Sunday, September 23, 2012

Holding your nerve while giving profits back

Psychologically, the greatest hurdle for inexperienced trend followers is dealing with the period where there is an element of 'giving back' some of the open profits generated.

There are two such scenarios where this occurs:
  • During a trending phase in the market, where there is a counter-trend movement, or
  • At the end of an existing trend, where usually (but not always) there is an expansion in volatility and either the market degenerates into a non-trending state, or the trend reverses.
It is critical to the success of someone who is using a trend following strategy that these periods are dealt with appropriately, both from a psychological and trading activity point of view.

Inexperienced traders tend to take any profits off the table way too early in a trending market, for fear of those profits evaporating. By the same token, these same traders do not necessarily take any losses and close positions when getting an exit signal, as they do not want to erode their trading capital in the hope that the trade will go back in their favour. In effect, they cut their profits short, and let their profits run - the exact opposite of what a trend follower should do!

In my own experience, when I first switched to trend following several years ago, the easiest part for me was to take losses. I've never had a problem in placing a stop, and sticking to it. However, coping with the periods where profits were eroded was more difficult. Learning to cope with this, and to stick with what the system is telling you, is in my opinion the biggest hurdle psychologically in a traders' development when trend following.

A mentor can guide you and give you the benefit of their experience, but unless you are able to accept these ups and downs, and the possibility of giving away some of your profits, then you will continue to suffer frustration with your trading and performance.

On a sample size of one trade, taking profits off the table may work out better than waiting for a trend exit signal, but over a sample size of 100 trades, then sticking to the system signals for exits will prove far more profitable.

We had a conversation on this very topic on the protected Twitter feed the other day, as we are currently in a phase where the general markets have pulled back slightly, causing some profits in our positions to be lost - indeed, I got stopped out of a couple of positions last week. Against this, some other positions continued trending with little or no pullback. However, the trend is still clearly up in the indices, as it is in the positions I still hold.

There is no way of knowing whether the market activity over the last few sessions is a prelude to a continuation or reversal of the current trend. However, I know from experience to stick with my positions until my stops get hit. Who knows, the markets could take off again next next, hitting new highs and building up more profits in my positions.

On the other side of the coin, the markets can reverse, causing more stops to be triggered in my positions - profits will still be banked, but nowhere near the highs hit several sessions ago. Who can tell? Remember the story of Old Partridge in Reminiscences of a Stock Operator.

As a trend follower you have to accept that either of these scenarios can play out at any time. You have to accept the risk, to be able to generate the rewards. What I DON'T want to do is close my positions for fear of losing more profits, only for the markets (and my positions) taking off again within a day or two, leaving me out of the market and missing out on further profits.

"Losing a position is aggravating, whereas losing your nerve is devastating" - Ed Seykota.

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