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Trendfollowing FAQ ***Read This***

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The purpose of this topic is to give our members an introduction to trendfollowing,  We will continue to add and update over time, but we wanted to get something up ASAP so interested parties could do some more research on their own.  Enjoy!

 

Trendfollowing Overview

 

What is trendfollowing:  In its simplest form trendfollowing is a systematic trading approach that uses current price data in conjunction with historical price data to identify trends in any given market.  In classic time series trendfollowing systems, a positive recent return would signal a long position while negative recent return would signal a short position.  Obviously, there are models that are more complicated than that and factors will vary from one program to the next, but the point is that there is no human discretion involved in entries or exists.  Rules are developed, often times systems will be back tested (an imperfect science in some cases), and then the system is programmed so that signals are produced automatically.  Some of the early modern trend systems were developed using punch cards!  Currently traders will use a variety of programming languages to automate the process.  Most trendfollowing systems are very simple with straightforward rules.  There are even still some traders that do everything by hand based on metrics like moving averages or breakouts.      

 

What role does fundamental data play in trendfollowing?  Trendfollowers are agnostic toward fundamental data.  We have no opinion and it does not influence our trades.  We are primarily concerned with catching as much of the  price trend in a particular instrument as possible, obviously we won’t be lucky enough to enter at the exact top or bottom, we just want to be there for part of the ride and we use price ( price is objective by nature) based rules  to signal our trades. 

 

How do we know Trendfollowing is an effective strategy?  To start, there are some very famous traders who have utilized TF successfully in their firms for decades.  We will point out some of the big names later for those who are interested as most of their stories are quite interesting, but obviously directing you to the stars of the industry would indicate a bit of survivorship bias.  AQR, one of the leading systematic trading shops with over 225 bill in AUM, published this paper on performance of trend strategies over the last century: A Century of Evidence on Trendfollowing Investing.   I recommend each of our subscribers read the paper as it dives into what makes TF effective and why it should be included in every trader/investor’s portfolio.

 

What are the characteristics of a winning system?  Well obviously long term profitability is what ultimately matters.  Perhaps counter-intuitively, many good systems actually have trading win rates of under 50%. To determine if a system is viable, we need to quantify the total expected return based on the size and frequency of winning trades versus size and frequency of losing trades.  This is referred to as the “expectancy” of a given system.  A positive expectancy over a large sample size would indicate we have tradeable model.   Good systems will also include specific risk parameters based on one’s account size.

 

What is typical involvement period in any specific system?  This is exceptionally important.  It’s so important that we will likely devote another topic just to this issue.  If a system is vetted and has a good expected outcome, we need to commit to a long trading period for the probabilities to play out.  We never know which trades will be our winners and oftentimes systems can endure prolonged drawdowns before paying off disciplined traders.  Check out this chart from Dunn Capital, one of the most famous TF:

 

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His firm has crushed the S&P since inception but suffered 12 separate drawdowns of greater than 25%.  He stuck to his rules, avoided reactional, emotional trading, and continues to win for his clients.  It should be noted that as of last check, Dunn’s firm is only paid when profitable…no 2 and 20 here.  That’s ultimate confidence in one’s system.  Our system has already endured four consecutive losing weeks but these were soon followed by one single contract returning 400% over a couple of weeks.  “Let your winners run” as they say.  We strongly recommend trading smaller initially if it will allow you to commit to a longer trading period.  By longer we mean a minimum of several months of disciplined trading.

 

       So where is the edge in trendfollowing?  Financial markets are still largely driven by speculation, behavioral biases, and influence from central banks.  Research has shown that these factors (and more) will often cause prices to trend in one direction or another.  While TF traders do use discretion when developing their models, all trading is systematized thus removing any sort of personal bias from the picture.  Discretionary traders apply their judgement in the execution of their actual trades.  The lack of bias and emotion in TF trade execution is a key variable in the long term efficacy of these models.

 

       Can’t I achieve similar or even better returns using more popular methods?  Possibly.  One of the advantages to most TF systems is that they demonstrate remarkably low correlation to various markets (in the Dunn example above, you can see the correlation to the S&P is close to zero).  They also typically perform very well during volatile periods.  Most intelligent advisors will recommend at least a portion of one’s portfolio be dedicated to managed futures or some other trend following system.  In addition, lower overall aggregate allocations to TF enhance performance for those of us in the game, so it’s not necessarily a bad thing if your neighbor wants nothing to do with it.  Longboard Funds  produces fantastic research, here is an interesting chart highlighting the performance of managed futures strategies during periods of significant draw downs in US equities: https://www.longboardfunds.com/pdf/Managed_Futures_Thoughts_11-19-18.pdf

 

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    Who are some of the great Trendfollowers?   Bill Dunn, Bill Eckhart, David Harding, Jerry Parker, Larry Hite, John W. Henry (Red Sox Owner),  Ed Sekoyta, Liz Cheval….to name just a few.  Most if not all of these traders have been interviewed on Michael Covel’s podcast “Trendfollowing Radio:”  https://www.trendfollowing.com/podcast/

 

    More educational resources:  see this thread: 

 

 

 

 

Edited by RapperT

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