Friday, December 18, 2015

The reality of trend following

Look at the performance records of some of the successful trend followers over the last 20+ years. You will see that there are plenty of losing months - as well as losing years.

These are people who have been successful over the long-term. Yet, how many individual traders do you know who are able to go through losing months or years? Some can't even stomach a losing week before they want to ditch a proven method and jump on the holy grail seeking wagon.

I've spoken to people in the past who have expressed an interest in learning more about trend following. Yet they seem to want to be able to guarantee themselves a fixed profit return over the next twelve months. Those people I simply cannot help.

As we know, markets go through different phases or 'states' - trending or non-trending, stable or volatile. Your chosen method may not be able to generate profits in all those different states. Trend followers struggle with non-trending markets. Spikes in volatility can also cause issues, whereas those types of conditions could suit shorter-term traders, or those who trade off support and resistance levels.

While we know that markets may move from one state to another, we never know (and we don't predict!) when this will happen. We can only react to what the markets and its price action are telling us. As a result, it is impossible to say whether you can make any profits in a certain period, let alone at what level.

Trend following is a reactive method - we let price 'tip its hand' as to what direction it may go and we then hop along for the ride. More often than not, we are quickly stopped out. If price is travelling in the wrong direction we jump off and wait for another signal to come along.

Trend followers can spin their wheels and get nowhere for long periods. You put the work in, follow your rules, and get little or no reward. Then, all of a sudden, you may get into a couple of position which suddenly take off. If that happens, you have to hang on for dear life until the ride is over. Those two trades can make your year. And if you mange to get into a major trending trade (such as shorting crude oil last year, or a major trend in a stock), then that can take your trading onto a different level altogether. Very occasionally, such as in the bubble, or the downtrend in 2008, trend followers can make huge returns.

It is for these reasons you can never guarantee what sort of returns you can achieve - or when. All you can do is try and limit the losses incurred when trend signals don't work out, and maximise the profits when you do get into a profitable position - in other words, cut losses short and let profits run.

Combine that with solid risk control, and the ability to follow your rules while controlling your emotions, and you are well on the way to achieve solid long-term performance.

I know the above probably won't appeal or interest many casual traders - they want to find ways to make hundreds of percent returns in a matter of days. But that is the reality of trend following.

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