Spinning your wheel(s)

A few weeks back, I spoke to a trend follower who had been experiencing a frustrating period in the market. This particular individual previously worked in the City of London and has a strong regard for good risk control.

In the time I have known him, he has also shown a great level of ‘emotional indifference’ towards any losses – the psychology involved in trading has never been an issue for him. He has one of the best mindset approaches I have come across.

That said, he was getting a bit frustrated with the lack of progress in terms of actual profits being generated.

I reminded him that, while the historical win rate for a trend following approach is typically 30% - 40%, there can be periods where a sample of trades can generate a win rate outside of that range – in either direction. I have experienced trend-friendly periods where my win rate has exceeded the dizzy heights of 50%! On the other hand, in a choppy, non-trending, whipsawing or volatile phase, that is when you can experience the runs of consecutive losing trades and the resulting drawdowns.

This particular trader has been experiencing once of those latter phases.

He asked me to look at some of the setups he had recently as he was concerned about the signals he was taking, and the resultant losses - in other words, was he still trading correctly?

Looking at the charts of the stocks he had traded, I couldn’t fault the signals taken – quite a few of them I would have loved to have traded! He was also taking his losses in accordance with his rules.

We talked about his performance metrics. He called his win rate "terrible" and indeed over recent months it is below the typical range. Against that, however, the profit factor is higher than my own, showing that, on average, profitable trades were well in excess of 5 times bigger than the losing trades. Therefore, he only needed a very small improvement in his win rate for his overall performance to start swinging around.

It so happens that this period of non-performance coincided with a choppy, non-trending phase where lots of stocks were attempting to break out and start new trends and were quickly failing.

So the conversation was (hopefully) able to provide some assurance that he was still seeing things in the way he should, that he was still making good trading decisions, and that things outside his control (i.e. the prevailing market conditions and the price movements in the stocks or instruments he was trading) were contributing to his frustration.

Sometimes that is all it takes.

Since then, I know he’s taken a few trades, and some of those are in profit. One trade in particular is starting to motor in his favour. 

Seeing the charts of those trades, those open profits have already covered a whole bunch of small losses he has recently suffered. Of course, the profits may evaporate if the current price direction reverses, or they may continue in the direction they are currently travelling. Who knows?

So, is he thinking of taking those profits for fear of losing them? Absolutely not. He knows that he HAS to let those profits run to get the big winners which help him achieve the overall positive expectancy of his approach. Trying to be 'smart' and cutting those winners would be self-defeating.

Trend following is a fat-tail approach to the markets. And you will have to accept that there may be profitable periods, mixed in with plenty of dull periods when nothing much is happening and you are basically treading water, primarily concerned with keeping any losses and drawdowns to a minimum. 

It is in these non-performing periods that you may have the feeling you are furiously running on a hamster wheel, and getting nowhere.

Successful trend followers like Richard Dennis, William Eckhardt and the Turtles will tell you that a relatively small number of the trades taken will generate almost all of your overall profit. In effect, trend following performance is an extreme example of the Pareto Principle, which I talked about here.