Saturday, April 27, 2019

Trend following, absolute returns and controlling open risk

At its core, trend following is an 'absolute returns' approach. You only have to look at the high-octane monthly performance generated by the Turtles back in the 1980's to see that. But to achieve that, you generally cannot impose too tight a control over the levels of volatility you have to endure. That is the other side of the coin.

Once the Turtles disbanded, most of those who went on to establish their own trading funds sought lower returns and better control over volatility and drawdowns. Jerry Parker was the first to do this with Chesapeake Capital, and others quickly followed. 

This was seen as a more pragmatic or conservative approach which would appeal more to those looking to invest in their funds. Some, however, remained faithful to the absolute returns approach used by Richard Dennis, using the logic that it was their performance which got them noticed.

Is there a right way or wrong way?

In a word, no. Everyone has their own attitude towards risks, returns and volatility. Of course, you do not want to be overly aggressive and bring the spectre of the risk of ruin into play.

But you can actually look at trend following as being an 'absolute returns' approach from two viewpoints:
  • the inherent logic in determining entries and exits and by letting price trends move as far as possible before exiting (none of this use of price targets, which can cut winning trades short); and
  • the money management side of things, where you determine how aggressive you are in terms of chasing the level of monetary gains, and controlling monetary losses, which trend following can generate.
In this second element, I would include the use of pyramiding into winning positions. Pyramiding was of course used by the Turtles, and undoubtedly contributed to the wild ride in returns they experienced.

In How to Trade in Stocks, Jesse Livermore set out his own rules for pyramiding and his general approach to risk. It is my belief that again, these contributed to the wild swings in his own equity and the bankruptcies he suffered.

In recent years, I have also come across some trend following systems where an overly aggressive pyramiding element actually contributed to equity blow ups.

Early on in my own trading, I experimented with pyramiding on a few occasions before dropping it altogether. 

The main reason for this was that, with every new tranche added to a position, it increased the level of risk, which I was never comfortable with. Also, the ever-present possibility of stocks gapping against you overnight was another risk factor.

My own approach therefore evolved to try and reduce risk as a price trend developed. 

Now, the risk of that happening can never be fully eliminated as those sudden price gaps can occur at any time, in any stock or instrument, and can render your stops worthless. 

Nevertheless, I developed my own stop methodology to try and reduce the potential risk and losses as far as possible.

To achieve this, I started looking at the concept of controlling open risk. This is where the use of what I call the uniform risk exit came into play. This is when my trailing stop is significantly lagging current price, and the distance between those two points is multiples larger than when the trade was opened. 

Like a lot of the performance metrics I maintain, I keep a track of open profits expressed in R.

Now that would not be classed as 'pure' trend following, however I was looking from risk control side, not the cutting trends short side.

With this, there is no doubt that it helps people during those stomach-churning periods where you see hard-earned profits quickly being eroded if price suddenly and sharply reverses direction. 

I have explained this concept to a number of traders and they have found it helped them both in terms of overall trading performance and avoiding the associated psychological turmoil.

So while the basic approach in terms of entries and exits seeks to capture absolute returns by capturing as much of a price trend as possible (and this should always remain so), there are elements within the risk control side of operations where you can maybe look to have a better control on both drawdowns and volatility.

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