Sunday, June 14, 2015

Trend following on stocks can work - with certain changes

If you have read the Market Wizards series of books, then you will have come across a bunch of super-successful traders talking about what they do. Do they all trade the same way? Of course not. In fact, they all trade differently to one another in terms of their chosen timeframe, entry and exit rules, and the instruments they trade. But they all have developed the necessary psychological skills to succeed, along with incorporating strong risk management. These core elements are evident in every successful trader I can think of.

Just that alone should tell you that no-one can say your approach to the markets is right or wrong. Your bottom line and performance metrics will tell you. I'm positive that there are loads of methods out there that can easily beat my own returns, but I know I can do what I am doing. I know my method's strong points and weaknesses, as well as my own strong points and weaknesses. My method suits me. There is no one right way for everyone to trade, but there is a right way for you - and for me. And in any case, if everyone traded the same way, there wouldn't be a market of buyers and sellers - and where would that leave us?

There are some bombastic people about who like to say that their way to trade is THE right way, and that anyone who 'dares' to trade in a different manner is an idiot. I know of some well-known people who seem to want to argue with anyone and everyone who has a different belief or opinion to them about how to trade.  I've gone as far as unfollowing such people on social media, blogs and trading forums who take that view - even if they advocate or champion a trend following approach themselves. Everyone should trade their own beliefs, both in terms of how the markets work and how best to make money - providing it has a positive expectancy or edge.

In addition, there are some who think that trend following strategies simply don't work on equities. To use a classic trend following strategy would condemn you to failure. And that is almost certainly correct. My own approach has its origins in one such 'classic' strategy however the very nature of equities has necessitated some changes or additional factors which have been incorporated into my own rules. These include the following:
  • Because of my chosen parameters and timeframe, I have to pay close attention to earnings dates;
  • I place an ever increasing reliance on interpreting volatility;
  • Trade (stock) selection becomes more important, as you are not restricted to trading a small basket of instruments;
  • I look at the basic visual characteristics and structure of the chart as part of the selection process;
  • I don't pyramid any of my trades - I want to try and reduce risk on a profitable trade, not increase it.
Those changes have come over time, and from different sources. Some from my own thinking, some from reading articles about successful traders and their own methods (whose basic beliefs or approach may be completely the opposite to my own!), some from being fortunate enough from speaking or corresponding with other successful traders, as well as from testing things in real time with real money.

As an example, I made a big change to my stop methodology following poor performance in 2011, and in particular the non-trending, high volatility environment we experienced in certain parts of that year. That change was directly inspired by reading one of the Market Wizards interviews - but again, I took what was suggested and tweaked it to suit my own approach.

So while my starting point was someone else's method, over a number of years these changes have made it 100% my own. And it is an ongoing process. I am sure that, while my own basic ideas will not deviate, in the future I will make further changes - possibly as a result of changes in the markets, possibly as a result of changes in me.

And the end result of these changes? A look at some of the resulting performance metrics show all the hallmarks of a 'classic' profitable trend following strategy used on futures:
  • A win rate between 30% and 40%;
  • The size of the average winners being significant bigger than the size of the average losers. This shows itself with the profit factor (expressed in units of R) being in excess of 5;
  • As talked about on this old blog post, a small number of trades providing nearly all of the profits generated, with the rest being small losses and small profits.
In other words, by taking a classic trend following approach typically used on futures, playing around with it and refining the rules, and making it my own, I have been able to retain all the characteristics and robustness a typical trend following approach can give you, within a different arena.

Now, it may well be impossible for a manager of a large fund to trade like I do. For example, I am not limited to the largest cap stocks, and trying to place trades on the stocks I have traded in the past using their position sizes may well be impossible. Indeed, as my own equity size increases, this may well necessitate some changes to my own approach in the future.

Notwithstanding that, for individual traders (like me), looking to trade their own account, and free of the limitations or restrictions imposed on the big money managers, my results (and those of others) have shown me that yes, trend following on stocks can work - with certain changes.

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