Thursday, July 15, 2021

On defining a trend, interpreting volatility and when to go fishing

Jesse Livermore aboard the Anita Venetian

"Your definition of trend is the smoothing method you use. The methods you use to define trend are entirely up to you, so you get to define trend any way you wish; everyone may have a different idea of "the" trend." - Ed Seykota.

As Ed says, there is no such thing as THE trend. By varying the the parameters / timeframe used to identify a trend, you end up with numerous different answers.

Often, traders tend to vary the method used to get the answer they want, which satisfies some internal bias.

Similarly, whichever stock or instrument you are trading, the price action at any time may be better suited to generating what you would class as shorter-term trends, and longer-term trends at other times. Again, different people will have different ideas as to how to define whether a trend is shorter or longer term.

However, most successful trend followers used a 'fixed' set of parameters, which is best suited to 'frame' the price movement they are looking to capture.

This is particular to each of us, and on that basis you can ignore the thoughts and opinions of others as to whether price is trending or not.

Those with sufficient capital may run a number of systems with differing parameters, designed to capture trends with differing characteristics and anticipated duration.

As a result, we could both be trading the same stock or instrument, at the same time. You could be trading an uptrend, whereas I could be trading a downtrend (or vice versa), and both of us could be correct within the context of our own trading.

Ultimately, your performance as a trend follower will come down to two things:

1. Whether the price action your method is designed to capture tallies with the current price movements in the market; and
2. Your ability to follow the entry and exit methods presented to you.

As always, Ed sums up these points very well:

"Following a system does not guarantee profits any more than not following a system. Profits over any time span depend on how well the system fits the market behaviour - and on how well the trader executes the system."

There are very few differences between trend following systems, other than the time constant (how frequently it trades). There are huge differences between the abilities of traders to follow simple systems."

When you understand the above, you realise that the periodic proclamations that 'trend following is dead' hold no water. What these people are actually saying is that their chosen timeframe and parameters were not compatible with recent market action. This can either be due to a lack of direction, or more likely the volatility characteristics being exhibited.

In my own trading, while I cannot do much about the lack of a direction post-entry, I CAN do something about looking at volatility when looking for trading opportunities. 

Basically, if volatility goes above a certain level (which is specific to that stock or instrument) then, even if all other criteria are met, my scans will avoid identifying those as potential setups.

This has meant I have been kept out of entering any new positions when volatility levels have spiked. To give a couple of examples, in February 2018 and then in March 2020 I was getting little or no opportunities to enter new trades - either on the long or short side.

This is what the scans were designed to do - from a purely mathematical point of view, an increase in volatility will affect my position size and initial stop placement. In those cases, price would have to move further in my favour to generate each unit of R in profit on a trade.

At those particular times, the odds became tilted against me, so I was content to sit on the sidelines and wait for the volatility to drop. It also meant I could avoid the whipsawing which generally accompanies any spike in volatility. While other market participants for sure may have seen potential opportunities, rightly or wrongly I was more concerned in looking at the risk of trading at those times.

Larry Hite's emphasized this type of approach perfectly in his Market Wizards interview:

"The fourth thing Mint does to manage risk is track volatility. When the volatility of a market becomes so great that is adversely skews the expected return / risk ratio, we will stop trading that market."

This means when market conditions are against you, those boring attributes of discipline and patience come to the fore. When this happens, I am reminded of a couple of quotes from Jesse Livermore:

"The desire for constant action irrespective of underlying conditions is responsible for many losses in Wall Street even among the professionals, who feel that they must take home some money every day, as though they were working for regular wages."

"There is a time to go long, a time to go short, and a time to go fishing."

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