Friday, October 18, 2013

Suffering from self sabotage? How trend following can help

In a trend following system, there a number of clearly defined rules relating to entries and exits, tied in with risk control parameters. They may be other discretionary decisions that need to be taken (market selection, possible pattern recognition etc), but discretion does not extend to selecting the buying and selling levels. 

In an ideal world, if price hits a certain level that should act as a trigger to either get in a new position, or to exit an existing one. However, there are a lot of people who are unable to follow to that sort of approach. Because of this, trend following is not for everyone.

Below are four of the issues that will impede anyone trying to use such a method:

Traders who like to be proven right about their opinion

We have seen this year the markets continuing to rise, literally from January 1st, up to all time or multi-year highs in many of the major worldwide indices. Having an negative opinion on the future direction in the markets, and therefore attempting to take short positions, certainly would have cost a lot of traders a lot of money so far this year.

While trend followers may have opinions about a certain market or stock, they do not trade based on those opinions - they trade based on price action. The price action this year would have told people to look for uptrends, rather than downtrends. They work on the basis that, if price moves against them, then they are wrong, regardless of what they think about a particular market, and they get out of their position.

Ultimately, those with a negative outlook may be proven right - but price will tell them when it is time to enter a short trade.

Traders who cannot avoid the opinions of others

It is all too easy for indisciplined traders to blindly follow the opinions and trades taken by other traders, rather than base their own trades upon what they see in the market, or what their own system is telling them.

A trend following system should assist those traders in their decision making process - there are clearly defined entry and exit rules, that are determined by the trader, and therefore the rules they follow should be suited to their own personality, risk profile, chosen timeframe etc. These traders do not waste their time listening to the talking heads on CNBC and Bloomberg, or the financial press.

Social Media can also be dangerous if not used properly. For example, I only follow a small number of traders on Twitter, who ideas and principles are closely aligned to my own. For trend followers, I would recommend these fellow traders.

Remember that price does not express an opinion - price is fact. Following price and its movement can help people avoid what others may be saying and focus on what is important.

Traders who cannot accept being wrong, and/or taking small losses

Pretty much all big losses start out life as small losses. The basic methodology of a trend following system is to cut your losses, while allowing your profitable trades to run. It is a fact that these types of system typically have a win percentage less than 50%. 

This means that, in terms of numbers of trades, you will be wrong more often than be right. However, what determines the overall expectancy of the system will be the size of those losses compare to the size of the profits.  Many successful traders (and trend followers) who have made large sums in the markets have been able to accept and embrace this.

What destroys the expectancy is where traders fail to accept a small loss on a particular trade. It is quite easy for that one trade to grow from a small loss to a big loss, causing a significant drawdown in equity, and a loss of confidence or faith in the system. In reality, the fault was not that of the system, but that of the trader who was unable to follow the rules.

Traders who have no concept of risk management

It is far easier for people to avoid the above issues, when they have their risk parameters set as sensible levels. If you only risk 1% or 2% of your overall equity on each trade, then a loss being incurred should allow you to accept it. As Larry Hite famously pointed out in his Market Wizards interview, you should have an 'emotional indifference' towards every trade.

You first question on each trade taken should be "how much can I lose?" rather than have pounds or dollar signs flashing in front of your eyes and you thinking "how much can I make?". Click here for more.

If you are anxious about a trade, or succumb to snatching a small profit too when no exit signal is given, or do not follow an exit signal that has been triggered, then you do not have the necessary mindset - you are trading too large a position relative to your equity!

As you can see, trend following demands that you develop a certain mindset, which will allow you to follow the specified rules. In my opinion, it is far easier to do this if you have the proper risk control in place. Without that, then you could suffer from self-sabotage. If you are able to keep these instances to an absolute minimum, the better the chance of long-term.

If you have been trading for a while, and are suffering from one or more of these issues, then adopting a systematic, trend following approach may help you achieve a significant improvement in your performance. Better still, why not join up with a small (but growing) group of like-minded traders? If this appeals to you, then go here for more.

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