Tuesday, April 15, 2014

Trend following works to its own beat

I was recently asked by a new trader what sort of returns he could expect by using a trend following approach. As always, the answer was "it depends".

There are so many variables in the market that, depsite what others may say, it is impossible to predict what will happen tomorrow, let alone over the next six months, year or five years. All traders can do is work on probabilities.

Trend followers work on the theory that, if a new trend starts, it will tend to persist. What they don't know is for how long the trend will last, and the magnitude of the price move. They also know that trends can finish at any point. New trend signals can and will fail - frequently. This is why risk control, as well as having the ability to cut your losses and let profits run, is such an important part of your overall approach.

It should be clear that trend followers need trends to make a profit. Therefore, the market needs to be trending one way or the other to make any money. Anyone looking at the indices so far this year will see that this has not been the case - this has made trading individual stocks (the majority of which would move in the same direction as the indices) difficult as well. Go compare to same period last year for a comparison. You never know when such a trend will start, or finish.

Trading is an odds game. You should focus on probabilities, risks and rewards, not on predictions or opinions. You shouldn't expect anything in this game, other than the unexpected. Different methods work in different market conditions. No doubt in recent weeks the shorter-term traders such as the swing or day traders will have capitalised and benefited from the volatility and lack of a clear direction, whereas trend followers have been dealing with the possible end of the uptrend that has been running for some time, and all that entails. Part of a trend followers' arsenal is to know when conditions are favourable or not favourable towards their method, and act accordingly.

By the same token, if you are considering trend following because you like the logic and the potential returns, you cannot use it as a method to pull a regular amount out of the market each week or month.

Trend following takes time, patience and discipline. You need to be consistent in your approach, control your risk, and let returns compound. And you need to accept that the market and its price action will determine whether you have suitable conditions enabling you to make a profit.

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