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Trend Following Entry: The Philosophy

Discipline

Discipline

There are so many questions to ask yourself before entering a trade. The most critical question to ask is “How much risk are you willing to take”:

The question investors typically avoid at all costs is the question of money management. Money management is also called risk management, position sizing, or bet sizing, and it is the critical component to trend following success as Gibbons Burke observes:

“Money management is like sex: Everyone does it, one way or another, but not many like to talk about it and some do it better than others. When any trader makes a decision to buy or sell (short), they must also decide at that time how many shares or contracts to buy or sell—the order form on every brokerage page has a blank spot where the size of the order is specified. The essence of risk management is making a logical decision about how much to buy or sell when you fill in this blank. This decision determines the risk of the trade. Accept too much risk and you increase the odds that you will go bust; take too little risk and you will not be rewarded in sufficient quantity to beat the transaction costs and the overhead of your efforts. Good money management practice is about finding the sweet spot between these undesirable extremes.”

When you look at a trading strategy, you must ask, “I’ve only got a certain amount of money. How much do I trade?” If you have $100,000 and you want to trade Microsoft, well, how much of your $100,000 must you trade on Microsoft on your first trade? Must you trade all $100,000? What if you’re wrong? What if you’re wrong in a big way, and you lose your entire $100,000 on one bet?

How do you determine how much to bet or trade each time? Trend followers make small bet sizes initially. So, if you start at $100,000, and you’re going to risk 2 percent, that will be $2,000. You might say to yourself, “Oh my gosh, I’ve got $100,000, why am I only risking $2,000? I’ve got $100,000. $2,000 is nothing.” That’s not the point. You can’t predict where the trend is going to go. One trend follower presented a view on the initial risk decision:

“There are traders who are unwilling to risk more than 1 percent, but I would find it surprising to hear of any trader who risks more than 5 percent of assets per trade. Bear in mind that risking too little doesn’t give the market the opportunity to allow your profitable trade to occur.”

Think about money management as you would about getting into physical shape. Let’s say you’re a male athlete and you want to get into great shape. You weigh 185 pounds, and you’re six foot one. Well guess what? You can’t lift weights six times a day for 12 hours a day for 30 straight days without hurting yourself sometime during those 30 days. There’s an optimum amount of lifting that you can do in a day that gets you ahead without setting you back. You want to be at that optimal point just as you want to get to an optimal point with money management. There indeed is just such a number. Ed Seykota describes that optimal point with the concept of “heat”:

“Placing a trade with a predetermined stop-loss point can be compared to placing a bet: The more money risked, the larger the bet. Conservative betting produces conservative performance, while bold betting leads to spectacular ruin. A bold trader placing large bets feels pressure—or heat—from the volatility of the portfolio. A hot portfolio keeps more at risk than does a cold one. Portfolio heat seems to be associated with personality preference; bold traders prefer and are able to take more heat, while more conservative traders generally avoid the circumstances that give rise to heat. In portfolio management, we call the distributed bet size the heat of the portfolio. A diversified portfolio risking 2 percent on each of five instruments has a total heat of 10 percent, as does a portfolio risking 5 percent on each of two instruments.”

Chauncy DiLaura, a student of Seykota’s, adds to the explanation, “There has to be some governor so I don’t end up with a whole lot of risk. The size of the bet is small around 2 percent.” Seykota calls his risk-adjusted equity “core equity” and the risk tolerance percentage “heat.” Heat can be turned up or down to suit the trader’s pain tolerance—as the heat gets higher, so do the gains, but only up to a point. Past that point, more heat starts to reduce the gain. The trader must be able to select a heat level where he is comfortable.

Also critical is how you handle your capital as it grows or shrinks. Do you trade the same with $100,000 as you would $200,000? What if your $100,000 goes to $75,000?

Trend follower Tom Basso knows traders usually begin trading small, say with one contract and as they get more confident they might increase to 10 contracts. Eventually they attain a comfort level of 100 or 1,000 contracts, where they may stay. Basso counsels against this. He stresses that the goal is to keep things on constant leverage. His method of calculating the number of contracts to trade keeps him trading the same way even as equity increases.

One of the reasons traders sometimes can’t keep trading proportional as capital increases is fear. Although it might feel comfortable when the math dictates that you trade a certain number of shares or contracts at $50,000, when the math dictates to trade a certain amount at $500,000, people might become risk averse. So instead of trading the optimal amount at whatever capital you have, people trade less. How can this be avoided? Create an abstract money world. Don’t think about what the money can buy, just look at the numbers like you would when playing a board game, such as Monopoly or Risk.

However, because capital is always changing, it’s critically important to keep trading consistent. A description of Dunn Capital’s trading echoes Basso’s view: “Part of [Dunn’s] approach is adjusting trading positions to the amount of equity under management. He says if his portfolio suffers a major drawdown, he adjusts positions to the new equity level. Unfortunately, he says not enough traders follow this rather simple strategy.”19

If you start with $100,000 and you lose $25,000, you now have $75,000. You must make your trading decisions off $75,000, not $100,000. You don’t have $100,000 any more. However, Paul Mulvaney felt I was missing a critical final aspect of money management:

“Trend following is implicitly about dynamic rebalancing, which is why I think successful traders appear to be fearless. Many hedge fund methodologies make risk management a separate endeavor. In trend following it is part of the internal logic of the investment process.”

Recent feedback in from a listener:

Hi Michael,

Nice to virtually meet you. My name is Natalie and I’m driving cross country and enjoying your podcasts! Episode 100 is my ultimate favorite, I listen to that one at least 3/4 times a month!

As of recently (last year or so) I’ve been getting more into trend following. Lately I’ve been on [nam] screening for stocks that have just crossed over the 200dma on the daily chart and seeing how they act.

I was hoping you could answer something that’s been on my mind. I was recently scanning [name] and came across 3 stocks I don’t know too much about at all, BUT, technically they look very good. (All have just cleared the 200dma on the daily chart which sparks my interest).

My question is… after you find something that looks technically good for trend following, what’s the next step you take for due diligence and good measure to confirm the trend and any thoughts one might have before starting a position? Do you check the fundamentals?

I’m sure your quite busy, but any response or guidance, or episode you can point me into would be greatly appreciated.

Thanks for everything you do for the community!

Sincerely,
[Name]

I will have to re-listen to #100 now!

To your questions:

1. There is no short answer.
2. You don’t use fundamentals.
3. You need a tracking portfolio from the start.

Now, let’s get practical. Answer the following five questions, and you have a trend following trading system:

1. What market do you buy or sell at any time?
2. How much of a market do you buy or sell at any time?
3. When do you buy or sell a market?
4. When do you get out of a losing position?
5. When do you get out of a winning position?

Said another way (Bill Eckhardt inspired):

1. What is the state of the market?
2. What is the volatility of the market?
3. What is the equity being traded?
4. What is the system or the trading orientation?
5. What is the risk aversion of the trader or client?

You want to be black or white with this. You do not want gray. If you can accept that mentality, you have got it.

Where to start? See: www.trendfollowing.com/start.

Then let’s circle back.

Posted in Risk Management, Trading 101, Trend Following
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