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.

Current market volatility and staying the course

In the last couple of weeks we have seen an ever-increasing level of volatility within the context of a sharp drop in price in the major market averages.

We have also started to see intervention in the markets by governments and regulators - additional liquidity being provided and interest rate cuts, as well as market trading halts (up and down) being triggered and the introduction of short selling bans on certain stocks.

Trend following and Epictetus

The stoic philosopher Epictetus once said that “We have two ears and one mouth so that we can listen twice as much as we speak.”

In the world of trading however, plenty of participants seem to think they have two mouths and one ear. They aren't interested in listening; they are simply wanting to speak - often over the market itself.

Using volatility contraction to increase your profits (part 2)

Following on from my previous post about the use of volatility-based position sizing, here is a little wrinkle you may want to consider:

Typically this type of position sizing method is calculated using a multiple of Average True Range over a specified 'look back' period, and is normally expressed as a pure monetary number. So, in the second example in the previous post, Stock B priced at $20 had a 2ATR reading of $1.

Letting the downtrends run

Having more losing trades than winning trades is to be expected as part of a trend following process. 

Part of the joy of trend following is that you never know when you will end up in a profitable trade, and once we do, we have no idea how long the trend will last for, and also how far price will move in our favour.

It is what it is

This is just a brief post, after seeing some comments on social media referring to the price action in the general markets (particularly in the US) today. 

I've seen some refer to it as 'ugly', while others are saying they have never come across price action like this, before looking to blame others for making price action react in a way which didn't conform with how they thought it 'should' have moved. 

Well, in answer to those:

Recency bias, and labelling markets as easy or hard

I've seen it said that one of the goals you should have as a trader is to try and make money when things are easy, and that you should be more defensive and protect what you have when things are hard.

That is all very laudable, but from a trend follower's perspective there is a problem with that.

Trading the line of least resistance

A lot of the people who were profitable in 2008 became unstuck the following year. They seemed to get in their head that, once the markets started rallying, they were anticipating a further, more pronounced price drop.

In the summer of 2009, they got their chance. There were numerous trading blogs of the day talking about a 'head and shoulders' pattern which had formed on the indices between May and June, and they were going to use this as a trigger to go short the market, and really make a killing.

Trend following - a simple way to playing the long game

Warren Buffet once said “There seems to be some perverse human characteristic that likes to make easy things difficult.”

A good trend following approach allows you to participate in the equity and other financial markets eliminating a lot of the difficulties.

Your basic rules will tell you:

• what to do;
• when to do it; and
• how much to risk.

You can trade 'parrot-fashion'. No opinions or predictions are required. You simply follow price, see how it interacts with your chosen entry and exit parameters, and only then do you need to do something.

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.

Richard Dennis, bubbles and crashes

To me as a die-hard believer in trend following, I never see market bubbles and crashes. To me they are simply uptrends and downtrends which, if you and your method can embrace the volatility, generate the types of moves where we can generate massive profits.

Jesse Livermore, the Dow and the changing market state

Below we have the current daily chart of the Dow. This is a classic example of a 'tale of two market states'. Up to the beginning of February, we can see a stable (low volatility), trending state. And from the beginning of February to date, a volatile, non-trending state. This is highlighted by the rise in the readings of the volatility factor indicator and the 2ATR measurement.

The payback for following your rules

Quite often I get into a trade where price starts moving nicely in my favour, before reversing and taking out my stop, leaving me with either a significant erosion of open profits, or may be even taking a small loss. 

Not very interesting or exciting I know, but that is what following my rules allowed me to get.

A tale of two setups

Rather than talk about the recent market shenanigans, the chart of the Dow covering the last few months offer us a good chance to compare a low volatility setup against a higher volatility setup.

Keep your eyes open for stocks bucking the trend

As a breakout trader, I only ever go long on new highs, or go short on new lows. Therefore, while the longer-term trend in the general market is still intact, the recent pullback or consolidation (not only in the major market averages, but more importantly in lots of individual stocks), in theory makes it difficult for me to participate.

One of the reason I am continuing to run through my scans and keeping my watchlists up to date is that you may find individual stocks that are bucking the trend, so to speak. 

Discount offer - 3 days left

A quick reminder that the discount offer for 1-2-1 training or mentoring expires in 3 days.

Be part of our team of like-minded traders, and use the timeless principles of successful trend followers and Market Wizards.

Those who do not have the desire to succeed, are not committed to put in the necessary work, or who do not want to learn to think for themselves with a trend followers' mindset need not apply.

My biggest loss in 4 years

So, let's not beat around the bush. This morning I suffered my largest loss on a single trade since the summer of 2013.

As of yesterday's close, the position was +1.13R in profit. Within a few seconds of the market open, I was stopped out for a -1.95R loss.

S*@t happens. Let's look at the chart:

Richard Dennis, trend following and leaving your ego at the door

The siren call of the high win rate strokes the ego of many traders, and this causes internal conflict amongst people who aspire to be trend followers.

Left unchecked, the ego within us would make the desire to be seen to be right its primary focus, rather than to make money. But this goes against the grain when it comes to trend following, where the typical win rate can be between 30% - 40%.

Coming up - new trade record

Regular readers of the blog will know that I kept track of all trades taken and the associated performance metrics covering the period July 2012 to April 2017, at which point I took a short break from the markets.

PDF copies of those records are available here.

This covered the good, the bad and the ugly of trend following. Sure, there were losing trades (lots of them!) and losing phases, but that is the nature of the markets, and typical of this type of approach to trading.

Despite a win rate of only 30%, the annualised returns equated to almost +75%, with an overall return of +470%.*

This can only be achieved by following the time-honoured principles of trading breakouts, cutting losses, letting your profits run and using good risk control.

As from 01 November, I will be starting a new record of all trades taken going forward, with all of the same metrics.

The fallacy of value investing - with Neil Woodford

This week, star London-based fund manager Neil Woodford talked about his recent poor performance, mainly as a result of the huge losses suffered in his holding in Provident Financial.

Below is the chart, which tells its own sorry story: