Wednesday, August 29, 2012

Trend following returns

People who trend follow have no expectation of obtaining a smooth level of returns over a period of time. It is simply not possible. I guess day traders can set profit targets for each day or week as they do not require much in the way of market movement to generate their profits. Generally trend followers, on the other hand, have to dance to the market's tune. If there is no trend, then there is no chance to make money.

This is where diversification comes into its own. Whereas day traders can concentrate on one or maybe two markets to make their money, trend followers need to cast the net around in the hope of catching a trend. Historically, trend followers have traded a basket of commodities, currencies, indices, interest rates etc - you can be sure that there will be a trend going on in one arena or another.

I prefer to do it slightly differently. I trade individual stocks, so instead of limiting myself to a basket of say 20 instruments, I have a  universe of 10,000 + stocks to go at. I use the trend of the major indices to determine my bias as to the direction the majority of my trades, however I always try to ensure that an element of my portfolio is geared towards trades in the opposite direction - partly as a hedge, and partly as a stock trending in a direction opposite to the general market can identify a high level of relative strength or weakness.

Even during the recent bout of slow moving markets over the last few weeks, there have still been plenty of profitable trends arising in individual stocks, both on the long and the short side, some of which I have caught (and have been covered on the protected Twitter feed), along with plenty of others that I didn't take (but others using the system did!)

However, there are periods where there is simply no trend in the general market. If combined with high volatility (such as during periods of 2011) then these are the most difficult conditions for a trend follower to make profits. During these periods it becomes more tricky to find trending stocks without suffering from the increased volatility and whipsawing. Against this, 2008 was almost like playing darts on the short side, or 2009 and 2010 on the long side - the trends in the general market made it easier to confirm the bias I should have in my portfolio, and the underlying market trend provided a degree of support to my own positions.

The trick is to maximise your returns in trending phases, and minimise your losses in those more difficult periods. There are a number of ways to do this:
  • It goes without saying, strict risk control (both on individual trades as well as your overall cumulative risk limits) will help minimse losses and drawdowns;
  • Phasing yourself into new positions when a new trend in the general market takes hold (I have a limit on the number of new positions I can open in any one trading session);
  • Above all, sticking to the rules of the system - particularly not succumbing to fear and exiting too early out of profitable positions when an exit signal is given;
  • Having a small number of trades in your portfolio that are opposite to the general trend in the indices (as discussed above); 
  • Looking for those potential trades that offer the best reward:risk ratio - this usually means identifying set ups where there has been a contraction in volatility before the signal is given;
  • Remember that cash is a position! If there are no identifiable trends, or the general markets are unstable and encountering high levels of volatility, then you have the option to sit on the sidelines;
  • Nuture the correct mindset, and have the confidence to be able to trade the system consistently throughout good and not-so-good periods in the market.

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