Trend Following & Trading Systems

INTRODUCTION

The biggest mistake both traders and investors make is thinking it’s ‘easy‘. Nothing worthwhile is ever easy! Do you allow yourself to fall for the advertisements promising, “Get rich by trading” or “Earn all the income you’ve ever dreamed of” perhaps “Leave your job and live off your trading profits.”

Being a market veteran (40 years and counting) sometimes you just feel too fed up, sick and tired of all the “technical indicators”, “misplaced fundamental analysis”, “holy grails”, “gurus” be they volume masters, e-wavers, or just the perma types (bull and bears).

In time you come to realize that No One knows where the market will be tomorrow or next week or next year.  Despite what the gurus and pundits would like you to believe. The Madoff scandal and scandals like Madoff’s are made possible because so many “wanted to believe.” If you look at enough charts, you’ll eventually walk away with the feeling that most often the chart says it can go either way.

Then finally one day you come to  realize that trading is NOT about being right or wrong! Trading is about managing your money and assessing risk. Are you reading this because you want your account to grow or because you want to be right?

Peter Bernstein when asked in 2004 to name the most important lesson he had to unlearn, he said: “That I knew what the future held, that you could figure this thing out. I’ve become increasingly humble about it over time and comfortable with that. You have to understand that being wrong is part of the investment process.

ARE YOU A TRADER?

First and foremost let’s discuss what a trader is and eliminate some of the misconceptions, even some myths. A securities /commodities trader can be one who sits in front of a screen all day long buying and selling. While that is the common concept, a trader is one who buys something in hopes of selling it at a higher price be that five minutes from now or five years from now.

Buy and hold makes the assumption that you are better off never ever selling what you own. Fact of the matter is that even if you never sell, your heirs, whom inherit your shares will, as they have no attachment. Someone will receive the proceeds; eventually. Even the biggest proponents of buy and hold; sell. Research Warren Buffet and see if he ever sells and you will find the answer is yes except for those companies he buys outright.

In many respects we are all traders, the only difference is the time frame we operate. If you buy an asset, be it a stock, commodity, product, or information and you intend to sell at some point in time then in essence you are a trader. You might be a businessperson, buying from a manufacturer and selling to a company or individual. You are a trader. If you sell what you bought and paid for or financed today or you sell it in a year you are still a trader, you have made a trade.

If a businessperson pays $X for his inventory, he hopes to sell it for $Y which is $X + a profit. If he/she cannot sell that inventory for whatever reason price is reduced to attract buyers. Hopefully for the businessperson the reduced price includes some kind of profit but realize it may not; it may result in a loss. Trading stocks and or commodities follows the same principles. Basically you buy a quantity (shares or contracts) in hopes of selling those shares or contracts at a higher price.

WHY MOST FAIL

The difficulty in any type of trading, securities, commodities, or as explained above is not in the concepts but in the application of said concepts. It is fairly easy to learn “what to do” the difficulty is bringing yourself to actually do it.

Everyone knows that traders face risk. What investors are just recently learning is that they too face risk. Think back just a few years, did any of you foresee the credit crisis, the collapse of banks and almost the entire financial industry.   Did you foresee the Internet bubble, the Asian Contagion, the blow up of Long Term Capital Management? Who would have ever thought that a conservative bond investment in General Motor’s would become worthless? We, and I am a member of the baby boom generation, would have believed that our investments for retirement in mutual funds could be so devastated causing many to put off the retirement they had been so looking forward to.

The great failing of traders and investors alike is emotion! “Human emotion is both the source of opportunity in trading and the greatest challenge. Master it and you will succeed. Ignore it at your peril” Curtis M. Faith (one of the original Turtles)

Academia has uncovered a large amount of evidence that demonstrates most individuals do not act rationally. There are dozens of categories of irrational behavior and errors in judgment. Think for a moment about the lows recorded in the bear markets of 2000 through 2002 and most recently the lows in March of 2009? Did you avoid opening your brokerage and 401K statements? Out of sight, out of mind control of your emotions. Or did you sell at the bottom before it obviously went to zero? Did you hold on to your General Motors figuring there was no way they could go bankrupt? Six months or so prior to that bankruptcy senior management was denying it was even an option.

Under duress poor risk assessments and probabilities are more the norm than not. Behavioral finance has proved that when it comes to such people rarely make completely rational decisions. Successful people understand this.

“The current proliferation of electronic technologies — computers, the Internet, cell phones, 24-hour news, and instant analysis — tend to distract us from the essentially human nature of markets.

  • Greed
  • Hope
  • Fear
  • Denial
  • Herd behavior
  • Impulsiveness, and
  • Impatience with process

{‘Are we there yet?’) are still around, and if anything, more intensely so.  Few people have absorbed the hard neuroscience research that reasons arrive afterwards.  That given the choice between a simple, easy-to-understand explanation that works and a difficult one that doesn’t, people tend to pick the later.  People would rather have any story about how a series of price changes happened than that there is no rational reason for it.  Confusing hindsight with foresight and complexity with insight are a few more ‘cognitive illusions’ of Behavioral Finance.”  – Charles Faulkner

Trading systems can help control those emotions however they can also add to them.  Trading systems are not for everyone and no single trading system is right for all those interested in trading systems.  We are all individuals with differing goals, finances, and risk tolerances.

TREND FOLLOWING

A trader who follows trends attempts to capitalize on large price movements over perhaps many months time or even longer.  A trend following trader will look to enter trades when a trend becomes, according to their chosen methodology, apparent and will look to exit that trend prior to or shortly after the trend has reversed.

Trend following has been shown to generate excellent returns over long periods of time and has done so on a fairly consistent basis.  It is however, not an easy strategy for most people to follow.  Large trends occur fairly infrequently.  This simply means that trend following strategies generally have a higher percentage of losing trades than winning trades.  This can play havoc with ones psyche.

As a general rule one can expect a trend following trading system to have draw-downs (loosing periods) about equal to the expected return.  That is to say if your trend following system is expected to return 30% per annum, draw-downs will then likely be about 30% from the highs.

Trend following generally requires a relatively (compared to other techniques) large amount of money to trade using reasonable risk limits because of the distance between entry and exit prices.

To mitigate some of these factors at least two factors are introduced.  First is a diversification across markets (ETF’s) that do not correlate well and second utilize position sizing and pyramiding to reduce the risk metrics to a very reasonable level.

There of course are trading systems that deal with other philosophies such as countertrend trading and swing trading however, at this stage the Prudent Trader will be concentrating solely on trend following systems on ETF’s, Indexes, Stocks, and later Futures.  Perhaps after they are set up and running well we will move on to others.

ON THE NATURE AND ORIGINS OF TREND FOLLOWING

Although trend following has been a popular trading philosophy for many years,surprisingly little has been written about its origins and history. This is partly due, no doubt, to the scarcity of available information prior to the early 20th century, and because until about 50 years ago trend following as a philosophy had not been completely articulated. To be sure, by the early 1950s many trend following methodologies were in common use – and may have been for centuries – but the underlying concept had not been fully defined, or even given a name…

Complete article courtesy of Michael Covel,com and written by Stig Ostgaard:  Click Here!

TRADING SYSTEMS

PAST PERFORMANCE IS NOT A GUARANTEE OF FUTURE SUCCESS

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