Saturday, October 12, 2013

Starting using a trend following strategy

I can pretty much guarantee that the first thing anyone implementing a trend following strategy will see is their cash equity levels dropping. Why is this?

Well, remember that the basic premise of trend following is to cut losses short and let profits run. Given that the historical win ratio of such a method is less than 50%, chances are your first few trades will have more losses than wins in them. So, as you close off the losing trades, you will see your cash level drop.

Ok, so what about the winning trades? Well, the thing NOT to do is quickly bank profits to cover the losses incurred. You let those trades run, until an exit signal is given. Now, it is possible that some of those may not go anywhere, or a trend may fail to develop and you get out at breakeven or thereabouts. However, just one or two trades might carry on in the direction your are trading. These may last weeks or even months, whereas the losses may have been taken in a day or two. And those one or two trades may cover all those small losses taken, and generate some surplus. That is trend following in a nutshell.

To use an analogy, it is like someone writing ten film scripts. Some may get rejected out of hand, one or two may end up as small budget productions, but there may be one or two that end up being Hollywood blockbusters.

People starting out on a trend following journey like the outcomes that are possible - after all, that is what attracted them to such a strategy. But, they need to develop their mindset in terms of patience, discipline and consistency, to enjoys the potential benefits that trend following can bring.

Say your first 20 trades end up consisting of 10 wins and 10 losses. The problem is you don't know what order the wins and losses will arrive. How would you react if the first 10 positions all ended up as losses? Runs like that can and do happen.

In the trades here, I've had a few runs of 6,7,8 closed losing trades in a row. One such run ended up with 12 losing trades banked consecutively. In the background however, there were winning trades kept open, letting the trends develop. Price trends do have a tendency to persist, and can run much farther than you would believe.

I've told the story here before of one of the guys I mentor - he went into a drawdown literally on day one of adopting the strategy, but is now at all-time highs. He had sufficient faith in the system at the start to accept that this could happen, and is now reaping the rewards.

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