Trend following crimes, and how to avoid them

Whether it’s backcombing your hair, wearing espadrilles or employing the services of a bum bag … trends are fraught with potential disaster. And what feels right for one glorious summer … can cause wince-inducing pain when we look back on the mistakes we made.

The lure of the trend is undeniable – and I’m not talking about the decision of whether it’s time to shave off my ‘hipster’ beard … I’m talking about trend-following trading strategies.

When you’re in a trend, it feels great.

At the moment, with the new system I’m developing, I’m short 4 European indices and USDJPY – a total of over 600 points up.

But one of the key characteristics of trend-following trading is that, for every glorious run, there are a string of failed trades. Trend-following systems suffer from low win rates. Personally, I like to be right more often than I’m wrong – so I’ve long struggled to overcome my blind-spot to this style of trading.

So let’s look at what goes wrong with trend-following systems, and how it can be remedied …

The most basic trend-following system is the moving average strategy

Here’s a moving-average crossover signal, telling us where to buy into an up trend, and sell a down trend …

It’s likely that the first few trades will have struggled to make any money, while the buy signal at the end of June could bring in a substantial return.

And this is the reality of trend trading – lose, lose, lose, win …

But these strategies are a great training ground for working on your trade management – i.e. how will you get out of those first three trades with, either a modest profit, or minimal losses?

And how that trading method won’t restrict the spectacular return that trade number 4 could bring you?

The first answer many traders will come up with is … Let’s add another indicator!

And it may be possible to add an indicator that will filter out some of the duff trades. But, in a trading method with a low percentage of winners, we mustn’t risk cutting out any of of those rare profit-taking trades.

So this won’t be the full answer.

Let’s take a closer look at the difficulties we have to overcome, and how we can approach them …

• Don’t force a trend on a non-trending market

There’s no trading fun to be had from sitting on your hands, and that’s exactly why so many of us love to spot trades where there are none. And it inevitably costs us money.

Be patient and don’t try to anticipate a trend that hasn’t happened yet. If it’s a good trend, it’ll have profit enough for us in it.

• Getting into a trend too late

I know, I just said don’t get in too early … but trends by their nature tend to kick off with some momentum, and if we miss these moves, we’ll struggle to make a profit.

The impossible task of perfectly timing our trend trading – not too early, not too late – is why we’re bound to have losing trades … and often. Which brings me neatly to my next point …

• Living with a low win rate

Psychologically it’s tough trading a system where you lose more often than you win, which is why for many years I’ve struggled to find a trend-following system that I’m happy to put money into.

You have to be more disciplined than traders who have high win rates – you can’t afford to miss a winner because you were making a cup of tea!

But as I’ve long stressed, profitable trading isn’t about risk-reward ratios or win rates … it’s about the combination of the two, and whether or not they give you a long-term positive expectancy.

While high-probability trades – ones which are likely to win, can afford to take small profits …

Those with a low win rate must have big winners and small losers. And this task means getting a little hands-on with your trade management …

• A low win rate means we need seriously good risk-reward rates

Here’s where trend-following strategies are made … or fail.

If we trade with tight stops, we don’t give our trends space to run.

But if we trade with wide stops, we’ll struggle to make the necessary returns, compared to risks taken.

And in this dilemma lie the corpses of many a trend-trading system.

Trend-following systems require a ruthless system of cutting losses and letting profits run – something that doesn’t come naturally to most of us. Most traders are desperate to take our profits off the table, and reluctant to admit our mistakes by closing out losing trades promptly.

As soon as it looks like our trend isn’t running … the successful trend-following trader jumps ship. These are the small losses along the way that our big winners will dwarf.

And when the trend is running … the trend trader must hold their nerve – yes, you can take profits along the way, but avoid tightening in stops too close. Big trends need room to breathe.

These tasks take strict trading rules and firm discipline to follow them. (I’m currently fighting the urge to cash in my 600+ points profit!)

It’s taken me a long time to build a trend-following system that I believe is workable – both in terms of risk-reward and with rules that are easy to stick to (practically and emotionally!) So far, the results of what I’ve created are keeping me very happy – I hope to reveal a lot more about this trading method over the summer.

And a final warning (from the man who’s short across 4 European indices at the same time!) – beware of doubling up on risk in correlated markets. Markets are more highly correlated than ever before, and big trends will tend to run across global markets (indices and any currency pair including the US Dollar), so be aware that if you’re trading the same trend across a number of markets, you’re increasing your risk level with every trade you open.

And fear not – there’ll be lots more details of the system I’m developing coming over the summer … watch this space.

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