Friday, May 27, 2016

Unrealistic expectations


Someone who decides to trade using a trend following approach should expect to achieve a win rate between 30% - 40% across a large sample of trades. Depending on the parameters used, this could cover a period of several years.

If this were the case, then the sample would automatically cover the mixture of different market states, be it trending or non-trending, stable or volatile. You may also include in that period a sustained trend in a downward direction as well as an upward direction.

Ordinarily when attempting to follow price trends on stocks you would look for the win rate to increase when the markets are in a trending phase, and decrease when there is no clear direction, increased volatility or ‘choppiness’.

If a trader decides to implement a trading strategy when the market conditions are clearly against them, then they should anticipate their win rate to drop. Such examples would be to attempt to follow price trends in a non-trending, volatile state, or to try and pick tops or bottoms in a strongly trending market. To me that's pretty basic stuff.

I have talked in the past how, when you start implementing a trend following strategy, you should expect to enter an immediate drawdown on your cash equity. Why is this? Because you should be cutting your losses and letting your profits run. Therefore, you would ‘bank’ any initial losses before seeing any profits credited to your balance.

Given that the typical average win rate of a trend following approach is below 50% (and may be as low as 30%), you have to condition your mind to expect that the majority of your trades will end up generating a loss. And if you start taking trades when market conditions are clearly against you, such as they have been so far in 2016 then this will be exacerbated. Therefore, you should expect to incur a lot of small losses.

Anything else smacks of having unrealistic expectations.

As I have mentioned on other recent posts, when the markets are in a non-trending, volatile phase, then this is where you lay the groundwork for future success - be it working on yourself and your mindset, your risk and portfolio heat control, or may be even refining your method.

Experienced traders know and accept that the markets can change their state at any time. They don't predict when this will happen - they simply react to what price is telling them.

As an example, the last few weeks I have seen a lot of good quality setups appear which I have put on my watchlist - so much so that my watchlist is the most populated it's been for a year or so.

But, when watching those stocks, a high proportion either fail to breakout at all (in some cases, price never triggers and sharply starts to move in the opposite direction), or price attempts to breakout before quickly failing.

Taking lots of trades in an environment such as this can result in a lot of frustration.

I was asked this week whether, given that my performance in 2016 so far, I would look to change my approach or my trading rules.

The simple answer to that is no. I have accepted that current market conditions have not been favourable towards my style of trading. I'm not going to change my approach based on 6 months of poor or non-performance, during which time markets have not trended and volatility has increased, when I know I will be trading for the next 30-40 years or so. I just have to wait it out, safe in the knowledge that I will either be in cash or very lightly invested until I see that things start to change.

And how will I know when this will happen? Easy, the level and quality of set ups I am seeing will be maintained (or even improve), and a higher proportion of those setups will trigger an entry, and the subsequent breakout will hold.

In practical terms, this means that any trades taken will effectively be me 'dipping my toe' into the market, maybe one trade at a time. I certainly won't pile into a whole bunch of stocks all on the same day. No, I will put a trade on, see how it reacts (as well as other stocks on my watchlist which may be breaking out).

If I am then able to reduce the open risk on that trade by being able to move my stop in accordance with my rules, then I will look for an additional trade to take. I will gradually increase my exposure (portfolio heat) based on what price is telling me and how those stocks I am trading or watching perform.

It is by doing this that I keep myself lightly invested when price isn't trending, and that I can look to increase my exposure when the odds are moving more in my favour. And consequently, I will have the most exposure (number of positions) in the market when I am in a number of profitable trends that have been accumulated over time.

I've only reached my own pre-determined maximum exposure levels once in the last four years or so, and that is when I was able to generate the most profits. You can clearly see this correlation between my performance and level of trades by looking at the metrics.

So approaching the markets in this fashion has proven to work for me in the past, and will continue to do so in the future.

Additional reading:

Starting using a trend following strategy

Keep an eye on your portfolio heat

Stress testing yourself and your method - sowing the seeds of future success

2 comments:

  1. Hi there, Great blog you have there, really. I learned so much from your posts already so please juse keep up the good work! :)

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    1. Hi Gustavo, many thanks for your kind words. Glad you have found my posts of use :) Any specific questions you may have please email me. Steve

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