“All through time, people have
basically acted the same way in the market as a result of greed, fear,
ignorance, and hope. That is why the numerical formations and patterns recur on
a constant basis.” –
Jesse Livermore
Trend
Following is built upon the premise that trends exist in the markets. These trends can be identified using specific
criteria. Traders can employ a
systematic process, discretionary process, or a combination of those two
trading processes. Predicting price
trends is nearly impossible and, as leading behavioral economists report, an
“illusion” (CFA
Institute). Further, consider the observations of Linda Raschke, a stocks and futures
trader featured in The New Market Wizards: “In the world of money, which is a
world shaped by human behavior, nobody has the foggiest notion of what will
happen in the future. Mark that word – Nobody! Thus, the successful
trader does not base moves on what supposedly will happen but reacts instead to
what does happen.” Trend Following is referred to as a reactive
form of technical analysis, not predictive.
Trend Following Traders use proprietary trading signals that identify a
possible trend underway in an instrument.
These signals are based upon centuries of empirical evidence which
suggests that a market or security should trend in a certain direction once a
particular set of criteria is met. Trend Following is a probabilistic process
by which trades are placed based on objective data and not a subjective bias or
a commonly accepted investing heuristic.
Or, as John Henry of John W. Henry & Co. puts it, “If you take
emotion – would be, could be, should be – out of it and look at what is, and
quantify it, I think you have a big advantage over most human beings.”
Brandywine
Asset Management offers the following perspective on Trend Following:
“Trends
exist and are perpetuated because winning behavior is reinforced, even if it’s
wrong. The distribution of stock market
returns shows strong evidence of trending behavior. A simple trend following strategy employed
across a diversified portfolio of just 24 uncorrelated markets can produce
returns relative to volatility and drawdowns that easily exceed that of
buy-and-hold strategy in stocks. If you were going to make a single investment
and had to choose between the S&P 500 and the S&P DTI (Diversified
Trends Indicator), the clear, logical decision is to place the money in the S&P
DTI.”
Furthermore,
AQR Capital Management provides the ensuing insight from its examination of
overlaying a Trend Following strategy with a century of market data. “A large
body of research has shown that price trends exist in part due to long-standing
behavioral biases exhibited by investors (e.g. anchoring and herding), as well
as the trading activity of non-profit seeking participants (e.g. central banks
and corporate hedging programs). The fact that trend following strategies have
existed well historically indicates that these behavioral biases and non-profit
seeking market participants have likely existed for a long time.”
Complementing
the work of AQR, the authors of the research piece entitled “Two Centuries of
Trend Following” (Bouchaud, J. P.) offer
the following observations:
“Trending
behavior is also observed in the idiosyncratic component of individual
stocks. There are two, possibly
complimentary, interpretations in research. One, agents under-react to news,
and only progressively include the available information into prices. For example, an announced sequence of rate
increases by a central bank may not be immediately reflected in bond prices
because market participants tend to only believe what they see, and are slow to
change their previous expectations.” This is referred to as “conservatism bias”
in behavioral finance. “Policy changes
are slow and progressive, thus not immediately reflected in asset prices. This gradual acceptance of change leads to
trends. Two, building upon the first
point, market participants’ expectations are directly influenced by past
trends. This, referred to as “extrapolative
expectations,” demonstrates how linear extrapolation is a strong anchoring
strategy. As a result, this perception
of trends can lead to positive feedback trading which reinforces the existence
of trends, rather than making them disappear.” In other words, trends are
self-fulfilling, recurring price anomalies observed and perpetuated by market
participants.
The trending
nature of prices is clearly evident to all traders. However, employing a process that exploits
trends in both up and down directions is not vastly accepted by the
participants in the marketplace. As
previously mentioned, Brandywine Asset Management contrasted the efficacy of
buy-and-hold to that of trend following.
While the latter process is under-utilized and not well-understood by
investors, the empirical evidence suggests that your bottom line will be better
off with a Trend Following strategy.
Additionally, the risk-adjusted returns will exhibit less volatility
thereby causing less emotional and psychological strain on the investor. As anyone with money at risk knows, the loss
of “emotional capital” can take its toll and disrupt a trader’s process. Trend following allows for losses to be
minimized through the use of stops at the position level and through
implementing a risk management policy at the portfolio level.
While this
risk management process is effective in practice, it is extremely hard to
execute. This is because trend following
risk management processes run directly counter to our natural behavioral
tendencies. Behavioral economists refer
to this as “loss aversion” or Prospect Theory.
Simply stated, investors value gains and losses differently. Understandably, people have a natural
tendency to avoid losses and prefer gains.
However, this innate emotional propensity predisposes investors to
missing the best opportunities in investing.
In other words, the investing public, by and large, will sell positions
to generate small gains and meet some psychological need (e.g. the need to be
“right”). At that same time, these
participants will let losses increase and even “average down” into a position
thinking that if a security costs less now and more can be bought, then it must
be a better value. This belief system is
pervasive among buy-and-hold investors and most traditional, relative-value
institutional money managers. However, Dr. Van Tharp offers the following
insight:
“Most
successful speculators have success rates of 35-50%. They are not successful because they predict
prices well. They are successful because
the size of their profitable trades far exceeds the size of their losses. This requires tremendous internal control.”
As can be
observed from Dr. Tharp’s extensive work with elite traders, most have
win-to-loss ratios that would not be appealing to the investing public. However, because a predetermined risk
management budget is put in place, the loss per trade is quite small and
drastically less than the average winner (e.g. a 2:1 Win-to-Loss ratio is a
baseline for most profitable trading strategies). Moreover, as positions continue in the
direction of a trend the trader has the ability to “leverage up” in the trade
(i.e. buy or short more). As a result,
good money is not thrown after bad (i.e. “averaging down”). Instead, once closed, money from a losing
position is redeployed into winning positions.
This is the essence of trend following in practice and reinforces
Brandywine Asset Management’s assertion that “trends exist and are perpetuated
because winning behavior is reinforced.”
Marcel Link, a professional trader and entrepreneur, echoes this
sentiment:
“Trades that
have the highest probability of working are usually in the direction of the
trend; fighting the trend means fighting the market’s momentum. A trend is in place for a reason: The market
participants as a whole believe that the market should be headed in that
direction.” Link’s comments explain the
essence of Trend Following’s nature.
Instead of a
perceived skill in the trade identification process (e.g. predicting price
behavior or forecasting fundamentals), whether or not a trader will be able to
generate alpha (i.e. excess returns over a benchmark or the risk free rate) is
determined by the risk management and position sizing processes employed. For example, a simple, random stock selection
study conducted by Tom Basso while running Trendstat Capital Management
generated a 38% win rate but was profitable overall. The entry (either long or short) was
determined by a coin flip (i.e. 50% chance of being long or short) and 1% of
the portfolio was risked per trade with a 3 Average True Range (ATR) trailing
stop. This study further demonstrates
how proper risk management is more important in developing a winning system
than the choice of trade identification methodology if profitability could be
achieved through random selection.
In essence,
Trend Following is a systematic trading process where traders react to
breakouts, manage risk using pre-defined stop-loss levels, and leverage up into
winning positions. While this is extremely easy to conceptualize, actually
practicing Trend Following can be difficult due to particular behavioral biases
or pervasive beliefs throughout money management concerning the power of the
prediction. In fact, the lack of knowledge of and conviction in Trend Following
will allow for its efficacy to persist since market inefficiencies and price
anomalies will go unnoticed by most market participants.
As always,
please feel free to contact me with any questions.
JD
Comments
Post a Comment