Bitcoin and the evaporation of open profits

One of the most difficult aspects of trend following for inexperienced traders to accept is that you never get out at the extreme of a price move, and that there is always an element of 'giving back' a portion of open profits before an exit signal is given.

Generally speaking, the longer-term the trends you are trying to capture, the more wiggle-room your trailing stops need to give to current price action - this is to ensure that you are not stopped out due to a relatively minor retracement or price noise.

When starting to trade a new method or parameters, even if you have may be got the confidence of decent back testing results, there is still the big step into the unknown when it comes to dealing with the psychological element of letting profits evaporate when you have real money in the game.

This was brought home to me recently when discussing a long-term trend following system with an aspiring trend follower.

Risk and the 1987 stock market crash

This coming week marks the 30th anniversary of the 1987 stock market crash. On 'Black Monday', the world's equity markets were in chaos.

Following this, circuit breakers were introduced in an attempt to prevent such dramatic one-day moves. These were further strengthened following the May 2010 'Flash Crash'.

Known unknowns and unknown unknowns

As traders, we have to accept that we do not know what is going to happen in the future. While our chosen method would look to to profit from an 'edge', based on some form of probability or odds (e.g. trends tend to persist until they don't), we should never approach the markets with an attitude that we can be sure what will happen from one minute to the next, one day to the next, or one week to the next.

Price action in an individual stock, forex pair or commodity can change behaviour at any time.

Therefore, we must account for that possibility in our own method, our mindset and our attitude towards risk.

Paul Tudor Jones - Is there a contradiction here?

"My metric for everything I look at is the 200-day moving average of closing prices. I’ve seen too many things go to zero, stocks and commodities. The whole trick in investing is: “How do I keep from losing everything?” If you use the 200-day moving average rule, then you get out. You play defense, and you get out." - Paul Tudor Jones

The above excerpt comes from PTJ's interview with Tony Robbins, which appeared in the book Money: Master The Game. I've not read the book, but I've seen this paragraph quoted enough on social media.

That was the week that was

Last week will have been an educational experience for many people, particularly those who have started trading since 2008.

Since the major market averages bottomed out in early 2009, they have generally been in a steady uptrend. There have been one or two short periods where there has been some downside volatility (August 2011 and early October 2014 spring to mind) but they were small beer to what happened over the last few sessions.

Then again, we still need to put this into perspective, particularly with people calling the beginning of the week a crash or even 'Black Monday'. Last Monday, the FTSE and DAX fell more than 5%, and the Dow fell just over 3.5%, although intra-day it fell a lot more. Back in 2008, the Dow fell more than 7% on more than one occasion.  And further back in 1987, the Dow fell more than 22% in on the real 'Black Monday' - now that's a crash!

2015 - any parallels to 1987?

As a trend follower, I'm not in the business of making predictions - I follow where price goes. Elaine Garzarelli I am not. Also, predictions can easily blow up in your face if you are proven wrong. On this post, however, I am simply observing and pointing out a few comparisons between what is happening now and what occurred twenty eight years ago.

So what happened in 1987? 

• The crash followed a recent move down from all-time highs made a couple of months earlier;
• There was an international situation which contributed to the price move - in this case, it was the spat between James Baker and the Germans;
• Price accelerated to the downside throughout the week, culminating in a big drop on the Friday on heavy volume.

A plan on how to get over a major drawdown or price shock

It is an unfortunate part of trading that people can suffer the traumatic experience of losing a significant part of their equity in one go. In extreme examples, some traders may even blow up their account. This may be as a result of some major unexpected news coming out. It may be as a result of your broker putting most of your money in a downtrending stock. It may be because you took a big position just before earnings were released which then gapped against you.

When something like this happens, your mindset will take a battering, and before you commit any fresh funds to the markets, you need to step away for a while and regroup. As hard as it may seem, how you deal emotionally with what has happened is of paramount importance, and may even determine whether you can make money in the future.