Systematic trend following is not for small traders

One of the most common suggestions in the world of futures trading is that to be successful, you must employ a mechanical trend-following system and trade with strict discipline. Many of the proponents of such wisdom point to the success of some of the biggest names among commodity trading advisers past and present, such as John W. Henry, who now owns the Boston Red Sox. Several books have been written on the subject of trend following systems in the last decade. Commercial system vendors are constantly developing new systems to sell to the public for hundreds or even thousands of dollars.

Unfortunately, the fact is that the small trader simply cannot afford to trade a mechanical trend-following system in the futures markets. Because? The answer is simple… the drawdowns inherent in trading a mechanical system are simply too great for the small trader to handle emotionally and psychologically. Consider this fact…during his career as a commodity trading advisor employing a systematic trend-following strategy, Dunn Capital Management’s Bill Dunn has experienced declines of more than 30% at least seven times during a 40-year career. years, and two of these instances involved withdrawals greater than 50%. During that period, the compound annual return on him was around 18%.

While Dunn Capital’s compound annual return is certainly impressive, most investors wouldn’t be attracted to withdrawals. A 50% drawdown is the equivalent of watching a stock you bought at $100 drop to $50. This kind of volatility is actually similar to how Apple stock has performed since 1990, with similar returns, but how many people have owned Apple stock since 1990?

Most systematic trend-following proposals will suggest that losses are simply the cost of doing business. They liken systematic trend following to a casino, which has a long-term “edge” over its clientele. This is indeed the case, but it is also clear that trend following systems can go through long periods of significant underperformance compared to other assets. Since 2009, this has been the case. Aside from 2010, the last four years have been very difficult for most trend-followers in the futures markets.

In fact, one could argue that apart from the years 2008 and 2010, trend-following performance has been pretty lackluster over the past decade starting in 2004. For example, John W. Henry went out of business as a result of volatility. yields over the past ten years. Some suggest that this was due to his entry into the world of Major League Baseball. However, this underperformance is also reflected in the decline in assets managed by former Turtle R. Jerry Parker and his Chesapeake Capital Management. Chesapeake’s assets under management in the futures business peaked at more than $1.5 billion in 2007 and now stands at just over $300 million. This is according to the performance record posted on Autumngold.com.

Regardless of this recent performance by many trend followers, proponents will suggest that this is the right time to start investing in such programs. This is probably true. Weak performance from trend followers is often followed by periods of strong performance, and this cycle should continue. However, systematic trend following is not yet the answer for the small investor or trader who wants to trade their own account, because there will still be significant drawdowns.

Most who suggest systematic trend following will refer the small trader to the handful of trading psychologists who will then suggest that the trader must learn to detach emotionally from his trade in order to be successful. In other words, they need to learn to accept these 30% or higher withdrawals simply as part of the wealth building process.

I remember the parallels with the world of golf. It’s not uncommon for a professional golfer who struggles to keep his tour card, or finds it difficult to perform well on a Sunday afternoon when he’s in competition, to hire a sports psychologist. I can’t think of any of those golfers who later became dominant players. The best players absolutely hate losing and never break away emotionally.

Consider this more recent example. Phil Mickelson has just won the British Open after a devastating loss at the US Open just a month earlier. He stated that he could barely get out of bed for two days after that defeat, but recovered and won the Scottish Open and the British Open on successive weekends. Meanwhile, Lee Westwood, who has never won a major golf championship, blew another chance to win the British Open, later suggesting “it’s just a game.” He has never won a major after 62 tries. He suspects that he will never win a major with that attitude.

Traders, like golfers, are constantly searching for the holy grail. What many traders hope to find is a mechanical trading system that makes all the decisions for them and generates profit month after month. Golfers are often looking for that one golf club, training aid, mental thought or new move for their golf swing that will transform them into scratch golfers. I find it comical when a 20 handicap golfer resorts to mental golf tips as if to translate his horrible golf swing into a hitting machine.

Another problem with mechanical trend following systems is that they still produce very different trading results. This is why most commodity trading advisors who employ the trend-following doctrine will manage their funds with multiple systems in an attempt to smooth out their capital curve. I recently tried two different trading systems on a basket of currency futures. One was a triple moving average system and the other involved a standard breakout strategy. I tested data going back to 1977 and found eleven years where one system made money and the other actually lost money. In many other years, the performances varied substantially, even if they both won or lost money in the given year.

In other words, there is no mechanical trend following system that works better, and this is a big reason why the small trader has a hard time trading with a mechanical system. As soon as a drawdown occurs, the trader switches to another system that may have proven to perform better when he was experiencing a drawdown with the other system.

With all this in mind, what is the answer? Discretionary trend following! Discretionary trend following simply means trading a strategy that exploits major trends, but is not consistently followed. In other words, there may be a central system of entry and exit signals, but the trader may miss some trades if he has a set of discretionary rules that mean trades have a lower probability of success. The discretionary trader is not concerned with missing out on some trends, but with preserving capital and waiting for the best trading opportunities.

One of the great myths in the world of futures trading surrounds the legend of the Turtles. The Turtles were a group of merchants trained by legendary merchants Richard Dennis and William Eckhardt. Many had successful careers as commodity trading advisers, including the aforementioned R. Jerry Parker. The myth is that these traders were given a mechanical trading system to trade the futures markets. In fact, they were simply given a set of rules, including mechanical entry and exit rules AND a set of discretionary rules. These strategies were never meant to be traded mechanically. Dennis even wanted individual traders to show their own style of trading. This is why performance among this group of traders during the program varied greatly, so much so that it was even suggested that some traders were given a superior system to trade with (this is another myth that one of the traders in the program actually accused Dennis of doing this).

Here’s the bottom line… successful trading requires very hard work and the discipline to consistently work hard. Successful trading has nothing to do with the discipline of following a certain mechanical trend following system as suggested by many authors and traders. Successful trading simply involves having a core set of beliefs, a core strategy if you will, and learning to beat that core strategy by using discretion by learning to understand price action and the psychology of the markets. While legendary hedge fund manager George Soros is clearly looking to get around the fences and capture big moves in his trading, he clearly does not operate on a mechanical trend-following system. If you are a small trader or investor, you shouldn’t either.