Trend-Following Strategy Insights

Trend-following has been around for 40+ years and is one of the most widely-used strategies among commodity trading advisers (CTAs).  In my personal library, I have six different books dedicated to the subject. I have experimented with futures trend-following strategies in the past, but was never entirely satisfied with the results.  Fortunately, a recent remote presentation by Alan Pryor of Long Term Trading prompted me to resurrect my research efforts.

Alan Pryor's "Ready-Set-Go" strategy was featured in Futures Magazine's article "Today's Top 10 Trading Systems."    During the recent presentation, Alan provided some very useful information about his Ready-Set-Go system that helped lay the foundation for my own futures trend-following strategy.  I wanted to share a few insights that I identified during my strategy development process.

Trend-Following Basics

For those of you unfamiliar with trend-following, the purpose of this strategy is to capture a significant portion of extended upward and downward movements in price.  Unfortunately, prices tend to spend more time consolidating than trending.  In addition, false breakouts lead to frequent losses.  As a result, there are typically more losers than winners.  In that case, why are trend-following strategies so popular?  Because when prices do breakout, they generate enormous profits that are many times the magnitude of losses.  In addition, these types of strategies also tend to perform well during recessions, providing valuable portfolio diversification to long equity strategies.

The secret to trend-following success is to ride your winners and cut short your losers.  If you are a student of the market, this should sound very familiar.  Unfortunately, regularly weathering a series of losing trades is difficult for most traders.  In addition, powerful trends are often followed by sharp reversals, which can lead to significant drawdowns.  Note: these types of drawdowns are not losing trades.  Nonetheless, it feels like a loss when a $100,000 gain turns into a $50,000 gain.

Trend-following strategies reduce risk by trading across a large number of liquid futures markets.  Unlike stocks, futures markets have relatively low correlations with other futures markets.  A few markets even have negative correlations.  When some markets are consolidating, others will be trending - either up or down.  To capitalize on all trends, trend-following strategies should incorporate both long and short positions.

To minimize the psychological pain of trading a trend-following strategy, it is essential to use a systematic, objective, rule-based system.  If you are interested in developing your own strategy, here are some insights that you might find useful.

Trend-Following Insights

1) The width of stops should be based on the volatility of the individual futures contract.

While the Ready-Set-Go system uses a volatility-based trailing stop, the money management stop is the same for all contracts.  I disagree with that approach.  Volatile contracts are stopped out too often and the stop levels for low volatility contracts are too wide to be effective.  The Trader Edge strategy calculates stop levels based on the volatility of the individual futures contracts. This guarantees that all trades are treated consistently across all markets.

2) The amount at risk (not the amount invested) should be the same for every position.

The Ready-Set-Go system purchases one futures contract in every market.  While this is simple to execute, it ignores the fact that futures contracts have a wide range of notional values and volatilities. The Trader Edge strategy determines the appropriate position size (number of contracts), by forcing every trade to have the same maximum dollar loss (except for rounding).  This improves diversification and ensures every trade contributes equally to risk and to return.

3) The notional amount invested in each contract should be a function of risk.

Since stop widths are a function of volatility (#1 above) and the amount at risk should be the same for every position (#2 above), the notional amount invested in each contract will be a function of risk: a large amount invested in low volatility contracts (e.g. currencies) and a small amount invested in high volatility contracts (e.g. metals).

4) Adaptive stops are essential.

Alan Pryor provided the inspiration for this idea.  Pryor incorporates adaptive stops in many of his strategies, including the Ready-Set-Go system.  Adaptive stops modify the width of trailing or money management stop levels based on the characteristics of the specific market.  Note, this goes beyond incorporating different levels of volatility.  Pryor does not disclose the specific rules or algorithms for calculating adaptive stop levels on his website, but he does state that "exit signals are all adaptive and change based on the strength of the underlying trend."

Leveraging this idea, the Trader Edge trend-following strategy varies the width of stops inversely with the value of ADX, which is a measure of trend strength.  The stronger the trend (the higher the value of ADX), the tighter the stop - and vice versa.

This concept is much easier to grasp visually.  The top panel in Figure 1 below depicts a weekly candlestick chart of the continuous gold futures contract from late 2010 to late June 2013.   The 14-week ADX is shown in blue in the second panel.  When gold exploded to the upside in 2011 (red box), notice how the ADX also reached extreme levels, climbing from 40 to 50. The elevated ADX level indicated an extremely strong and unsustainable trend.

By definition, most trend-following strategies would have been long gold in 2011 and most would have had significant gains. In this environment, an adaptive technique would have narrowed the width of the stop to preserve those gains. Notice the sharp pullback that followed immediately after the peak - gold lost almost 200 points in a single week  We are seeing a similar situation in the bearish gold trend right now.  The bearish trend is very strong and ADX is again above 50.  However, an elevated ADX level does not justify exiting a trend-following trade, but it does suggest using tighter stops to protect hard-earned gains in a high-risk environment.

Figure 1: Gold - Weekly Trend Following 6-2013

Trend Following Results

As a rule, I do not discuss the specific rules or historical results of my proprietary trading strategies, but I wanted to make an exception in this case.  Most investors would benefit from allocating a modest amount of capital to a trend-following strategy and I wanted to provide some indicative results.

Figure 2 below includes a table with the results for the Ready-Set-Go system and for my new trend-following strategy.  In both cases, the portfolio size remained constant.  In other words, gains were not reinvested in the strategy.  The Ready-Set-Go results were calculated from 1/1/1970 to 12/31/2012.  The Trader Edge strategy results were calculated from 1/1/1978 to 6/26/2013.  Both are weekly strategies.

Figure 2: Trend-Following Results

First, the above comparison is not exactly apples to apples.  As I mentioned before, the Ready-Set-Go strategy only buys or sells one contract per futures market. The minimum contract size for the Trader Edge strategy is one contract (for the most volatile market), but the number of contracts would be higher for low volatility markets.

This explains why the average profit per year and Max Drawdown values are much larger for the Trader Edge strategy.  The margin requirements will vary over time, but the Ready-Set-Go system requires about $100,000 in margin.  The margin requirement for the Trader Edge strategy would typically fall between $150,000 and $200,000. However, being able to meet the margin requirement is not sufficient.  The maximum future drawdown (as a percentage of your total capital) must also fall within your personal risk management limits.

Based on the number of trades per year, the Ready-Set-Go strategy appears to be more active, or possibly uses tighter stops than the Trader Edge strategy.  The Trader Edge strategy has a higher percentage of profitable trades and a slightly higher profit factor as well.  The profit factor is lower than my typical strategy and the annual return on the notional market value is quite low.  Nevertheless, the return on required capital is very attractive (due to leverage).

Figure 3 below is a graph of the historical equity curve for the Trader Edge strategy (including back and forward test periods).  Again, the portfolio size was held constant and gains were not reinvested.

Figure 3: Trader Edge Trend-Following Cumulative Profits (no-compounding)

Alan Pryor sells the Ready-Set-Go strategy via his website (I am not affiliated with Alan Pryor or with his company).  The Trader Edge strategy is proprietary and is not currently available for sale or subscription.

Conclusion

It is surprisingly easy to create a profitable trend-following strategy.  Most are profitable across a wide range of parameter values.  However, incorporating the above insights could significantly enhance your strategy results.  If you are not adept at strategy development or do not have sufficient capital to trade a trend-following strategy personally, you might still be able to invest through a hedge fund (or fund of funds) or via a CTA.

Feedback

Your comments, feedback, and questions are always welcome and appreciated.  Please use the comment section at the bottom of this page or send me an email.

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Brian Johnson

Copyright 2013 - Trading Insights, LLC - All Rights Reserved.

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About Brian Johnson

I have been an investment professional for over 30 years. I worked as a fixed income portfolio manager, personally managing over $13 billion in assets for institutional clients. I was also the President of a financial consulting and software development firm, developing artificial intelligence based forecasting and risk management systems for institutional investment managers. I am now a full-time proprietary trader in options, futures, stocks, and ETFs using both algorithmic and discretionary trading strategies. In addition to my professional investment experience, I designed and taught courses in financial derivatives for both MBA and undergraduate business programs on a part-time basis for a number of years.
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