Sunday, January 05, 2014

Is trend following for you? A checklist

There are thousands of ways you can make money in the markets, however you will not be able to follow all those methods and attain the results you desire. 

However, there is a method out there that will suit you. What this is will depend on the following points:
  • Your personality;
  • Your basic beliefs about the markets or the various categories of trading;
  • The amount of time you are able to devote to your chosen method, both on a daily or weekly level.
In the case of trend following, the psychology involved is the biggest obstacle to achieving success. Quite often, trend followers will be entering when swing traders for example are getting out of a trade in the same instrument. Trend followers go long on strength, and go short on weakness.

Historically, such a method has a win percentage of less than 50% over a large sample. That can fluctuate over short periods depending on market conditions (trending or non-trending, stable or volatile). Against that, a good system will ensure that losses are kept as small as possible, and any winning trades can potentially end up being far larger.

This is the polar opposite of a lot of automated forex systems, for example, where the target appears to be a very high win rate, but the wins are minute compared to any losing trades. In systems like that, it should be clear that any (small) run of losing trades can lead to significant drawdowns or equity blowups. Or a run of say 20 winning trades can easily be wiped out by one loss.

Below is a simple checklist which may help you determine whether trend following is a method that would suit you and your beliefs about the markets.

Trend following is NOT for you if you:
  • cannot accept being wrong more often than you are right;
  • are unable to take small losses, frequently;
  • cannot utilise proper risk management parameters;
  • like to predict what will happen in individual instruments or stocks;
  • like to follow hot tips;
  • consider fundamental analysis more important than price action;
  • like to try and pick tops or bottoms in markets.
Trend following IS for you if you:
  • are able to accept that your price and its movements is all you need to rely on;
  • know and accept you will be wrong more often than you are right;
  • are able to avoid the opinions or predictions of other traders, on social media or on Bloomberg/CNBC, of who 99% will have a different method or timeframe compared to you;
  • are able to follow entry and exit signals that your system generates;
  • have clearly defined risk parameters both on an individual trade and a portfolio basis;
  • have (or are able to develop) the correct mindset to stay in a position until you get an exit signal denoting the end of a trend;
  • understand that, prior to exiting a winning trade, you will give back a portion of those profits, as you will never get out right at the extreme of the trend;
  • accept that you will never get in a long trade right at the bottom of a market, or a short trade right at the top;
  • understand is that in volatile, non-trending markets, or when markets are trying to reverse trend, you will likely suffer losses and frustration;
  • understand that in strongly trending markets in either direction (such as 1999, 2008 or even 2013) you potentially can make a lot of money;
  • can therefore accept that cash is a position available to the individual trader - you do not have to play if the market conditions are not favourable.

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