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A Trend Following Clarification: Thinking in Terms of Statistics

Famed trend trader David Harding offered:

“Our approach to markets is a science. It is an unpublished science, but it is a real one. You would have thick leather-bound volumes of papers on it if there were a willingness to open the kimono, as the horrible modern expression has it. The process of trading our system is like repeatedly drawing different colored balls from the statisticians apocryphal bag. As we draw out a ball it becomes part of the track record, and we put it back in the bag, but there is no guarantee that the balls will come out in the same order in the future.”

Do you have a clear sense of probabilities and payoffs? Did you answer no? If so, you need to figure it out, and fast. For example, trader Jim Simons (arguably a closeted trend trader, he does not identify as one), worth about $8.5 billion, has said that the advantage scientists brought to the trading table was not their computing or math skills, but their ability to think scientifically. That means the scientific method is in play:

  1. Define the question/theory.
  2. Gather information and resources (observe).
  3. Form hypothesis.
  4. Perform experiment and collect data.
  5. Analyze data.
  6. Interpret data and draw conclusions that serve as a starting point for new hypothesis.
  7. Publish results.
  8. Retest (frequently done by other scientists).

Sometimes scientists employed by trend trading firms are astrophysicists. Why? Astrophysics is an observational science. You have to learn by studying what is there. You cannot create an experimental solar system in the laboratory (source: Chuck Cain blog post, January 9, 2011). For example, take a stock, multiply the number of firm employees by the sales, then divide by the dividend and subtract the CEOs age and you get a number. But so what? Just because you can compute that number does not make that number useful for anything. Scientific thinking immediately sees the logical errors.

Being wrong is part of the trend following life. Many just cannot wrap their head around that (source: Chuck Cain blog post). Bottom line, there are scientifically established principles of market behavior that you can observe and use for profit. As Ripley said, “Believe it, or not!”

Statistical Thinking

Trend following is about non-normality of market returns. You will never have, nor will you ever, produce returns that exhibit a normal distribution. You will never produce the mythologically consistent returns that many believe to exist. When trend followers hit home runs from the likes of Barings Bank, Long-Term Capital Management, and the 2008 market crash, they are targeting unknowable extreme occurrences that happen to occur with a probability greater than expected. Those occurrences are fat tails, in statistician speak.

Trend following’s nature of riding a trend to the end when it bends, and then cutting losses very fast, puts you in a position to benefit when the next unexpected flood rolls in. Trend following’s alpha comes from letting winners run on the right-hand side of a fat tail and cutting losses short on the left-hand side. Eliminating losing positions and holding onto profitable positions puts you in the big game hunt for positive outliers.

A normal distribution is simply worse than useless as a risk management tool.

An associate of mine, an accomplished businessman, and I recently had lunch. He knew some about my career, but not much. During our conversation he mentioned that he was recently caught up in a very well-known hedge fund scam (not Madoff). I asked him quickly, before he could explain much, if his returns were positive every month. He replied, “Every month.” Later, I Googled him and found out that he had lost several million. However, thinking in terms of statistics is more than just measuring where on the bell curve trend traders find their inconsistent profits.

For example, I want you to look at statistics from an alternative perspective. Imagine there are two hospitals. In the first, 120 babies are born every day. In the second, 12 babies are born every day. On average, the ratio of boys to girls is 50/50. On a given day, in one of the two hospitals, twice as many girls are born as boys. Which hospital was it more likely to happen in? The likelihood is higher in the smaller hospital. Why? Because the probability of a random deviation from the population mean decreases with an increase in sample size.

Take two traders who win 40 percent of the time with their winners being three times as large as their losers. One has a history of 1,000 trades and the other has a history of 10 trades. Who has a better chance in the next 10 trades to have only 10 percent of their total trades end up winners instead of the typical 40 percent? The one with the 10-trade history has the better chance. Why? The more trades in a history, the greater the probability of averages holding true. The fewer trades, the greater the probability of moving away from the average.

Consider a friend who receives a stock tip, makes some quick money, and tells everyone about it. There is a big problem with this scenario. His population of winning tips is extremely small, one to be exact. That’s statistically insignificant. He could just as easily follow his next hot tip and lose all of his money. One tip means nothing. The sample is essentially anecdotal evidence.

Thinking in terms of statistics is everywhere if you are observant. During a Monday Night Football game, one of the announcers, Ron Jaworski, put numbers and odds in perspective for playing the game of football: Play calling is about probability, not certainty. It is the same in trend following trading. All else being equal, you want to follow trend trading strategies with the most positive skew and the most negative excess kurtosis. These would be strategies with the fewest occurrences of large negative return (source: Ken Tropin).

Efficient Market Bullshit

I love it when people tell me the trend following winners are the lucky survivors. In my humble opinion people who think like that are either ignorant in the short-term willing to learn/be corrected or, and I say this bluntly, losers in life unable to accept reality. If trend following winners are the lucky monkeys hitting the keyboards, than the king of the monkeys must be Warren Buffett.

Buffett himself makes the case for why this is BS in an excerpt from Snowball:

Part 1
Part 2
Part 3
Part 4
Part 5
Part 6

Note: bullshit baffles brains.

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