Tuesday, March 29, 2016

Longevity is the key to success

For a trend follower, the lack of decent trends over the last couple of years or so in the stock markets was perhaps expected - 2008 on the downside, followed by 2009 and 2010 on the upside were fertile periods to profit from price trends. 2011 was a difficult year for me, whereas 2012 and 2013 offered favourable conditions.

The recent past has been much more difficult, somewhat akin to 2011. If you simply look at the indices, you can see the lack of a decent trend - in either direction. Where there has been a directional move, it has been choppy and been short-term in nature at best. Yes, there have been trends out there in individual stocks, but the increased volatility and inherent 'choppiness' has definitely made things more difficult.

That can be clearly seen in the metrics shown here. Because of these factors, my trading activity and consequently the returns have dropped over the last couple of years, with more losing months being endured. 

Even though these days I concentrate on the price action in individual stocks, and pay little attention to what the major market averages are doing, I do pay close attention to volatility. It is one of the key conditions I look at when evaluating a stock set up, and certainly the general increase in volatility has helped me limit my exposure over the last couple of years. This was something I learned greatly from 2011, where I suffered a losing year.

With that in mind, consider the following from Ed Seykota:

"The profitability of trading systems seem to move in cycles. Periods during which trend-following systems are highly successful will lead to their increased popularity. As the number of system users increases, and the markets shift from trending to directionless price action, these systems become unprofitable, and undercapitalized and inexperienced traders will get shaken out. Longevity is the key to success."

Trend followers know that they can suffer a run of weeks or maybe months (or even longer if using longer-term systems!) where you can suffer a run of losses and a drawdown. That has to be expected and accepted by the traders trying to utilise such a method. If they can't, then they won't be around to benefit when the market conditions do change for the better.

Trend followers are not looking to make a fortune by this time next week - and if you are looking at trend following as a method to use, then you need to accept this too. Trend following is a proven, robust method to be used over the long haul. As we know, the typical win rate is in the range of 30% - 40%. With that in mind, the occasional run of losing trades has to be experienced.

If you have read Peter Brandt's Diary of a Professional Commodity Trader, the period immediately prior to that covered in the book (October and November 2009) he had a run of 24 losing trades out of 27.  He goes on to say "Over the history of my trading, I have been profitable in approximately one third of trading events"

How many traders do you know who would have been able to survive a period like that, both from a risk and psychological point of view?

I had a similar run of losing trades in the second half of 2014. Reading Brandt's book, along with reviewing the long-term trading performance of successful trend followers reinforced that this can happen even to the best. I knew my method had a positive expectancy, and this period was something that had to be experienced.

As a trend follower, you have to go through those runs of continuous small losses to get to the big wins. That is what gives you the positive expectancy. Unfortunately, that is also why impatient traders cannot stick to the method when one of those losing periods come along. Or, they become so desperate to quickly recover that lost equity, they start to overtrade.

Experienced traders (and trend followers in particular) talk about having to learn how to lose before you can win. Knowing and accepting that means you can avoid tying yourself up in emotional knots, starting to second guess the signals, or trying to 'outsmart' what your method is telling you. If you can't accept that, then trend following is not for you.

When will the markets change to a more favourable environment? That I do not know. Thankfully, my crystal ball broke a long time ago. It could be tomorrow, it could be in six months or a year's time. 

But what we do know is that markets move from trending to non-trending states (and vice versa), as well as the inherent levels of volatility continually move upwards or downwards.

I had to go through the losing year in 2011, and learn the lessons from it, to get to the profitable years in 2012* and 2013 (which are summarised here), as well as eke out a smaller profit over the last couple of years (even with that major run of losing trades in there). An impatient trader wouldn't have stuck around long enough to get to those wins.

And when the conditions do change again for the better, I will be ready for it - will you?

*the metrics start from July 2012 - this is when I implemented the change in my stop methodology, based on the lessons I learned in 2011.

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