Seven simple do’s and don’ts of systematic trend following
A few simple rules will go a long way to significantly improve your chances of success over the long term. Here are a few guidelines to observe and keep in mind at all times:
1. Keep your bets appropriately sized
For investment traders, “appropriately sized” means small. For industry hedgers, it means just as it says. Either way, you must determine the size of your trades in advance. For example, I advise customers to budget at least $25,000 to trade a single 1,000 barrel contract of crude oil ($25/bbl). Thus if you’ll allocate $25,000 to trading crude oil, you should trade no more than one contract. For smaller allocations, you should look to mini contracts or other instruments that offer exposure to oil prices. Whatever you decide, be sure that your bets are s mall enough not to keep you awake at night. If your trading puts too much strain on your emotions, you’ll be more likely to make mistakes and overtrade. Most of the time you’ll end up worse off for it.
2. Never chase after losses
Investment trading should be a long-term pursuit where performance accrues through a long series of transactions. But instead of considering every decision as just one of many, we tend to treat each transaction as a departure from the status quo, where our fear of loss overpowers our desire for gain.
In fact, the logic we apply to decisions about gains is opposite to that which we apply to decisions about losses: we are strongly inclined to be risk averse when preserving a favorable status quo, but prone to taking risks when dealing with losses. In trading, this creates the disposition to exit profitable trades too early, and “work” the losing trades and take more risk to try and reverse the losses.
Loss aversion is hardwired in human psychology and it can induce traders to greatly escalate risk. This seldom leads to happy endings. This is another reason to keep your bets small enough so that it doesn’t weigh on your emotions.
3. Don’t let a winning streak get to your head
A winning streak in trading may give you the idea that you’ve mastered the game and the confidence to bet more frequently and more aggressively. Absolutely resist such temptations: no matter how well you may have done in the recent past, believe me, you have not mastered the game. Do not get ahead of yourself. Think of it as driving your car: the harder you press on the gas pedal, the more likely you are to get hurt. Keep it steady within your emotional comfort zone.
4. Diversify as much as possible
Because we can’t predict the onset of a trending move in any particular market, trend followers invariably diversify their bets across as many uncorrelated markets as possible – usually 30 or more. In this way their returns are typically driven by one or two markets at any one time while the rest of their positions tend to be a mix of smaller gains and losses.
Clearly, trading in 30 or more futures markets requires a large capital base. With smaller amounts, you should seek to trade in at least 4 or 5 markets. For example, you may consider allocations to one equity index (FTSE 100 or Russell 2000), one or two currency pairs like USD/YEN, USD/EUR, or EUR/GBP), a precious metal like Silver or Gold, and an energy security (Brent crude oil or Gas Oil). While crude oil and metals can be too volatile and risky for some, markets like Corn, Oats or treasury bond futures offer a tamer venue for diversification.
Finally, you should seek to keep equivalent risk exposure in each market. To achieve approximately equal risk weighting, use Value-at-Risk to measure the riskiness of positions in any given market.
5. Stick with the plan
Many traders find it hard to trade against their convictions, and when trading signals go against them, they hesitate to execute the trade or decline to trade at all. It is best to execute every trade. You’ll find that some of your best trades will be the ones you least expected to make profits, and you’ll also see your favorite trades flop time and again. Disciplined adherence to the pre-determined set of tried-and-tested rules holds the best likelihood of achieving satisfying results and avoiding disappointments.
6. Avoid gunning for best execution
Another hard-to-resist temptation is trying to get the best price for your trades. Investors may typically spend considerable time waiting for the best moment to place a trade but this is never a good idea. Even if you are successful a few times, other times you’ll miss favorable price moves and in the end the whole exercise will likely prove futile.
To avoid this, it is best to execute all your trades at a fixed time during the day and use market orders, not limit orders. During the 15 years of my active hedge fund career I adopted the practice of always executing my trades between 4 and 6 PM, corresponding to mid-morning hours in the U.S. futures markets. Most other trend followers do something similar. A word of caution: some online brokers and many trading platforms use algorithms to take advantage for lax trading orders. If you see that your executions seem consistently unfavorable, you might need to use limit orders. However, do so judiciously: prioritize getting your trades executed rather than day-trading for the best fill.
7. Don’t spend too much time
Spending too much time analyzing markets and overthinking your trades isn’t a good idea either. Fluctuating almost around the clock, modern markets generate a constant flow of news and information. This may seem like a good thing, but most traders would be better off staying away from the news flow altogether. Numerous empirical studies have shown that even among experts, more information doesn’t, in fact, improve decisions. In one such experiment, MIT psychologist Paul Andreassen found that traders who got no financial news at all earned double the returns of those who frequently checked the news. •