Saturday, July 06, 2013

Being wrong is acceptable, staying wrong is unacceptable.

Trend followers are frequently wrong. It is all part of trying to identify potential set ups to profit from. More often than not, they fail.

As I've mentioned here several times, I do not trade the indices, but they do help me determine the bias in my own positions, as to whether I should hold predominantly long or short positions. 

Given the volatility and lack of direction over the last few weeks, it has been a difficult time to profit from trends. Those who trade longer term trends may not have had as many stops hit as me, but by the same token they would have suffered a bigger erosion of profits. This is due to the inherently wider stops that traders looking at longer timeframes would use.

This is all part of the discretionary decisions taken when setting up a trend following system - are you looking at trends that could last for a few weeks, months or even years? You set those parameters and construct the rules around that. Using this proper framework with good risk control will keep your losses small and let your profits run.

Against that, the longer the timeframe you use, the later into a new trend will you get an entry signal. Those who use shorter term parameters will get into a new trend earlier, and will also have tighter initial stops. This is my own preference. There is no right way or wrong way that is for everyone. However, there will be a right way - for YOU.

This has manifested itself clearly over the last few weeks - my system gave short signals in the indices, and therefore my bias started switching to looking for potential short positions. However, I have now been stopped out of the majority of those. One or two long positions have survived. As of now, markets are still undecided.

The benefits of my own system parameters and stops is that, when I am wrong on a new position, I know quickly, and keep my losses to an absolute minimum. That is how I keep cash equity drawdowns as small as possible. None of this waiting (hoping) to see if a position moves back in my favour. If I am wrong, I take the loss, and move on. The simplest way to keep drawdowns small is to take small losses.

The reductions in my overall performance mainly result from an erosion of open profits. That is because I do not want to try and anticipate the end of a trend. I want price action to determine that for me. Sure, it is frustrating when price starts slowly against you, and falls back to hit a trailing stop. But that is all part and parcel of trend following. I want to restrict my losses, and place no restriction on how big profits could be.

While frustrating, have periods of trades not performing is to be expected when trend following. Potential changes of trend offer a higher possibility of failure, but a bigger potential profit. If you want to profit from the rewards, you have to accept the risk that goes with it.

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