small hits, with 1 or 2 being the major blockbuster ideas that bring in the large profits.

Not all traders or investors are mentally 'wired' to accept such a low win rate, but trend followers know that, by structuring their trading in such a way, there is a positive expectancy which means they will profit over the long run. 

Critical to this is to accept that they have to let their profits run until the current trend has exhausted itself, and only then exit their position in accordance with their system rules.

A trend following system can be utilised either by traders or investors. Providing the various components of such a system are adhered to, history has shown that it is the hardiest profitable way to make money in the markets. And you will afford yourself a little smile when you hear someone pronounce that 'trend following is dead' for the umpteenth time :)

If you would like to know more, look at my e-book, consider joining the mentoring programme, or even look at some 1-2-1 training, and learn how trend followers make their money.

1 comment:

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