Sometimes it helps to view a schematic of the trading process with all the interconnected parts.
Review Trading ‘Process’ Chart (PDF)
Most trading education presents the components of a trading system as a sequential checklist: pick a market, identify an entry signal, define a stop, size the position, exit when the rule fires. The checklist format implies that each component is independent of the others. In practice, the components of a systematic trend following approach are deeply interconnected, and understanding those interconnections is what separates a complete trading system from a collection of rules that happen to be applied to the same account.
The interconnections begin at position sizing. The correct position size for any trade is not determined by conviction about the trade’s direction. It is determined by the volatility of the market, the distance to the stop loss, and the maximum percentage of account equity the system permits to be at risk on any single trade. Change the stop distance and the correct position size changes. Change the account equity and the correct position size changes. Change the market’s volatility measure and the correct position size changes. Position sizing is not a step that occurs after the entry and exit decisions. It is the result of a calculation that depends on the entry and exit decisions simultaneously.
The interconnection between position sizing and exit rules runs in both directions. The stop loss determines the maximum loss per unit of position. The position size determines how many units are held. Together they determine the maximum loss in absolute dollar terms if the stop fires. The relationship between these two components determines whether the system’s actual risk per trade is consistent with the target risk percentage. A trader who sizes positions without reference to stop placement is not managing risk. They are managing exposure.
The portfolio level is where the most important interconnections occur. Individual positions that appear appropriately sized may aggregate to excessive total risk when multiple correlated positions are held simultaneously. The correlation table showing that systematic trend following managers produce returns that are 0.65-0.94 correlated with each other demonstrates the same effect at the manager level: diversification requires genuinely uncorrelated positions, not just multiple positions in multiple markets. A trend following system that holds five positions in energy markets is not as diversified as it appears, because those five positions will tend to win and lose together.
The process chart is a visual representation of these interconnections. It shows how market volatility feeds into position sizing, which feeds into total portfolio risk, which interacts with exit rules to determine actual outcomes. Seeing these relationships visually makes the interdependencies concrete in a way that a sequential checklist cannot. The system is not a series of independent steps. It is a set of simultaneous constraints that must be satisfied together.
The practical implication is that optimizing any single component of the system in isolation is not the right approach. A trader who finds the best entry signal without reference to the exit rule and position sizing may have found an excellent entry for a system with different risk parameters than the one they are actually running. The process chart shows the components together so the interdependencies are visible and the optimization is performed at the system level rather than the component level.
Frequently Asked Questions
Why is trend following better understood as a process than as a set of rules?
Because the components interact with each other in ways that make the outcome of any individual component dependent on the settings of the others. Position size depends on stop distance and market volatility. Total portfolio risk depends on position sizes and correlations between positions. System performance depends on the interaction of entry signals, exit rules, and position sizing together, not on any one component in isolation. Understanding the system as a process makes these interdependencies visible.
What is the relationship between stop placement and position sizing?
They are jointly determined. The maximum risk per trade, expressed as a percentage of account equity, is the product of the position size and the distance from entry to the stop. To hold risk constant at the target percentage while varying stop distance, position size must vary inversely with stop distance. A wider stop requires a smaller position. A tighter stop permits a larger position. Position sizing and stop placement must be calculated together, not sequentially.
Why does the process chart show interconnected parts rather than sequential steps?
Because the trading process is not sequential. Entry signals, exit rules, position sizing, and portfolio-level risk constraints all affect each other simultaneously. A sequential checklist that presents these as independent steps misrepresents how the system actually works and can lead to inconsistencies where individually reasonable decisions aggregate to unreasonable portfolio-level outcomes. The interconnected schematic shows the system as it actually operates.
Trend Following Systems
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