Portfolio Management Theory: Trendfollowing

Discussion in 'Strategy Building' started by Spectre2007, Jan 13, 2007.

  1. equity
    stop loss
    take profit
    lot size

    Above are the basic variables one works with, with any disciplined approach to speculation.

    The idea behind trendfollowing, is to magnify returns over time by capturing price progression directionally over a longer timeframe then a day.

    Now with a undisciplined approach, its pretty easy to blow any amount of money given to you. Even when you have significant ratio of winners, when the absolute amount lost on the losers is greater then the absolute amount on the winners.

    The first thing we see when we speculate is the amount of capital at hand, ie equity.

    Next we have to 'screen' the markets the look for markets that are trending or ranging. The definition of trend we will use is, progressive price progression over weeks to months.

    Its as simple as screening a book of charts, and looking for linearity. Low volatility linearity seems better then high volatility linearity.

    Noone knows where trends will end or when trends will start. It seems prudent to avoid highly hyped derivatives, since there is more 'gaming' going on. The markets that noone talks about, seem to be the ideal.

    So far:

    1) Equity
    2) Markets with linearity high volatility, low volatility.

    The other thing to look for in a market is looking for a range breakout. The idea is that if a market breaksout of a range in a definitive manner, it will trend.

    Why is this better then looking for markets that are already trending? Trending markets might have a higher probability of a reversal then markets that just have broken out of range.

    3) Markets with range breakouts.

    So now we have capital and we have screened a book of commodity charts to identify the above two types of markets(range breakouts, trending). One can apply this to even individual stocks.

    Ok now we have screened the markets, and have possible candidates for investing our capital.

    The other aspect is also look for significant emotional events, according to chart patterns, exponential spikes on the daily chart or drops. Peaks and valleys. Why these? After one of these events, the trends established persist. After a peak and minimal drop consolidation phase usually persists. After a drop and minimal rise, consolidation phase persists. These consolidation phases appear as ranges on the chart.

    When macro economic shifts happen, these consolidation phases either breakout on a counter trend or trend with the previous trend that was established.

    The whole point of this mental exercise is to go through what speculators do and refine the process.

    To a minimal extant we have covered: Market Screening. We do this so that we increase the probabilities that our trades go in our favor. And they go in our favor over time ie the trend.

    Next we will cover how much to risk per trade.
  2. Lets look at some markets first:

    The idea is to look at daily weekly monthly charts and to see what has happened recently in different markets.


    This is the SP 500 chart, a 100 point advance after breaking the high. 100 point advance since October. How much money is that?

    Trading Unit: $250 x S&P 500 Stock Index
    Tick Size: 0.10 (10 pt.) ($2.50/pt.) ($25.00)
    Initial Margin: $19,688 Maint Margin: $15,750
    Contract Months: Mar, Jun, Sep, Dec
    First Notice Day: Not applicable (cash settled contract)
    Last Trading Day: The Thursday prior to the 3rd Friday of the contract month.
    Trading Hours: 8:30 A.M. - 3:15 P.M. Globex: 3:45 P.M. - 3:15 P.M. Mon - Thrs; 5:30 P.M. - 3:15 P.M. Sun + Hol.
    Trading closes at 3:15 p.m. on last day of trading.
    Daily Limit: - 5.0%, 10.0%, 15.0% and 20.0%

    1 index point is 250 dollars, 250 x 100 = 25,000. So to trade this full contract, you would need about 35,500. Lets say 50,000 to have twice the maintenance margin. 25,000/50,000 = 50% in 3-4 months. So if you bought this on the break of the high, and left it alone, you would be up 50% on capital.

    Now this is all in hindsight, you would have to ride all the emotional aspects and bulls and bears debate throughout this time period for this derivative. So the other aspect, is buy and hold once the trade starts going in your favor.
  3. Once a trade is placed, what happens?

    Well if your disciplined, you would have put a stop loss, on that trade.

    So your portfolio has this SP 500 contract that you bought in october, and your account keeps fluctuating day to day. What can happen is either the price moves away from your stop loss or it hits it.

    How do you calculate the size of the stop loss? The size of the stop loss should be based on account equity and derivative volatility, minute to minute volatility should be not enough to hit your stop loss. The size of the stop loss should be enough to handle minute to minute volatility and even day to day volatility.

    So if you accounted for minute to minute and day to day volatility, and your stop loss gets hit. It means the direction you entered the trade has a high probability of being wrong.

    So when a stop loss gets hit in a market, it has to signify something more then just random fluctuations in the market.

    So sometime in the third quarter of last year, you see the world falling apart, and equities crashing and then recovering on the weekly chart. The exponential drop and minimal rise and consolidation we talked about in the post above. Weekly new highs is much more significant then daily new highs.
  4. Trendfollowing is not "Portfolio Management Theory", it is a simple method of choosing when to enter and exit trades. You can apply it to a single instrument (e.g. the USD/CAD forex pair) if you wish; you can follow trends without having or managing a portfolio.

    Trendfollowing requires two things: (1) Trends, and (2) following them. The basic idea is simplicity itself:
    • Wait until it is screamingly obvious that a trend is underway
    • After it's screamingly obvious a trend is underway, enter a position in the direction of the trend. If the trend is up, go long. If the trend is down, go short
    • Hold your position until it is screamingly obvious that the trend is over
    • After it's screamingly obvious the trend is over, exit your position
    That's it. That's the big idea, in four simple bullet points. Various bullshitters and blowhards have tried to expand these simple points into $1000 courses and book length discussions (for example, this book) and now it seems, lengthy monologues on ET. But the idea is simplicity itself.

    You will need to do some technical work to define "when is a trend obviously underway" and "when is a trend obviously over". This need not be complicated; one famous trend following proponent says "look at the chart from ten feet away. If you see a trend, then it's a trend."

    And if you decide to actually place trades, you'll have to make some generic trading decisions: how much will I risk, what instruments will I trade, and so forth. You would have to make these same decisions no matter what entry/exit method you trade; they are not unique to "trend following".
  5. Now even if your correct on your assumption of the direction of the trade, ie getting long. Your stop loss can still be hit if your entry is in the middle of the daily or weekly range.

    That means our entry might not hit for days or weeks. The impatient trader will enter in the middle and see his account fluctuating like crazy day to day.

    How do we minimize, this?, Our entries have to be at the outliers. Now I dont like to chase markets, I would rather wait for daily volatility to hit my entry on a retrace. The problem with this method, is that essentially your entry is in the middle of the range. And has a high probability of being hit when a small stop loss is placed.

    1% of 50,000 is 500 dollars. 500 dollar fluctuation is 2 index points. Now when you think about it, 2 index point fluctuation is not much. If your wrong 10 times, you will be down 5,000 or 10% on account equity.

    That means the size of the stop loss is too small. Looking at the way the SP trades, 10 index points seems the bare minimum for a stop loss. 10 index points is 2500 dollars, thats 5% of acct of equity. No we can only be wrong twice before we hit 10% drawdown on equity. For 1% equivalent account size, the size of the acct would have to be 250,000.

    So 25,000 profit /250,000, now our return drops down to 10% in a few months. Still decent but not stellar. Even with 10 index point stop loss, it still has a chance of being hit if the entry is not precise.

    How do we formulate a entry strategy?
  6. Whats your entry strategy? and how do you calculate a stop loss?
  7. The concept is very simple, but when it actually gets down to implementation more issues arise then are obvious.

    Just because you stand six feet away and look at a chart, and say 'up', doesnt amount to much, the daily volatility itself will be enough to scare people out of prudent positions.
  8. http://futures.tradingcharts.com/chart/ES/37

    20 index point deviation in the trend on this chart enough to shake off some trendfollowing positions if we used the 10 index point stop loss plus a 10 index point trailing stop.

    Thus the trailing stop has to be greater then the average 'wave deviation against the trend'. The TS has to be greater then 20 index points.

    To do this effectively, requires spreadsheets, and calculations.

    But the same principles can be applied to any market. The above examples are crude.

    If the deviations become greater then the average wave deviation, probabilities increase that the trend might be reversing or has entered a consolidation phase.
  9. low volatility linearity has less chance of hitting your stop loss or trailing stop then high volatility linearity.

    thats why people will screen for markets that have a 'low volatility linearity', risk/reward dynamics arent as advantageous with high volatility markets.

    Those unkown commodities that people rarely talk about on the news can trend for months without hitting your TS or SL.

    Even stocks that meet this criteria, can be used. Once our instrument continues to trend, how do we increase position size without triggering the TS or SL (pyramiding).

    The whole point of this exercise and strategy is to obtain returns mutiple times the underlying vs equity. Otherwise you might as well just buy TIPS and leave them alone.
  10. low volatility linearity, with profit in the trade, one technique is to buy options with the trend, with the incremental gains in equity, throughout the whole trend.

    with fixed risks, returns can be magnified.
    #10     Jan 13, 2007