The science & success of trend following: Part II

In The science & success of trend following: Part I, I revealed what trend following is, and where it came from. In Part II I expose how trend following works. I also try to answer the question: If trend following is so profitable, why aren’t more traders trend followers?

How does trend following work?

The success of trend following is based on the simple premise that markets only really do two things. They trend, or they consolidate. That is, they move in an upward or downward trend for a period of time, and then they go sideways for a period of time.

There are many different trend following systems that look to exploit this understanding, including those that use breakout systems, moving average systems or volatility systems. All of them, however, use the current market price in combination with one or more technical indicators and overlays (such as moving averages and trend channels) to determine the direction of the trend and to generate buy and sell signals.

According to Russell Sands, the turtles used several different trend following systems, one of which was a breakout system which used daily bar charts.

The system defined a breakout as a market that moved higher or lower than any price on the previous 20 bars. As Sands puts it, “The market has to go higher or lower than it’s been at any point in the last 20 days for me to get interested.”

Sands stresses the point that the stronger the breakout the better the returns are likely to be: “30-day highs are better than 20-day highs, 50-day highs are even better, 6 month highs are even better, annual highs are even better, life of contract highs are even better.”

NB: The turtles used daily bar charts. Using shorter duration bars such as 30 minute or 5 minute bars is not recommended due to the cost of trading commissions.

The turtle traders looked to trade markets that were breaking out of long consolidations. That’s because the longer and tighter the consolidation, the better, or sharper, the breakout tends to be.

Other rules that formed the basis of the system used by Sands and the other turtles include:

  • You must exit your position when the market makes its lowest low (or highest if you are short) in the past 10 days.
  • Use 2% of your capital as a “hard money stop loss” in case the market moves against you.
  • Do not use a profit target. The only way you get out of a profitable trade is when the market turns against you.

In addition to these basic rules Sands reveals that they did add to winning trades, however they never added to losing ones.

Another vital aspect of trend following is money management. Money management, which in this context is the same as risk management, dictates how much capital you place on each trade, and when you must take a loss. In trend following, money management is the difference between success and failure.

According to Sands the original turtle trading system still works today. He recently stated that if you had started with $10,000 at the beginning of 2007 and followed the rules used by the turtles, you would have ended the year with $25,000.

Some trend following systems use moving averages to issue buy and sell signals. The chart below shows a simple system which uses the 20-day moving average in combination with the 45-day moving average. When the 20-day crosses above the 45-day, it issues a buy signal, and when it crosses below the 45-day, it issues a sell signal.

A 3 year chart of cotton

A 3 year chart of cotton

Chart courtesy of stockcharts.com

A trend following trader using this system would have gone long cotton at around 18.00, and would have sold at around 47.95, producing a gain of 166%. They would have then reversed their trade and gone short capturing more profit as the price of cotton declined.

Because such a simple system would issue many non-profitable trading signals during the consolidation phase, it is likely that traders would combine the use of moving averages with other technical indicators. In any event, a typical trend following trader will rigorously back-test their rule-set against historical market data before using it in anger.

As Michael Covel, author of Trend Following: Learn to Make Millions in Up or Down Markets, explains, “great trend following systems use rules, logic, parameters, methods, processes, formulas, data, and research.” Nothing is left to chance.

If trend following is so profitable, why aren’t more traders trend followers?

Trend following traders are concerned only with what the market is doing, not what the market might do. As a result they are never blindsided by black swan events such as the 2008 financial crisis. In fact, according to Covel, most trend followers “made fortunes. Often from 50% to more than 100%” during that year.

There is no doubt that trend following can be an extremely profitable trading strategy. It is also very simple to understand and takes no special skills or even experience. So why aren’t more traders trend followers?

The reason is that trend following takes extreme levels of patience, discipline and resolve. Traders using a trend following system have to be prepared to be wrong, i.e. make losing trades, for weeks, or even months at a time, and because of that very few traders are capable of sticking with it. In effect, the market doesn’t beat them, they beat themselves.

As humans we have a tendency to become mentally destabilised and as a trader, that is your biggest enemy. As Russell Sands jokes, “There are only three things that will mentally destabilise you: making a lot of money, losing a lot of money, and breaking even.”

Another reason that more people are not trend followers is that most traders and investors don’t like to admit that they don’t know where the market is going.

Interestingly many of the best trend followers today use computer programs to execute their strategy. That’s because computers don’t have an ego to contend with. They just follow the rules they are given day in, day out, and that is the key to being a successful trend follower.

The bottom line is that trend following just isn’t sexy.

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