Whenever a trend follower captures a big winning trade, outsiders often wonder if it down to pure luck, skill or something else?
In a lot of cases, trends can start to develop in spite of the current sentiment and beliefs of many of the market participants.
Trend followers however approach the markets in a unemotional state - if their method tells them to enter a trade at a certain price level, they enter. Similarly, if their method tells them to exit at a certain price level, they exit.
A trend follower would never get into a situation where they would allow price to start trending significantly in the opposite direction to that they are trading - witness Bill Ackman and the chart of Valeant Pharmaceuticals. If their exit level is hit, they get out, no questions asked, and move onto the next opportunity.
They are conditioned to exit based on price and their chosen parameters, not on opinions or beliefs about where the price on a stock or instrument may or may not go. In other words, they are slaves to their own system or method for getting in and out of their positions.
Now, there is undoubtedly luck involved in getting into a major trend on a sample size of one. And historically, trend following has a typical win rate of between 30% and 40%. However, trend followers work on the premise that trends have a tendency to persist. So, they take their entry signals at the start of a potential new trend. If they are wrong, they will know quickly and will exit as soon as possible, with as little damage as possible to their equity.
If however, they do get into a position where a significant trend starts to develop, then the only skill involved is having the ability to stay in the trade until an exit signal is given. They never predict when that will be, or at what price level. The price action in the market they are trading will tell them when that time has arrived.
Psychologically, it can be very difficult for people who start to use a trend following approach to truly grasp how it works until they have been through the myriad of emotions and cycle of market conditions that accompany such an approach: lots of small losses, some small wins, and the occasional big win.
Trend following is not an approach geared toward achieving a high win rate. You have learn how to lose (small) before you can win. It is not easy telling someone they are trading well when they are clocking up small loss after small loss. But that is all part of the game. Similarly, you also have to accept that hard earned gains can be lost as part of the process when a trend starts to end or reverse. Those who can understand and accept that, along with applying strong risk control, have the best chance of success.
I talked here about how a trader friend I've mentored for a few years went through this process. All his development, learning and initial frustration, in effect, was the precursor to making a big psychological breakthrough. But all through that process, he was sticking to what his basic method was telling him to do. It kept him in the game. It eliminated the possibility of big losses. He knew he was getting closer and closer.
I'll never forget the phone call I got from him when he managed to get into a few positions, the majority of which started to develop major trends. I was on holiday at the time, but we kept in touch as the profits were mounting up day after day. The urge to take profits off the table was huge, however he knew that would go against the basic premise of letting the profits run: "This is really testing my mettle", he said "but NOW I truly see and understand the power of trend following."
He now trades more than one trend following system on different timeframes and is making decent returns. Whenever we chat about things, he continually refers to being a slave to his system, and stresses to himself the need for him to not listen to his own thoughts and opinions about what may or may not happen. He continues to take the positions when he gets an appropriate signal and his risk limits allow, and then he lets the markets do its thing.
And that is the way it should be.
Excellent!! Thank youReplyDelete
Hi I just read many of your past blog posts. All really good. I just wonder though if there are some trends you stick with and others where you might be more cautious. For instance, at the moment the larger market trend is negative but the short term is positive. Doesn't it make sense to have tighter stops in a counter trend such as this current short term uptrend?ReplyDelete
Hi Douglas - Thanks for your comments. I do not attempt to change my exit strategy - my stop placement remains the same regardless of the market conditions. As Larry Hite says "We are not looking for the optimum method; we are looking for the hardiest method." The parameters I use for trailing stops I have used for years through varying market conditions, and I am 100% comfortable using them. My stops are very aggressive at the beginning of a new trade, hence why most of my losing trades are very short in terms of length (a lot of the time losing trades are closed within 1-2 days) and most of those losses are contained to well below -1R. Once I get into a profitable trend, I do not want to start fiddling around with exit parameters based on something which may or may not happen. My stops are designed to try and allow a suitable amount of 'wiggle room' or price noise without necessarily being stopped out, but are tight enough to avoid giving back a huge proportion of open profits. What works for one trader may not work for another... :)ReplyDelete
You are also referring to general market trends in your comment. I prefer to concentrate solely on the price of the stock or instrument I am trading, rather than looking at the stock market as a whole. Watch out for my next blog post, which talks about this very subject!