Sometimes trend following logic sounds so simple, but then again how many will really work (and be patient) for the big profits?

Amos Hostetter: Trading Don’ts

• Don’t sacrifice your position for fluctuations.
• Don’t expect the market to end in a blaze of glory. Look out for warnings.
• Don’t expect the tape to be a lecturer. It’s enough to see that something is wrong.
• Never try to sell at the top. It isn’t wise. Sell after a reaction if there is no rally.
• Don’t imagine that a market that has once sold at 150 must be cheap at 130.
• Don’t buck the market trend.
• Don’t look for the breaks. Look out for warnings.
• Don’t try to make an average from a losing game.
• Never keep goods that show a loss, and sell those that show a profit. Get out with the least loss, and sit tight for greater profits.

Amos Hostetter: Dangers in Trading Caused by Human Nature

• Fear: fearful of profit and one acts too soon.
• Hope: hope for a change in the forces against one.
• Lack of confidence in one’s own judgment.
• Never cease to do your own thinking.
• A man must not swear eternal allegiance to either the bear or bull side.
• The individual fails to stick to facts!
• People believe what it pleases them to believe.

More Guidelines

Trend following is not anticipatory. Does the 60% drop in NASDAQ stocks mean the bull market has finally run its course? Who knows. Don’t worry about what the markets are going to do, worry about what you are going to do in response to the markets today. You can’t undo the past and you can’t predict the future. No one can consistently predict anything. Prices, not investors, predict the future.

Meticulous risk management strategies are absolutely crucial. Everyone makes money in a bull, but if you don’t have a money management plan and an exit plan, you are in trouble when the bull is replaced by the bear. Trend followers plan when they will get out before they ever get in. They are interested in one variable: price. They forget forecasts, fundamental factors, and technological breakthroughs.

Successful trading systems adapt to change. Inefficiencies in a variety of financial markets around the world lead to sustained trends. Mechanical trading systems exploit these trends for profits. With global markets in various stages of expansion, retraction and equilibrium, your trading strategy adapts.

Know every day what your portfolio is worth. Calculate what your risks are on any given day for all positions.

Controlling risk is not the same thing as avoiding risk. If managing risk is an integral part of your philosophy, when your risk level goes up or down, you simply adjust.

Manage your risk. Position liquidations are triggered by significant adverse price action and are never pre-determined objectives. Concentrate on managing the risk. The returns will take care of themselves.

Large profits engender larger size. Thin profits engender cutting back. If you are flush with profits, you trade larger size. If you are thinly capitalized, you have to cut back.

Equalize risk. Allocate a fixed dollar amount of risk to each new position. For example: a corn position will have the same initial dollar risk as a T-Bond position. By trading a system with the same parameters across the board you protect yourself from curve-fitting.

Enter and exit with rules. You can’t expect to enter a market at the precise moment a bottom is hit, nor will you exit a market at the exact top. Capture the middle of the trend.

Seek profit opportunities in trending markets whether those markets are moving up or down.

Obtain profits from long-term volatility. View volatility as a cornerstone of your trading system. Volatility is the root of profit.

Do not attempt to buy lows and sell highs. Buy market strength (highs) and sell market weakness (lows).

“Trends always go further than rational people expect, or even imagine. Most investors don’t have the stomach for extended rallies or declines. The philosophy of not having a predetermined profit objective allows us to continue with a trend for its full duration and then some. We try very hard to avoid the pitfalls of liquidating a trade too early, even at the cost of giving back large profits…Trends exist and they endure for a specified time, longer than most imagine. In a very uncertain world, perhaps nothing makes more sense than simply following trends.” — John W. Henry

What These Rules Share

Hostetter’s don’ts and the guidelines above were written across different periods by different practitioners, but they converge on the same operational principles. Do not sacrifice position for fluctuations: the position exists for the trend, not for the daily price variation within it. Never try to sell at the top: exits are triggered by rules, not by guesses about where the top is. Don’t average a losing position: cut losses, do not compound them. Get out with the least loss and sit tight for greater profits: the asymmetry of letting winners run and cutting losers short is the system’s structural source of positive expected value.

The human nature section identifies the psychological mechanisms that cause traders to violate these rules. Fear causes premature exits from winning positions. Hope causes holding of losing positions. Allegiance to a directional view prevents responding to what price is actually doing. These are not personality defects. They are documented features of human cognition under financial stress that systematic rules are specifically designed to prevent from affecting trading decisions.

Henry’s closing formulation is the practitioner’s synthesis of everything above: trends always go further than rational people expect, and the approach that has no predetermined profit objective is the one positioned to capture the full duration. The predetermination of profit objectives is the error that Hostetter’s don’ts warn against. The refusal to predetermine exits is what allows the trend to deliver its full value to the trader who stays with it.

Frequently Asked Questions

What does “don’t sacrifice your position for fluctuations” mean?

It means the position was entered because a trend was developing, not because the daily price variation was expected to be smooth. Fluctuations within a trend are normal and expected. Exiting the position because the price pulled back during a continued uptrend is sacrificing the trend for the fluctuation. The position should be held until the exit rule fires, which is defined by a reversal of the trend, not by a temporary adverse move within it.

Why should trend followers buy strength and sell weakness rather than buy lows and sell highs?

Because buying at new highs is entering a confirmed trend. The breakout above a new high is evidence that the market is accepting value at elevated prices and moving in the direction of continued price increase. Buying at lows in the hope of a reversal is the opposite: it requires the market to be wrong about where value is. Systematic trend following enters when the market’s own price action confirms the direction, not when the trader’s analysis predicts a reversal.

What does Henry mean when he says trends go further than rational people expect?

That the behavioral dynamics producing trends, loss aversion, anchoring, and herding, extend trends beyond what any fundamental model of fair value would predict. Participants who should be selling wait because of loss aversion and the endowment effect. New participants are drawn in by herding. Each extension of the trend beyond its fundamental justification is followed by further extension as more participants respond to the trend itself. A predetermined profit objective exits the position before these dynamics have fully played out.

Trend Following Systems
Want to learn more and start trading trend following systems? Start here.