Tuesday, May 01, 2012

Psychological hurdles for wannabe trend followers

A trend follower has to have the mindset whereby they are comfortable to trade based on what the charts and system signals are showing, rather than one's own perception or beliefs. They need to be comfortable trading both on the long and the short side, and if a signal is given to exit and/or reverse direction, they must be comfortable in following that signal. Similarly, if you get a signal in the same direction to that of a recent failed trade, then you need to be comfortable in following that signal.

The markets, which less than two weeks ago gave short signals, have since reversed and are now starting to give long signals. Again, this signal could fail, but that's what your risk management is for. Remember, it is quite possible to have several consecutive failed signals in a market, before you get the signal that will generate the profits to cover all those small losses, as well as a bit of 'genuine' profit. This is the nub of trend following, and why so many who want to follow such a system struggle with the psychological aspect.

Historically trend followers have achieved a relatively low win percentage rate - 40% is considered the norm. A lot of traders (particularly those new to trading) seek comfort in a high win rate, however that is not the critical metric to trading success. You also need to take into account the average size of the winning and losing trades, so that you can calculate your 'expectancy' per trade. And for a trend follower to be able to succeed, with that relatively low win percentage, his average wins need to be bigger than his average losses. Those system with very high win rates tend to have the opposite - lots of small wins, punctuated with the occassional large loss, whoch can cause havoc to your overall equity. This is why trend followers refer to the old adage 'cut your losses short and let your winners run'.

To be blunt, if you are not comfortable in:
  • Trading both on the long and short side and being able to 'switch sides' depending on what your system tells you;
  • Acting on entry signals given by your system, even if you have suffered a run of losing trades in that market, and;
  • Letting your winning trades run until you get a system exit signal, and exiting your losing trades as soon as your stops are hit;
then your mindset is not geared towards trend following.

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