Do you have the patience, discipline and nerve to follow trends?

Why does trend following have such a devoted niche following? One reason is that becoming a successful trend follower requires a real commitment and discipline. It is relatively simple to create such a system, but it can be hard to adhere to the rules (at least in the beginning), and to develop the required mindset to follow the system during periods of poor or non-performance. Traders who are able to work their way through these issues, create a loyal core of practitioners. From there, if needed, come a small number of refinements that can personalise or tailor the approach further to your own preferences or requirements.

When a system such as a trend following has risk control as part of its core components, it is worth taking a closer look at. Trend following has the best of both worlds in that it is an absolute returns approach, but with risk management a key ingredient of its success.

One area however that can put people off trend following is the level of drawdowns that can occur. This normally arises from a bunch of losing trades during volatile and/or non-trending markets. There are different ways you can try and minimise these drawdowns.

In the case of my own approach, volatility is a key component of helping to decide which trades to take, as well as interpreting the overall market conditions. This is then used to help determine my overall exposure to the market. By referring to my cash equity curve or R curve here, you can see how the drawdowns have been contained as far as possible. But by the same token, once I am in profitable trades I do not restrict my profits in any way by using price targets.

It is quite possible that the markets in general may be in a favourable state for trend following only 2-3 times per year - sometimes more, sometimes less. However, no-one can predict when these conditions will change, and how long they will last for. Hence, why both overall portfolio heat and individual trade risk are inherent components of a trend following strategy.

I know of traders (including some who I have mentored) who have seemingly struggled for months, making small losses and small profits, making little or no headway. However, all the while they are learning and developing the necessary risk control, patience, discipline and mindset to follow trends. Then, one day, the markets start to trend. With only a few positions open, some of these trades start to develop decent price trends. In a short period of time, significant returns can be made, not only covering all the previous small losses, but also generating an overall profit. See here for a real-life example.

That is the nature of trend following. There are periods where it can be painful - of that there is no doubt. And that is when most traders who are not truly committed to trend following fall by the wayside. But, when major trends do occur such as in 1999, 2000, 2007-8, 2009-10, and early 2013, that is where a trend follower can see huge increases in their overall returns. If you go back and look at individual stock charts in those periods, you will see that the vast majority will be moving in the same direction as the major market indices. Only the amplitude will be different.

And don't think that its necessarily the underlying fundamentals of a company that will be the catalyst for any move up or down.

Back in 1999, most dot.com companies had no earnings at all! So, if you were trading or investing using fundamental analysis as part of your overall strategy, you probably would have missed all that opportunity on the upside.

The same thing happened in 2008, but on the downside. Even the strongest companies on a fundamental basis saw their stock price driven down by the general market downtrend.

"They say you never grow poor taking profits. No, you don't. But neither do you grow rich taking a four-point profit in a bull market. You might lose your position and with it the certainty of a big killing. It is the big swing that makes the big money for you." - Jesse Livermore

Fundamental to this is having the discipline and patience once you find yourself in some profitable trades to let them play themselves out. While you want to limit your downside at all times (by using good risk control and adhering to your stops), you do not want to limit the upside in your account. You have to let those profits run until such time that an exit signal is given. Given that the typical win rate using a trend following approach is less than 50%, then this is an imperative part of achieving the overall results you want and desire.

So what of the future? Well, below is a chart of the FTSE on the weekly timeframe, which I have posted several times now. This clearly show that there has been no trend in this index basically since May 2013. The Volatility Factor indicator I use shows an extremely low reading, highlighting the dramatic compression in price.

Is this part of a topping out process or a major consolidation before continuing to the upside - who knows? What we do know is that markets oscillate between trending and non-trending phases. When a new trend is signalled, then there will be an expansion of volatility in the direction of the new trend.  And whether it breaks out to the upside or the downside, we will be ready.