Monday, July 20, 2015

Accepting the bumps along the way

If you think you can adopt a trend following approach, and then guarantee that you can pull X% out of the market each month/quarter/year, then you are very much mistaken. Your performance when utilising a trend following strategy will go through peaks and troughs. There may be periods when you are fully invested (up to your own portfolio risk limits), and there may be times when you are fully in cash.

Look at any performance record of a trend follower and you can quickly identify these peaks and troughs. Why do these happen? Very simply, trend followers need trends in whatever markets they are trading to appear. If they don't, then a trend follower will struggle. That you have to accept.

Trend followers generally have a set of rigid entry/exit criteria, and these have to be met to trigger an interaction in the market place. No-one knows when these criteria will be met.

My own trend following approach falls into the 'rules-based discretionary' arena - that is, it is not 100% systematic or automated. I am extremely systematic in what I do once I am in a trade, but there are additional variables I take into consideration before pulling the trigger. These are partly because I do not trade a small fixed basket of instruments (I trade stocks, so there must some additional filtering of the trades I take), and also partly because my primary concern is to control risk (for example, I avoid initiating new positions just ahead of scheduled earnings releases).

People look at trend following and like to see the end results and the potential rewards that can be achieved. However, they often are not prepared to ride out the periods of poor or non-performance which crop up from time to time. When these do occur, they tend to fall by the wayside.

If we just look at two particular characteristics of my own performance over the last three years:

Firstly, there have been the occasional periods where I have been 100% in cash  - in one or two cases for weeks at a time. One was then there was general uncertainty over the 'Fiscal Cliff' negotiations in the US a couple of years back. A more recent one was related to the increase in volatility and uncertainty over the Greece/Eurozone situation.

In both those cases, I had been stopped out of all my own trades, there was a lack of decent set ups coming up on my scans, and those that did either did not trigger entries, or tried to break out only to quickly fail. That was the markets way of telling me to step to the sidelines. The odds were against me, so I heeded the message.

Most traders simply do not have the patience and discipline to do that. They think that, being a trader, they have to be doing something every day! Overtrading when the odds are against you is an easy way to build up significant losses, and dent your confidence.

Secondly, in the summer and autumn of 2014 I had a horrendous run of losing trades. Most people would have given up on trend following in that period. Once I had carefully analysed my own trades, and put a corrective plan in place (which basically related to only one aspect of stock selection and timing) then I was able to put that bad patch behind me. As a result, I made back all the money lost in that drawdown in only a few months.

As fellow trader and follower of trends @jboorman said last week: "The fact a methodology sometimes doesn't work is why it does work. Losses and drawdowns are part of a winning system."

The bottom line is, you will never achieve a nice smooth equity curve, with consistent results from one period to another. There will be bumps along the way. If you can't accept that you will have losing trades, or suffer periods of poor/non performance, then you have no business being a trader, and in particular a trend follower.

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