When a trader starts adopting a trend following approach, there can be a steep learning curve in terms in truly understanding the ups and downs they will experience - both in terms of open equity and the emotions involved.
Aspiring trend followers will more often than not go straight into a drawdown on cash equity. This is due to them adopting the basic principles of cutting losses short and letting profits run, combined with the low win rate that is typically achieved.
My observation is that people quickly develop the need for good risk control and the cutting of losses, but by far the most challenging aspect of a trend following approach is the ability to remain faithful to your exit rules once you get into a profitable trade.
As a price trend develops, volatility can increase due to the battle between people eager to catch a piece of the action, while at the same time others are taking profits off the table.
As trend followers with clearly defined rules, we need to stick it out until an exit signal is generated. So we need to learn to embrace this increase in volatility.
What we want to avoid is suffering from the fear of losing open profits, and bailing out of the trade when a price move may stall or have a gentle retracement - if you do that, there is a danger that your intervention could lead to cutting winning trades short.
In addition, we also want to avoid taking profits on a whim simply because you think price has moved as far as it can.
As Richard Dennis said: "The correct approach is to say: This structure means up, and this structure means up no more, but never that this structure means up this much and no more."
Given the typical win rate for a trend follower, it is vital to capitalise from those big moves, both to cover all the small losses, but also to grow your equity base over time.
It is generally only when someone is able to get into a position where a significant trend develops that they truly appreciate the power of trend following, together with experiencing and understanding the psychology involved.
Late last year I was able to capture a decent downtrend in Bitcoin which was discussed here. This trade was discussed within our mentoring group, and one of those traders in the group, Paul, who had watched this develop and missed the trade resolved to ensure that such an opportunity was not missed again.
Well, Bitcoin gave us another opportunity back in late March. After another set up which met our criteria appeared, Paul placed his order to open at the appropriate price level, and as a result was able to profit accordingly.
During this trend, he was able to embrace the increase in volatility caused by the sharp down days on 25 April and 17 May, and by the time his trailing stop was finally triggered on 04 June, a profit of +21R had been achieved.
This was Paul's first major winning trend. Here is his own thoughts after the event:
"Having a slightly pessimistic view is actually beneficial because you don't expect anything other than a small loss when entering all new trades, and this is the case on most trend following systems. I haven't had to work to develop this state of mind, it happens naturally to the traders benefit.
I now see that as soon as you start thinking of how much money you might make on one trade, you're screwed. At this point you are just one click away from closing a trade early because of fear and missing the big move. You may also be inclined to chase a trend already underway in a desperate plea for money, or override your stop rules because you have a bias view about where the trend is going - big mistake.
Being inside the trading platform for too long, you naturally start to think about what the trade might do next and that quickly leads onto how much money you may or may not make. So, placing orders and checking in to adjust stops needs to be a quick process. Get in and get out!
Each day I logged in I barely had any reaction other than "oh" whether it was up or down. I knew that once the stop was trailing along, the trade was profitable either way and as long as I adjusted my stop accordingly, I'd catch the largest chunk of the trend however long it lasts.
That's all you can ask from a system and the system delivered that very well. Although I will admit that I did for a slight bias that bitcoin was 'going to the moon', it did not affect my behaviour in anyway.
My favourite thing about the recent bitcoin trade is that I proved to myself that I can trade. The fact that it turned into a 21R trade is just a bonus :)"
While Paul gave credit to the 'system' being used, any method is only as good as the person using it. As he mentions, it is far too easy to try and be smart and override the rules, thinking you'd know better. Paul did a great job of letting things happen, and waiting for his trailing stop to take him out of the trade.
Paul has gone through the drawdowns and the suffering of a string of losses, and the small winners. He has now also experienced dealing with a big winning trend. As a result of all this, equity is increasing, his mindset is developing and his underlying confidence is growing.
Finally, let's take another quick look at the Bitcoin chart. The Hindsight Harry's out there will point out that price is moving back up again, and that he would have been better off staying in the trade.
All a trend follower can do is follow his rules - in the same way they will tell him when to enter a position, they will also tell him when to exit. The trailing stop got hit, so there was nothing else to do.
Overriding the exit signal could have easily set a dangerous precedent. On this occasion, price is trying to move back to upside so there was potential to make more money than was actually achieved. By the same token however, on a different trade, on a different day, price could have accelerated to the downside and you could have lost even more of those hard-earned profits.
To me, when you have taken the time and effort to construct a rules-based approach, to then go and override them based on a hunch or someone else's opinion is just illogical.
Following your own process and rules in a diligent manner will help you to ensure that the long-term profitability you desire can be achieved.