Sunday, May 18, 2014

Something that works in the long run

These are uncertain times in the markets at the moment, and I am currently in the highly unusual position (for me) of being fully in cash. The market conditions in 2014 have not been favourable towards my style of trading, and therefore the number of trades taken in the last few months is a lot lower than normal. That said, as the returns here show, they are still more than acceptable.

Now, one can ask were those returns down to luck? There is always an element of luck involved in whether a single trade will make a profit or a loss - it is the proverbial coin-toss. But all I did was follow my rules, identified stocks that met my criteria and put on the trade.

"It wasn't like I threw a dart and decided what to do. I did something that should work in the long run - I went with the trend." - Richard Dennis, from his Market Wizards interview.

The thing most people have difficulty with is that with a typical trend following approach, the win percentage is less than 40%.  This fluctuates, so in favourable conditions, the short-term win percentage can be higher, and conversely it can be lower when market conditions are not as favourable.

Where trend followers can still win though, is by seeing when a trade is going against them and then acting quickly to cut those losses, so they are as small as possible. They do not care if a trade is cut with a small loss - it is a cost of doing business.

"There are really four types of trades or bets: good bets, bad bets, winning bets, and losing bets. Most people think that a losing trade was a bad bet. That is absolutely wrong. You can lose money even on a good bet. If the odds on a bet are 50/50 and the payoff is $2 versus a $1 risk, that is a good bet even if you lose. The important point is that if you do enough of those trades or bets, eventually you have to come out ahead." - Larry Hite, from his Market Wizards interview.

The other side of the coin is that, once in a profitable trade, they will let it run until an exit signal is generated. Sometimes, this means that profits can be wiped out, due to a combination of the system parameters used and if price starts to move quickly in the opposite direction. What they will avoid at all costs though is taking a profit based on some profit target. In effect, that is cutting potential profits short.

They know, based on previous experience, and the positive expectancy that their method has, that sooner or later a winner will come along - maybe a big one. One winning trade that generates a +10R profit, or even a +20R profit can turn round your whole performance, and wipe out a whole bunch of losses. It is those big winners that help generate the overall positive expectancy.

Keeping trading losses as small as possible also means that your equity is as large as possible, so that when a winner does appear, they can maximise their profits from it.

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