Saturday, February 08, 2014

Commitment and discipline

When trend following, apart from using a system that has an underlying positive expectancy, you also need to develop a commitment and discipline in following the system signals and your overall strategy. If you can do this, and use good risk management at the same time, then you have a good chance of success.

Commitment is required as the markets go in and out of being favourable towards your method. Basically, there are four market states - trending or non-trending, stable or volatile. It should be clear that a volatile, non-trending environment is the worst combination for a trend follower, and that a trending, stable environment is the best.

Of course, the opposite is true for other traders. Those who prefer to trade short-term or swing trading methods using support and resistance levels love volatile, non-trending markets, and will suffer repeated losses when a strong trend takes off. You need to determine what methodology suits you, learn to interpret the market conditions and trade accordingly. You need to ride out those non-performing periods, to allow you to profits when the markets are conducive to your method of trading.

When the market conditions are not favourable, then good risk control is an important ally. It will allow you to step slowly into the market  when an appropriate signal is given, without risking a huge amount of your equity. Should a trend begin to develop, and your initial positions start to show a profit, then other positions can be added. What you should try and avoid is piling into a bunch of positions on day one of a getting a new trend signal in the S&P, for example.

Quite often, to the uneducated trader, when a trend follower gets into a new position it will appear that they have entered late. Typically, a trend follower will open a new long position after there has already been some strength already shown in the price action. You can pretty much guarantee that, on a long entry signal, someone who uses oscillators will be saying that the stock or instrument is already overbought, and when a trend follower is buying, those other traders will be the ones heading for the exit (or even looking to trade in the opposite direction).

However, when a meaningful trend does take hold, and you look at a chart several weeks or months later, you will see that the trend follower has got in exceptionally early into that price move.

If you think back to 2008, trend followers started getting into short positions on stocks or the indices while the majority were still saying the markets were in a pullback, or a correction. As it turned out, trend followers were able to start building a whole portfolio of short positions way before the public at large, or the talking heads on CNBC and Bloomberg really acknowledged or accepted what was happening.

The same happened in the spring of 2009 - as the markets were bottoming out and potential new uptrends were giving signals, the majority of people were still thinking there was further downside to come, equities were going further down the pan etc. Again, several months later trend followers had done very nicely, thank you.

2011 was the opposite. There were repeated trend signals given in the indices and in stocks which quickly failed. Trend followers tried taking those signals and were quickly stopped out. The non-trending nature and the higher levels of volatility meant that the market conditions were not favourable.

In all these cases, trend followers had the commitment and discpline to heed what their systems were telling them, and acted accordingly, even if it went against public opinion or widely held beliefs. And, in two out of those three situations, were able to generate significant profits.

Last week I talked here about the possibility of a new downtrend trying to take shape in the general market. Since then we had another strong downward move in the early part of the week, only to see markets stabilise and move back up. The indices are basically back to where they were a week ago.

I talked in this post last year about the dangers of piling into too many positions, too quickly.

Discipline also means looking for good set ups that match your criteria. If the markets starting moving in a particular direction, you simply wouldn't pile into any old stock - you still need to select those setups that give you the best opportunity for success. If you cannot find those setups, then don't force it. If a meaningful trend is to develop, let the good set ups come to you.

Market trends never move in a straight line. And, in a matter of days, market sentiment seems to have done a complete about turn. Time will tell if this was a short-lived downtrend, and the uptrend will re-assert itself. This may even be a 'V' shaped reversal. Who knows?

A typical trend follower knows that on at least 50% of his trades he will end up losing. So if he was able to identify some good setups and started opening some short trades over the last couple of weeks which have failed, so what? Good risk control will keep any losses to a minimum. What he DID do though, was have the commitment and discipline to follow his system and to act accordingly. And by doing so, he gave himself the best chance of getting into the early stages of new trends, and consequently the chance to make profits.

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