Losses and Whipsaws - one good trend pays for them all!

Any aspiring trend follower should expect runs of consecutive losing trades to be the norm, interspersed with the occasional small winner and, every once in a while, a big winner.

At some point, most people tend to look for some silver bullet to eliminate at least a chunk of those losing trades, and get the win rate up to 50% or even better.

But the harsh reality is that, throughout history, the most successful trend followers have prospered with a typical win rate of between 30% to 40% - irrespective of timeframe, or the markets traded. That, combined with a method allowing the cutting of losses and the ability to let profits run is from where the positive expectancy of the approach comes.

Some words of wisdom from David Druz

David Druz is a long-time trend follower who was the first mentee of Ed Seykota. He has run Tactical Investment Management since the early 1980's. Here are some of his nuggets of wisdom:

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.

The case for simplicity and the dangers of trying to improve

"Everything should be made as simple as possible, but not simpler."

The above quote is attributed to Albert Einstein, and it is something I try to adhere to with my own trading. That said, there is a balancing act between keeping things as simple as possible, against striving for improvement which may mean adding complexity to what you are doing.

A positive start to 2017

Markets always go through different market 'states' - either trending or non-trending, stable or volatile.

During the last couple of years it has been difficult (but not impossible) in making money adopting a trend following approach, for me using my preferred timeframe and parameters. That is the nature of the beast. You cannot force the market to march to your beat. You can only take what it is prepared to give you.

Controlling your losses, good trades and bad trades

Good traders continually worry about trying to minimise any potential downside. By the same token, they try to avoid placing any restrictions on the potential upside.

Take the four possible scenarios on any individual trade: 

• Big win; 
• Small win; 
• Small loss; and 
• Big loss. 

Good traders try to avoid the big losses at all costs. If you have a robust trading approach that has a positive expectancy, then the small losses can easily be recovered from.

Trend following, unrealistic expectations and a look into a fund's performance

Some people have unrealistic expectations when it comes to trend following - and trading in general, for that matter. 

I remember a trader contacted me once about some mentoring and essentially was looking for some assurance that, if he adopted a trend following approach, he would be able to make a +100% return over the next year.

Gearing up for 2017

In recent months, one of the most popular posts on the blog has been 'Trend following is dead - apparently...'

I wrote this back in 2010, based on the fallacy that every few years, people talk about how trading trends no longer works, trend following is so 1980's, etc. All this talk usually coincides with a period of poor or non-performance.

We know that markets always go through different market 'states' - either trending or non-trending, stable or volatile. What we don't know is when they will move from one state to another. And when they do start to trend, we can never predict the magnitude of the resultant trend.

A reality check - looking at drawdowns

Quite often I meet or correspond with people who seem to think that they can pull a certain amount out of the market on a regular basis. This is impossible - particularly when using a trend following method. 

Depending on your timeframe and parameters, you can easily go weeks, months or even years before new equity highs are made. Therefore, you will actually spend the majority of your time stuck in a drawdown. 

For a lot of people who may be attracted to the potential overall returns of a method, the reality of what you have to go through in terms of drawdowns (both in monetary and time terms) to achieve those returns can be difficult to accept.

Choosing not to play - how one trader approached the EU referendum

"Systems trading is ultimately discretionary. The manager still has to decide how much to risk to accept, which markets to play, and how aggressively to increase and decrease the trading base as a function of equity change. These decisions are quite important - often more important than trade timing." - Ed Seykota

Two weeks have past since the result of the EU referendum here in the UK was announced.

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.

Reckless risk - and back to square one (again)

A while back, I talked about a long-time friend of mine and his battle against repeatedly losing all his hard earned gains in his own trading account (the original post is here).

I had not spoken to him for a couple of months, but he called me yesterday. Sadly, he had done it again. So what had he done this time?

Longevity is the key to success

For a trend follower, the lack of decent trends over the last couple of years or so in the stock markets was perhaps expected - 2008 on the downside, followed by 2009 and 2010 on the upside were fertile periods to profit from price trends. 2011 was a difficult year for me, whereas 2012 and 2013 offered favourable conditions.

New testimonial

Craig is an experienced trader based in London who approached me a few months back to assist him with his trading development. He has been kind enough for forward the following testimonial:

The reality of trend following

Look at the performance records of some of the successful trend followers over the last 20+ years. You will see that there are plenty of losing months - as well as losing years.

These are people who have been successful over the long-term. Yet, how many individual traders do you know who are able to go through losing months or years? Some can't even stomach a losing week before they want to ditch a proven method and jump on the holy grail seeking wagon.

Don't just work on your method

Studies have been carried out proving that, even with a completely random entry, traders can make money by adhering to good risk control and cutting losing trades quickly. In his book Super Trader, Van Tharp talks about one such experiment with Market Wizard Tom Basso.

Yet, when you talk to inexperienced traders, nearly all of them continuously focus on some form of 'holy grail' to get them in right at the start of a price move - be it based on fundamentals, technicals or some thermo-nuclear indicator they have developed.

For 99% of traders, concentrating on the twin pillars of good risk and emotional control will help far more than continually fussing over how to get in a trade.

Learning from past mistakes - and the markets

For those who have not traded through such a period in the markets before, you have been all geared up for an important educational experience over the three months or so. We have seen a big jump in volatility, combined with a sharp move to the downside followed by a 'V' shaped reversal in the general markets. Ideally, when experiencing these changes in the market state you want to keep your tuition fees as low as possible.

Talking in terms of R - updated

Note: this post originally appeared in July 2014, and has been updated to reflect performance since then.

1R is the amount you risk on each trade. Profits or losses are calculated by taking the result and dividing by the initial risk. For example, if you risk £100 per trade, and you end up with a profit of £500, that's a +5R profit. If you lose £80, that's an -0.8R loss.

I love taking losses - do you?

I was reading another trend following blog the other day when I saw a comment along the lines of "as a trader, you will never be happy taking losses".

Accepting the bumps along the way

If you think you can adopt a trend following approach, and then guarantee that you can pull X% out of the market each month/quarter/year, then you are very much mistaken. Your performance when utilising a trend following strategy will go through peaks and troughs. There may be periods when you are fully invested (up to your own portfolio risk limits), and there may be times when you are fully in cash.

Look at any performance record of a trend follower and you can quickly identify these peaks and troughs. Why do these happen? Very simply, trend followers need trends in whatever markets they are trading to appear. If they don't, then a trend follower will struggle. That you have to accept.