Trend Following Trading Systems

How Much Starting Capital Do I Need?

There is no stated minimum capital to trading as a trend trader. There is no magic number. There are many factors related to starting capital not the least of which is your own personal discipline and ability to stick with a trading system. Read more on starting capital issues for trend followers.

Fat Tails: Trend Following Traders Make Their Money in the Tails

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Michael Mauboussin offers clarity on outliers in trading. While Mauboussin concludes standard finance theory has little to say on the subject, we note trend followers regularly hunt and win outliers in the trading game.

Bell Curve and Outliers
Full House The Spread of Excellence From Plato to Darwin

Blackjack and Trend Following Trading

Blackjack is the only gambling game that is not determined by chance alone. The shrewd player can influence the outcome by counting the cards and using a system. The fact that most casino visitors unconsciously aim at losing or play for the thrill creates chances for the rational gambler, the one who sits down at the blackjack table well-prepared and poised to win. The key is to have the odds on your side and bet properly. The same goes for trading. A former student of Richard Dennis once said:

When you are invested properly, money management is relatively simple. [We] adjust trading size for profits and losses using Richard Dennis’ model for volatility. No trader can control volatility completely, but you can improve your odds.

Improving those odds or getting at the probabilities is central to any trend following trading system. Pierre Simon knew and wrote about this concept in his book, Theorie Analytique des Probabilites, back in 1812:

It is remarkable that a science which began with the consideration of games of chance should have become the most important object of human knowledge. The most important questions of life are, for the most part, really only problems of probability.

What else do winning blackjack players and great trend followers have in common? More than you think:

  1. They are in business: Successful blackjack players and great traders pursue their goals as a business, not as a leisurely pursuit. From blackjack to trading, making serious money demands they get serious. As a result, the winners take a completely different approach towards betting from people who play for the action, the excitement and, of course, the dream of winning big.
  2. They keep records: People who are successful at either trading or gambling, keep detailed records. Keeping records builds confidence and discipline. You are keeping a journal of your decision-making of when, where, why and how much you bet on each trade or wager. The idea is to reach a comfort zone for yourself and stay within that zone whenever you are tempted to leave it, which will happen, we assure you. Keeping records is a part of managing your money, and if you are not disciplined in your money management, you are going to lose your entire bankroll.
  3. They are calm, cool and collected: To become even-tempered about money takes practice. You must force yourself to detach. You want to create an abstract money world where profits and losses are viewed in terms of abstract dollars. In this abstract world you don’t get excited about profits and you don’t get down about losses. You don’t want your emotions to go up and down with your account equity. If you can’t control greed, fear and hope — trading might not be for you.
  4. They are running a marathon: Successful gambling, like long-term trend following is a marathon. If you try to sprint, you’re going to lose the race. It’s just business.

The Downsides of Bad Gambling (and Trading)

The following questions are courtesy of The Massachusetts Department of Public Health. We could not help but see their relevance for the legions of losing day traders out there. Just replace the word gambling with trading:

  1. Have you often gambled longer than you had planned?
  2. Have you often gambled until your last dollar was gone?
  3. Have thoughts of gambling caused you to lose sleep?
  4. Have you used your income or savings to gamble while letting bills go unpaid?
  5. Have you made repeated, unsuccessful attempts to stop gambling?
  6. Have you broken the law or considered breaking the law to pay for your gambling?
  7. Have you borrowed money to pay for your gambling?
  8. Have you felt depressed or suicidal because of your gambling losses?
  9. Have you been remorseful after gambling?
  10. Have you ever gambled to get money to meet your financial obligations?

No-Curve Fitting: Trend Followers Use Robust Trading Systems

When evaluating any trading system, hold it to these standards:

  1. It is profitable in a wide variety of market groups
  2. It is not curve-fit or over optimized.
  3. It is profitable across a range of parameters.
  4. Its logic and rules must be fully disclosed with no black box aspects.

More on Curve Fitting

  • Trend following is not a curve-fit. Curve-fit systems customize the trading rules differently for each market you trade, producing unrealistic results. Trend following rules are the same for each market.
  • Computer technology can be easily used to over-optimize a trading system and produce something that looks good. By testing thousands of possibilities, you could create a system that works. However, trying to produce a magical or perfect system falls apart in the real world.
  • Trend following parameters or rules work across a range of values. System parameters that work over a range of values are robust. If the parameters of a system are slightly changed and the performance adjusts drastically, beware. For example, if a system works great at 20, but does not work at 19 or 21 you have a system with poor robustness. On the other hand, if your system parameter is 50 and it also works at 40 or 60, your system is much more robust (and reliable).
  • Traders often only focus on future profits when looking at a system. The key, however, is risk control (or money management). If you control your risk and let your profits run, you position yourself to make bigger money throughout the long term.
  • A good system with robust and adaptive parameters must not require re-optimization. Trend following uses indicators and parameters that adapt to changing market conditions.

Indicator Bullshit: Do You Really Think All of the Indicators Will Help You Win?

We are repeatedly asked: Which is better: MACD or Bollinger Bands? Which is more profitable: ADX or Williams %R?

And we repeatedly answer: None of them. Technical indicators are simply small components of an overall trading system, and not systems in and of themselves. They are like a couple of tools in a tool kit, not the kit itself. A technical indicator accounts for typically 10% of the overall trading success of a trend following system. Comments such as: I tried Indicator X and found it was worthless or I tried Indicator Y and found it useful, make no sense. These statements imply that an indicator is the actual trading system. Nothing could be farther from the truth.

Many popular financial web sites (i.e. CBS MarketWatch, etc.) and many trading books have popularized the idea of technical indicators as Holy Grails. Keep in mind, when you hear the hype about indicators, money management actually makes up the bulk of a winning trading system.

No Predictions

Trend following is not based on support and resistance lines or areas of congestion. Trend following is not based on Fibonacci numbers, the golden mean, nor is it related to the works of Gann or Elliott. The following predictive indicators are not used in trend following:

  • No Bollinger bands
  • No RSI
  • No MACD
  • No OBV
  • No stochastics
  • No ROC
  • No Williams %R
  • No P/E ratios
  • No momentum
  • No Advance/Decline lines, etc.
  • More

These indicators are all designed to predict what a market will do. You can discount all indicators designed to predict a market move. They are not, by themselves, a predictive trading system. Technical indicators are only useful as part of a complete reactive trading system.trend following uses a straightforward, reactive, technical indicator as part of an overall-trading plan. The only true method for trading is a long term trend following system that reacts to the market.

Don’t fixate on the technical indicator used in any trend following system. It’s important, but it is not the key. It’s the tool, but not the kit. Moreover, by itself, a technical indicator is meaningless.

Entry and Exit Straight Talk

Q. My understanding of trend following is that if you want to make money, buy low and sell high. Sounds simple. The trick is to identify entry and exit positions and there is a host of guys out there promising that their particular system will solve all your needs. Right?
A. Why do you feel entry and exit is the crucial issue in trading? What if you have an entry that wins 80% of the time but wins you very little money? And what if you only lose 20% of the time, but when you lose, your losses far exceed your wins the other 80% of the time? Additionally, you don’t buy low and sell high. Good traders buy higher and sell lower all along, focusing on how much money they are making or losing (not just winning percentages). Buying higher means that as a trend moves up you buy more as the price increases. For example, let’s say a trend begins at a price of 5 and goes up a 100. Would you only want to buy at a price of 5 or 6 or 7? Of course not. Depending on your system, you might buy at 20 or 30 or even higher. Not sure what we mean? Email and ask!.

Q. If the trend goes to 100, how do you know it in advance?
A. You don’t know. Let’s say looking back into the past we knew a market went from 5 to 100. The point is to ask yourself, when do you buy? At price levels of 5, 6 or 7? At 20 or 30? Buying more as the trend progresses is what we mean by buying higher highs. Trying to buy low is nonsense. You can’t ever know that it is going to go to 100, but you are fully prepared with a precise well thought out strategy so it doesn’t matter that you don’t know. Whether it’s from 5 to 6 or 5 to 100, you are ready to act.

Q. Are you promoting an alternative way of identifying the trend plus a money management system?
A. Realize that identifying a potential trend is maybe 10% of the overall success of a trend following trading system. The key is not where you enter and whether you have a profit or loss on a position. The key is how big must you be trading based on market volatility. That must be your concern. You’re not interested in the level of the market is; you’re concerned with the market’s volatility. For example, if it’s the day of a crash or the day after a crash, the volatility is a lot bigger. So you should be trading smaller. Lose the concept that where you enter is critical. What is relevant is your current position, your equity and where the market is now.

Editor’s Note: Of course, there is an entry/exit method involved in trend following. But, focus on where real trading success comes from: money management.

How High Will It Go?

The other day we were speaking with a successful broker and he revealed that one of his strategies was to ride a stock up for 30% gains and then exit. That was his strategy. Let it go up 30% and get out. Sounds reasonable. But as trend followers know, this type of strategy is prone to problems. The biggest problem being that it goes against the math of getting rich. He is not letting his profits run!

Tom Basso tells the story of the new trader who approaches an old trend follower and asks, “Where’s your objective on this trade?” The old trend follower replies that his objective is for the position to go to the moon. He says, “I have not had one get there yet, but maybe someday.”

When you trade as a trend follower, your objective is to stay in a position forever. You don’t want to think about exiting. Of course, you have a plan for exiting long before you enter the trade, but the idea is to follow the trend as far as it will go up.

Support, Resistance and Entry

Many people use the jargon terms support and resistance. You have probably heard brokers talk of their importance or TV’s continuous babble of predictions, meaningless advice and analysis. The words are used to describe perceived tops and bottoms in a market.

Unfortunately, support and resistance is a waste of time. Whether the market is going to penetrate support or resistance has nothing to do with your entry price. Your entry price has only personal significance. It has no objective significance in the market. The market is not going to go through a support point or go through a resistance point just because of what your entry price is. The concept is not a relevant factor. It’s hype.

Wealth-Lab: System Testing Software for Trend Followers

Wealth-Lab was founded by Dion Kurczek & Volker Knapp. They recently agreed to an interview to discuss an assortment of trading system related issues.

Q: How did Wealth-Lab get started? What’s the story? There were many different trading software packages out there already. How did you know what you had to offer was needed?

Dion Kurczek:

Because all of the other products I tried to implement my trading system ideas I found lacking. In particular, I wanted to test systems that could maintain multiple positions of varying share/contract sizes independently. I found this impossible to achieve using the existing tools. Also, I realized the value of testing a system against a portfolio with true portfolio-level position sizing rules and risk management. So I started developing Wealth-Lab to implement my own trading system ideas. It evolved into the commercial product and the web site.

Volker Knapp:

Before I discovered Wealth-Lab I had purchased software for over $10.000 and was just considering buying an add-on for TradeStation from RINA-Systems. After looking at Wealth-Lab and talking to Dion Kurczek, the mastermind behind Wealth-Lab I knew that I was talking to one of the most talented software developers and that I had to search no further. BTW, at that time the desktop version of Wealth-Lab was at version ONE and was US $300 at that time.

Q: How much do you attribute the “community” to Wealth-Lab’s success?

Dion Kurczek:

I’d say it was a most important factor. It’s great to have an active online community that can help answer questions from newer users. Also, our community shares and refines trading strategies via the web site, resulting in a unique form of trading system evolution and development.

Volker Knapp:

We are very proud of our active, friendly and helpful community. Trading is often an isolated business, and system trading can be even more isolating. With the Wealth-Lab web site we have created a platform for all traders worldwide to exchange ideas, improve the ideas they’ve collected and share information about the latest in the industry.

Q: Tradestation has been around forever. Why do I want to consider Wealth-Lab? How are you making my day-to-day trading life better?

Volker Knapp:

It is interesting that you ask. Like most people interested in a trading system you think you have to buy the expensive stuff because you want the best. So I bought TS2000i. If you stick around for long enough and still feel challenged to “read” the market with a system, you realize the limitations of TS. One of the major limitations of TS is the ability to perform true portfolio level backtesting. This was a feature I personally was waiting for many years to be added by Omega Research. Until today they were not able to add this most important feature to their system trading. So then I bought Excalibur (for Windows) from Futures Truth but soon found out that the portfolio backtesting was limited and the programming language (C or C++) was quite a challenge. I also bought Behold. Behold is a Mac trading software developed by Jim Payne. Behold has a similar programming language and I loved it but it had several limitations and Jim Payne was not able to keep up with the demands of fast changing technology. Later I bought several other products as well. Finally I came across Wealth-Lab. Wealth-Lab has so many unmatched features. For a none programmer I would mention the following:

1. Creating custom filters just with drag and drop.
2. Creating trading systems just with drag and drop.
3. Create indicators and indicators of indicators with drag and drop.
4. Test strategies on a whole portfolio with true portfolio level backtesting.
5. Optimize a whole portfolio and apply the best values to each symbol with a single mouse click.
6. Applying optimized value on symbol/system combination and on all relevant tools.
7. Powerful scanning/filter tool.
8. Real time scanning for systems.
9. Automated Trading Execution via Fidelity.

Q: You talk a lot about “strategy testing at the portfolio level”. What do you mean exactly? Can you give an example?

Volker Knapp:

Michael, you know the best how important strategy testing at the portfolio level is. A lot of people who start out in system trading develop one system for the S&P mini or some individual stocks. The truth is that even though the markets have certain characteristics, you only know if a strategy is valid if you have tested it on a portfolio. With Wealth-Lab we have a tool called ChartScript Scanner, it can scan the whole published system database of Wealth-Lab (over 1000) and show you exactly which system performed the best on one market (or even on a portfolio, since we are geared towards portfolio testing). But that results only tells you half of the story or even less. You need to apply the right money management or position sizing strategy to your portfolio too. Only then you see your real risk and possible drawdown and profits.

Q: Everyone talks about risk management and money management. How does Wealth-Lab tackle the issue of adding to positions and controlling risk?

Volker Knapp:

With Wealth-Lab you can scale in and out to your current position. There are several pre-programmed money management methods. To see the effect of position sizing you don’t need to change the whole code. You just key in a number in the appropriate field. In fact for programmers we developed several interesting features. For example you can create your own money management strategy (called SimuScript) and apply it to any system on a portfolio level by just clicking on it. You can create your own performance report metrics by using the PerfScript tool. I believe that, besides Wealth-Lab covering the most important methods natively it also gives extremists the power to extend the program to their needs.

Q: What instruments can I NOT trade with Wealth-Lab?

Volker Knapp:

I cannot think of any instrument that you cannot trade with Wealth-Lab.

Q: Do you have links to reviews that I can read?

Volker Knapp:

We have been reviewed in Stocks & Commodities, Futures magazine and Active Trader magazine. Our rating has always been excellent and so has the rating on the EliteTrader web site.

Q: Now that Wealth-Lab is a part of Fidelity — what does that mean for me?

Volker Knapp:

US citizens cannot buy Wealth-Lab direct. But there is good news! Fidelity is marketing the Wealth-Lab Pro to their Active Trader clients (120 trades per year) and offering free real time data, free end of day data plus the extremely helpful automated trading feature. So it actually means that instead of spending approximately $1000 for real time data you get it for free when you trade with Fidelity.

Q: What information can people find on your web site?

Volker Knapp:

Our web site is all about system trading, designing and testing. The desktop offers much more power and more features but the web site also offers some unique and interesting features. You can program your strategy on the web site, save it in your “personal only for you” accessible folder and test systems on a portfolio of stocks or individual stocks although to test futures or FOREX you would need the desktop version. You can even scan your systems for tomorrow’s signals. You can do paper trading on our web site and note your entry and exit points. The entry and exit points will be displayed on the corresponding chart. Besides these features we have one of the most active web site focused on system trading with a very active and friendly community. Community members also have the opportunity to publish systems (currently over 1000) on the web site. These systems often become part of discussions and have great potential for our community members after they customize them to their personal preferences.

Thanks guys! As a side note, I have had the opportunity to spend time with both Dion and Volker. You could not meet two more passionate individuals. They live and breathe Wealth-Lab and it shows in their work!

Trading Systems Frequently Asked Questions

Q. Can you offer insight about adding to positions?
A. Richard Dennis offered:

When you have a position with a profit. Anytime the market goes up a reasonable amount, say a strong day’s work, after you’ve put on a position, it’s probably worth adding to that position. I wouldn’t want to wait for a retracement. That is everyone’s favorite technique; to buy something strong that retraces. I don’t see any justification in the statistics for that. When beans are at $8.00 and go to $9.00, if the choice is to buy them at $9.00 or buy them if they retrace to $8.80, I’d rather buy them at $9.00. They may never retrace to $8.80. Statistics would show that you make more money buying them and not waiting for a retracement.

Q. Are real time quotes needed to trade?
A. Richard Donchian offered:

If you trade on a definite trend following loss limiting-method, you can [trade] without taking a great deal of time from your regular business day. Since action is taken only when certain evidence is registered, you can spend a minute or two per [market] in the evening checking up on whether action-taking evidence is apparent, and then in one telephone call in the morning place or change any orders in accord with what is indicated. [Furthermore] a definite method, which at all times includes precise criteria for closing out one’s losing trades promptly, avoids…emotionally unnerving indecision. In other words, you do not need real time quotes to trade successfully. You can use end of day quotes.

Q. Isn’t the accuracy of trade entry important?
A. No. You want to buy when the market is moving up. Period. You never question the accuracy, direction or how long the move will last. What if you have an entry that is 80% accurate, but loses money? Entry accuracy is no Holy Grail. If you find yourself staring at quote monitors all day and watching CNBC to figure out when and what to enter, stop trading.

Q. Why not day trade?
A. How can you compete with floor traders while sitting at a quote monitor far removed from the action? Consider the amount of random movement within any 24 hour time period. With maximum profit limited to only one day and the risk relatively large in relation to realizable profit, how can you possibly win in day trading over the long run?

Q. There is no way to day trade profitably?
A. Jerry Parker offers:

Probably my best technique is not picking up the phone to close out a winning trade. What is left to be said about the futility of day trading? Trend followers know that trading decisions need to be looked at over the very long term. The results of one trade are almost meaningless.

Q. Why is the price so important? Why is it the key?
A. The emotional reactions to trading, hope, fear, guilt, over-confidence, panic, etc., are avoided with trading systems based on price. The personal burden is lifted and trading can become objective when price is the only variable. The price already reflects all other variables filtering out subjective nuances of whomever is offering the information. Focusing on price, to the exclusion of fundamental data such as earnings, crop reports, consumer confidence and market news, allows for a scientific approach to trading.

Q. How do people overuse statistics?
A. Many traders have developed subtle techniques that squeeze information from small amounts of data. If trading results don’t hit you in the head, they are most likely not real. You need robust trading schemes not curve fit academic studies.

Q. Why do you call trend following a robust system?
A. David Druz offers:

  • Robustness is the ability to survive.
  • Robust trading systems are designed to remain valid for years.
  • They rarely exactly fit to any specific market situation.
  • Robust trading systems should ideally trade successfully at all times, in all markets, in all conditions.
  • A robust system is difficult to kill even in bad markets.
  • Short term volatility is inconsequential to trading success.

Q. Is picking the right market crucial?
A. No. Picking the right market alone is not the absolute key to success. Great success relies on money management. Money management determines whether you win in the long run.

Powerpoint Slides from Trend Follower Dunn Capital

A broad overview from a long time trend follower:

Our long-time readers will also note some of the introduction was pulled directly from the TurtleTrader site.

Trend Following Food for Thought

“Depth is the percentage loss from an equity peak to an equity valley based on a fixed reference starting equity. $ Depth is the dollar loss from an equity peak to an equity valley. Prior peak represents the last monthly equity high prior to the beginning of the Drawdown. Valley is the monthly date where the Drawdowns lowest level occurred. Length is the duration in months of the Drawdown, which is the number of months between Prior Peak and New Peak. Recovery is the duration in months starting from the first month after the Valley of the Drawdown to the month of a new equity Peak, which includes the new Peak month.”
Definition from Trade Center

Hypothetical questions to consider:

  • How do you feel about peak to valley drawdowns?
  • How do you feel about recovery?
  • How would you feel about an average major peak to valley
    drawdown of -34.0%?
  • How would you feel about an average drawdown duration of 7.0 months?
  • Would you run for the hills?
  • But what if the average time to recoup the drawdown was only 7.0 months?
  • Sound better?
  • What if the average rolling 60 month (5 year) period gave
    a return of +225%?
  • What if the track record showed NO 60 month periods resulting in a loss?
  • Last but not least, what if a hypothetical $1,000 investment increased to $400,000, over nearly 30 years, but over the same time period the S&P 500 increased to only $40,000?
  • A 10-fold difference in return? Yes, that is the example.

This is all just food for thought. Think about the trend following numbers. The numbers paint a picture.

Process Versus Outcome Is Key for Trend Following Traders

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Trend Following Products

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