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A Trend Following Debate

A recent email exchange:

Name: Reading “The Talent Code” by Daniel Coyle. A superb book, I wonder if you know it. On the subject of TF may I also suggest you to consider a podcast with Gary Anderson (The Janus Factor). His work is superb because he has developed a way on knowing when to use tf tools or when to be a mean reverting contrarian. We know that TF does not always work: to know WHEN it offer a different edge. I really believe you should talk with him.

Covel: So all those drawdowns taken by some very smart and successful TFs over the decades were all in vane? They could have avoided them all by switching out at the exact right time to another strategy?

Name: Not 100% but to a certain extent it would seem so. Before you dismiss the idea, have a look at his papers / work. You can measure momentum for leaders and laggards separately; then you calculate the spread in relative performance, some sort of relative strength between 2 equity lines: one for a portfolio with only leaders and one with only laggards. Say from the universe of all commodities you look at the top 20% and bottom 20%. TF has its own cycles, they are not of fixed length clearly but its feature, positive feedback, can be measured. This is another level of analysis not seen in the Turtle work: having a plan, having a broad universe of asset classes, normalizing risk, adjusting risk is all a way to mitigate the inherent volatility of trend following. Anderson’s work has, so far, since 2003, limited to stock but there is no reason not to apply to commodities. Consider this: TF works like a peach until it breaks, then it starts to work again. Maybe the WHY cannot be explained but the WHEN, in reasonable terms, can be calculated, plotted and, possibly, integrated in a TF portfolio. Can you remember how from March 2009 the market has gone up overall but it was led by the laggards? Applying TF to stocks would not have generated good profits or even losses (what I call a “dirty” trend, where reversals are deep and costly for TF). Nowhere in the TF work I have done I have seen this interesting concept. Food for thought.

Covel: At first blush if tomorrow can’t be predicted the idea of a money making system that shifts gears such as you propose … would be novel. I would wonder why all the big names over the years have not been available to invent such a fool proof system? And beyond academic efforts, does a track record exist to show this bi-polar trading system in action?

Name: I am working to see if there is a way to use this “technology”. Tomorrow cannot predicted but you can reasonably sure that it is not going to go very far from where you are. There is a gradual transition from TF to MR and that can be measured – the HOW one implements the idea is another matter. Anderson has been working on stocks. No there is no track record.Consider this: work on relative strength goes back to the 60s with Levi’s paper. Only now there is widespread acceptance of momentum. It took ages to dismantle the idea of EMH. Anderson is trying to show / describe why and when TF (momentum) is “shape shifting”. It is a fascinating subject. And Levi’s work was snubbed from academia if you remember. Original ideas take time to establish, to be accepted. In any environment. You are showing yourself that TF works with numbers and yet very few out there are adopting it. It is what someone called one of those “mysteries of life”.

Covel: Good luck here. I would read Taleb’s work, consult with TFs who have come before us, objectively analyze why TF works, and maybe not try to reinvent the wheel.

Name: First I did not say that one could exactly know when to switch from TF to MR. There is of course some lag but what is interesting, is the persistence of a particular “state” until it changes again. I cannot say that TF drawdowns were in “vane” because either they recognized the problem and accepted to go with it anyway by sticking with their strategy no matter what (a-la Dunn) or they have tried to reduce the impact of the rotation between positive and negative feedback by adjusting risk and market exposure by calculating correlation coefficients to change the mix. Also adding more and more markets, reducing exposure when all the markets are working too much too nicely (a sign that risk has gone up too much), or simply by decreasing risk during drawdowns. ALL these methods address the problem from a different point of view without necessarily asking the question: is TF working NOW, is there a way to see if the lack of performance in leaders and laggards from a TF can be distilled in an indicator to warn… I have added some of his work available on internet for you to see and ponder. It’s your call.

Covel: What is the problem? The idea of a drawdown is the problem? Losing any money is the problem? What do you mean by “impact of rotation between positive and negative feedback”? A loss? BTW Connie Brown dodged my podcast. MTA really needs to clean up the hocus pocus on the train!

Name: I agree with that 150% – you know I dislike “normal” TA. But it is YOUR fault! You are going to someone that a.) is not systematic, b.) she uses EWaves, c.) she makes “calls”. Basically your are asking the right questions to the wrong person. Unless you are deliberately an agent provocateur with technicians. My humble suggestion is to interview those technicians that are systematic like Kirkpatrick. Connie Brown is the exact opposite. But you already knew that.

Covel: Yeah, but if the people in MTA let that nonsense in, on their boards, etc. — what value is CMT/MTA?

Addendum for everyone: Yes, that last sentence may be controversial, but tell me how my thought goes in the wrong direction?

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Posted in Feedback, Psychology, Trading 101, Trend Following
4 comments on “A Trend Following Debate
  1. Fred says:

    The Holy Grail for traders is knowing which trading system will work best in the current market environment. There are numerous issues here though. Sometimes it takes months to determine what the current environment is. Also, one can never forecast when the trading environment will change.

    Any trading system developer worth his weight in salt can produce a trading system tuned to a specific environment. For example, undoubtedly there were many pundits in February, 2009 who had the benefit of hindsight and showed the best trading strategy for trading the equity markets from the fall of 2008 to the spring of 2009 were bear market strategies. The problem is that anyone who adopted those strategies got slaughtered in the bull market in US equities that started in March, 2009.

    There are many out there now who use the very narrow time frame of the past several years and point out how great a buy-and-hold strategy has worked for the US equity markets. Trust me, those same people had different opinions in early 2009.

    I am a systematic trader of mostly US equities and some ETF’s. I believe it is naive to follow one trading strategy without regard to its current performance. Sometimes trend following strategies are in tune with the markets. Sometimes they are not (the Newedge CTA index is slightly under water over the past three years). The same is true for mean reversion trading systems. There are statistical methods for determining if a given trading methodology is working right now. If the statistical analysis determines that the trading strategy is not working, one should either stop trading the strategy or reduce position size.

    Fred

  2. Jeff says:

    Ricardo’s supposition that “Tomorrow cannot predicted but you can reasonably sure that it is not going to go very far from where you are” is incontrovertibly a truly fatal flaw that will be his strategy’s undoing. What happens when the tomorrow comes that the Black Swan lands?

    In dialogue with individuals like Ricardo, I find myself constantly reiterating Covel’s one and only humble request: show me the track records. With trend following, res ipsa loquitur.

    Jeff

  3. Jim Rohrbach says:

    Michael: I do not know why people waste their time discussing predicting the future course of the stock market. That’s correct, Tomorrow Can Not Be Predicted. But then we do not have to predict the future, we need to identify the change in trend by working with the present. Each day the market tells us what it has just done. With that data I have been able to identify changes in the trend of the stock market for over 40 years. Recently, on 5-13-13 Timers Digest ranked me 5th in the country on the Top Ten Timers List. When I wrote this on Linkedin someone wrote that I was either a “fool or a liar”. You know me Mike, but that statement convinces me that there are a lot of people out there who do not know the first thing about Trend Following or Market Timing. And since they can’t do it, they tell everyone that it can’t be done. I do not try to predict the future course of a stock or the market. But I do an excellent job of identifying changes in the trend, using the data that the market provides to me, every day, after the close. My Mission is to help the average investor, but I find that they are more interested in “Predictions and Hot Tips.” Maybe this could be the theme for another Podcast like we did some time ago.
    Jim

  4. Rob Blay says:

    Four lines into [Name’s] second paragraph and I switched off. Some people just don’t get it! Perhaps [name] is an economist still struggling with the theory of profit maximisation in a rational world that doesn’t exist.

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