Sunday, July 22, 2012

The up and downs of a trend follower

Trend following has been proven over many decades, and by many of its practitioners, as an excellent methodology to make money in the markets. In terms of absolute returns, it may well be the best way to make money.

That said, if you are targeting absolute returns, then you also need to be aware that the drawdowns can be bigger than many other methods of trading. With that in mind, there are two other aspects you need to consider and religiously implement if you are to succeed as a trend follower:
  • You must have rigorous risk/money management controls in place;
  • You must have the psychological strength to have faith in your method, to withstand and come through those periods of drawdowns.
Not everyone can answer those two questions positiviely, but it is critical if you want to succeed as a trend follower, especially the question of dealing with the psychological aspect.

From my own experience, I have been through periods of drawdowns, and have been able to prosper after coming through the other side. The periods where there ARE big trends you can profit from (such as the 2008 market downtrend, and ther 2009-2010 market uptrend) more than compensate for those periods (such as late 2011) where there is increased volatility coupled with whipsawing and a general lack of trends you can prosper from.

A lot of people are happy to profit when the market conditions are conducive to making profits, but struggle to cope with those periods where drawdowns occur. As a result, they ditch trend following and move onto another strategy. More often than not, those periods where drawdowns occur are the periods to get ready for profitable trends.

The markets naturally go through phases of trending and not trending. People tend to withdraw funds from trend following CTA's right at the bottom of the CTA's equity curve, after a prolonged period of suffering non-trending markets. This is exactly the right time to get in. The equity curve of a trend follower is subject to trends itself, often acting in concert with the trending phases of the market(s) they trade.

You can think of a trend follower such as Bill Dunn, who has had prolonged success trading over three decades and more. As highlighted in Michael Covel's Trend Following, "Dunn had losing years of 27.1% in 1976 and 32.0% in 1981 followed by multiyear gains of 500% and 300% respectively."

The majority of CTA's and funds who trend follow do not obtain gains such as these, nor suffer as big a drawdown as those highlighted above, because they have 'de-tuned' the system by reducing the risk and accepting they will not achieve the absolute returns possible.  Therefore they get lower returns while suffering lower drawdowns. This is because if the drawdowns get too large, you can be sure there will be plenty of investors wanting to pull their money.

The other side of the coin is someone like Ed Seykota, who achieved average annual returns of almost 60% between 1990 and 2000, far larger than most CTA's. The difference here is that Seykota has very few outside investors and is extremely selective of his clients. Because of this, he is able to persue the absolute returns that trend followers are capable of, and is comfortable with suffering those periods of poor performance.

My own performance mirrors that, in that yes you can suffer drawdowns, but the historical positive expectancy and absolute returns acheived make it easy to sit through those non-performing periods. Remember the vast majority of trend followers will make (or lose) money in the same markets at the same time - the only differences are possible the timing of the entry and exit, and whether they are chasing the absolute returns possible, while still keeping a watchful eye on the overall risk. Whether you can do that, only you can answer.

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