Sticking with the process

My historical win rate is about 30%, so with the majority of my trades generating losses, I have learnt to accept losing money along the way.

To me, what is far more important than the monetary outcome of any one trade is whether I am sticking to my process and my execution:

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.

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.

Using volatility contraction to increase your profits

Often you see people talking about a winning trade, and how far in percentage terms price moved in their favour after entry.

But on its own, this doesn't tell you anything - to me, it is a worthless metric when evaluating performance.

As a trader, I'm far more interested in the size of the profit (or loss) generated when expressed in terms of R.

Experiencing the first big winning trend

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.

Questioning some popularly-held beliefs

Stripping back our beliefs and subsequently our rules to their absolute basics, as trend followers, ideally we would want to be able to:

• generate an entry signal as early as possible into a new trend;
• exit a non-performing trade, if the new trend has failed, as soon as possible; and
• allow our position to run as far as possible on our chosen timeframe until that trend is invalidated.

Around those basic concepts people can follow pure price data or utilise technical analysis to 'formulate' their entry and exit rules.

As I've said before, I can be a bit of a trading heretic, and like to challenge some of the more popularly-held beliefs about how to trade successfully.

Below are a couple of those beliefs which I believe are worth further scrutiny - the use of multiple timeframe analysis and trend 'filters'.

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.

Trading the downside - remaining faithful to the process

The last couple of months have been very positive as profitable downtrends have appeared in a number of stocks, both at home and abroad. Fortunately, I have been able to profit from some of these (while suffering small losses in a few others!), and while some which developed into downtrends have now triggered their exit signals, prices in others have remained in a downtrend.

This has potentially meant I may have been able to profit from the downwards move while those who trade longer-term trends have had to suffer an erosion of open profits, or even suffering losses, from a pullback or retracement within the context of a prevailing longer-term uptrend.

Another example of a nasty price gap

If you subscribe to the Mark Douglas theory that in the markets anything can happen, at any time, then you will know and accept the potential effect that sudden or unexpected announcements can have on price of a stock or instrument.

Seemingly you can be comfortably sitting in profit on a trade, even with your trailing stop above your entry price, only for a price gap to occur against you, resulting from the reaction to such an announcement.

It is for this reason why I never take into account open profits for position sizing purposes. A profit or loss on a position is not known until the trade is closed. Open profits can disappear - seemingly overnight with little or no warning, and your trailing stop may be rendered worthless.

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.

Volatility issues

Below I have shown a chart of the Dow which highlights the split personality of the markets in recent times.

Up until the end of January, we can see the market clearly in a trending, stable (i.e. low volatility) state. From there, the chart is a mess, and the Volatility Factor and 2ATR measurements clearly show the explosion in volatility.

An example in trade management - the trailing stop

When trading using a clearly defined set of rules, it can easily become frustrating for an inexperienced trader to get stopped out of a position, only for price to then reverse and start moving back in the direction of your trade.

Some see that as a weakness of their method. Yet I, and many other traders who religiously follow their rules (be they automated or not), see that as a strength. 

An example in trade management - the breakout stop

A few days back, I posted here about the potential long set up on Gold that was forming. Lo and behold, later that day price broke out.

Once you are in a trade, the next stage to consider is the ongoing trade management and the use of stops. So we will look at the updated gold chart (shown below) to see how I do this.

Back to cash

Price action earlier in the week meant the trailing stop in my last position was hit, taking me completely out of the market.

Over the preceding weeks there was a dearth of setups which met my own criteria - and the few that did simply didn't trigger an entry.

As always, I have NO idea what is going to happen, both in the market averages in general, as well as the individual stocks I am looking at.

All I can do at this stage is continue to look for potential opportunities in accordance with my own criteria, maintain my watchlists, and wait to see if any entries are triggered.

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.

Not 'jumping off' the ride, and letting trades play themselves out

A trend follower never takes positions based on predictions or opinions about what may happen. Trend following is reactionary, and based on what price is doing - therefore price has to show some strength before you look to go long, or some weakness before you look to go short.

Just as importantly, trend followers never try and predict potential turning points in a market. There is a process where price can look to change trend from one direction to another - this can happen very quickly, or in some cases take several months! Generally speaking though, this takes time, and a single day's movement does not constitute a change of trend.

It is for this reason that trend followers never get out of an existing position at the extreme of the move. There is always a process of 'giving back' some of the open profits before an exit signal is triggered, and/or a change of trend is signalled.

Trend following and the ‘V’ shaped reversal

Occasionally when utilising a trend following method you have to deal with a ‘V’ shaped reversal. This is where, after moving strongly in your favour, price decides to sharply reverse direction, before your trailing stop has had chance to 'lock in' the bulk of those gains.

This type of price reversal can be the bane of a trend follower. I know my own basic approach struggles with them.

Some thoughts on stops

There are some inexperienced traders out there who seem to have a strange attitude towards the use of stops. A stop should be based on a price level where:

a) their trade idea should be proven to be invalidated;
b) the loss incurred tallies with the pre-determined amount they are prepared to lose on that trade.

A frustrating week - and a look at stops

Last week was a frustrating week. At one point I had three positions open but by the end of the week I was back to being 100% in cash. Lets look at what happened:

Oprah Winfrey and Weight Watchers

In my last post, I talked about putting on very few positions recently. Those who have checked out the trade list will have seen that one of the few was US stock Weight Watchers International Inc. 

Having been starved of many trading opportunities due to the market volatility, I was hungry to get back into the market. This came up on my scans a while back and when it triggered an entry I duly entered a position in mid-September (see chart below). As it turns out, my stop got hit triggering a modest loss a few days later.