Most system threads begin with a set of rules, or a strategy, for a particular trading system. If that is what you seek, this thread is not for you.

I will share my system with you, but TF is more than just a set of entry/exit signals. TF is, ultimately, about you. If you do not have the confidence and the discipline to stick to your system, it does not matter how good your system is.

So how do we develop the confidence to stick to our system? Well we don’t start with the finished product (a set of rules) and hope that our faith in it will stay strong.

What we do is build our system ourselves, from the ground up. In the next few posts, I will go over some of the philosophy behind Trend-Following. Next, we will begin to explore the different parts which will ultimately make up a complete TF system.

Looking forward to following this.

Thanks, TalonD.

First thoughts:

We’ve all been conditioned to think that the amount of time we spend at work should relate to the amount of money we make. We’re paid mostly by the hour in our formative years. So when we become traders, we naturally assume that staring at quotes all day, getting in and out of positions will make us more money. We could not be more wrong.

In fact, one the first principles in TF is that [B]the more you trade, the richer your broker gets[/B]. Also, the more time you spend looking at charts, the less time you have to spend with your family, or surf :).

In TF, [B]we make no arbitrary decisions about anything[/B]. When deciding which time frame to use for our trading, we test our system against various time-frames and select the most profitable one. It just so happens that longer time-frames and less getting in and out of trades is more profitable for us.

So, to sum this up:

  1. More trades do not mean more money.

  2. Staring at charts for too long is bad for your social life.

  3. In TF, most of your time will be spent [I]preparing[/I] to trade, not staring at charts and getting in and out of positions.

2 replies so far so you beat my record:D
I will watch as well.

Ok, so the million dollar question - How do you identify these relatively large trends?

I’ll be interested to see how you minimize drawdowns inherant in a system with few trades, a low win ratio, and relatively large S/L’s. :slight_smile:



[B]Ernie McCracken[/B]:

I think that the answer will be clearer when I go through an actual example, but for now let me say this:

Ok, so the million dollar question - How do you identify these relatively large trends?

I’ll be interested to see how you minimize drawdowns inherant in a system with few trades, a low win ratio, and [B]relatively large S/L’s[/B].

Identifying the trend is really very simple, but that is not where the millions are made.

How much to risk on each trade has a much greater effect on equity than ‘timely’ entries and exits. It may sound counter-intuitive, but I will show how this works when I go through an example.

In short, if my stop-loss is far away from my entry, I trade less units and vice-versa. This normalizes my risk across the entire portfolio. You’re right though: minimizing drawdowns is the key to successful Trend-Following (and trading in general).

In my next post, I will discuss Trend-Following’s “edge”, or how TF systems make their money.

Thank you everyone for the questions and support. I welcome more of both :slight_smile:

been following since last night and the suspense is building :frowning:

No matter what trading system you use, you ought to know what your edge is. In other words, you should know [B]how[/B] your system makes money.

We already know that TF systems look to benefit from large trends. Let’s dig a little deeper:

In TF, we do not try to predict the future. [B]We do not know when a trend is going to start, and when it does start we do not know when it will stop[/B]. And we’re comfortable with that. Our edge does not rely on our predictive ability.

We do not use fundamental analysis. We do not care [B]why[/B] trends happen; we simply position ourselves to benefit from them when they do happen.

In TF, we do not care about being right, we care about making money. Our win/loss ratio is nothing to write home about. It’s typically below 50%.

We simply place out trades according to our rules. When it goes against us, we quickly get out with a small loss. When it goes our way, we “let it ride” until our rules tell us to get out.

So what is our edge?

Our edge lies in the fact that on average, [B]our wins are much larger than our losses[/B]. For example, take 20 trades. If we’re profitable 40% of the time we can expect to win 8 times and loose 12. If we place our stop-loss at $100, we’ve lost $1200. Our wins are, on average, twice as much as our losses. So we made 8 * $200 = $1600. Our profit: $400.

In practice, we would not make $200 each time we win. We may win $100 five or six times, but once or twice we’ll make maybe $1000.

Next, I will discuss what makes such a seemingly simple system hard to follow.

still listening :smiley:

Several factors make TF difficult for most people to accept. For starters, it is not a ‘get rich quick’ scheme. Patience is a requirement, and that is in short supply in modern society.

But beyond that, there are two aspects to TF that can really take a lot out of you:

  1. It’s one thing to understand conceptually that you can win less often than you loose and still be profitable. It’s quite another to keep your faith in yourself and keep taking trades as you’ve suffered as string of losses. Let’s go back to the 20 trades example from my last post. The 12 losses we can expect to experience could happen consecutively. At that point, a trader may loose his nerve and stop trading. The 13th trade (the one not taken) could turn out to be the $1000 one. This is even harder in TF because this 12 loss streak does not take place in one day but might stretch over several months.

  2. It also takes some discipline to ride your winners. Let’s go back to our $1000 win. What I didn’t tell you before is that this trade may have been up to $1500 in profit and that you had to watch that $500 profit evaporate before you could close your position out. Again, it is counter-intuitive to give your profits back, but in TF it is [B]essential[/B]. This will be more clear as I go through an example.

So how do we overcome these challenges? Unfortunately, there is no amount of math, no set of indicators that will build up your confidence, your patience, or your determination. But here’s what you cannot do: take my word for it. If you simply take the rules I use for my system and start trading, I guarantee you that when that loosing streak comes, you’ll blame me for giving you a bad system and you’ll stop trading it.

In the next few posts, we will go about building a simple, yet complete, TF system from the ground up. This will require some work on our part, but that work will translate into confidence when our system is finished and that confidence will help us stick to our system when the loosing streak occurs.

In the meantime, please, feel free to ask any question you may have. If there is something I need to elaborate on, I will happily oblige.

My trading system is a set of rules. These rules determine:

  1. What instrument(s) to trade.
  2. When to enter a position.
  3. When to exit a position.
  4. What my risk is.

These are [B]the only things I can control[/B]. In fact, after I’ve entered a position, I can only control 1 thing: when to exit.

This is an important point. Many traders think their indicators tell them something about where the price is going. They believe that because sometimes they are right.

In TF, we know that [I]we’re “wrong” more than we’re “right”[/I]; yet, [I]we’re still successful[/I] (see ‘What’s my edge’). So we accept the uncertainty and we focus on what we know for sure we have control over, and those are the four items above.

Of these four, by far the most influential (on you equity) [I]is number four[/I] (how much you risk). Again, I suppose that intuitively we think that numbers 2 and 3 would have more of an impact. This is not the case in TF.

This brings me to the title of this post. In order to get the most benefit out of this thread, you need backtesting capabilities:

If you go back over this post, you’ll notice that I’ve slanted some statements. You should treat those statements as [B]assumptions[/B] at this point because, without backtesting all you have is my word on it. If you start trading a system based on the word of a stranger, how long is it before you loose faith?

Backtesting a system, and then adjusting the various parameters (1 through 4 above) will help you see how varying your risk has a greater effect on your equity than your entry/exit signals. Once you have seen this not just once but across various systems and instruments, then and only then will you be confident in your knowledge.

The choice of software is not important. If you don’t have backtesting capabilities, but a little know-how, you can use Excel.

In the last post, I mentioned that my trading system is a set of rules. I will begin with the rules that govern:

  1. When to enter
  2. When to exit

We are trying to ‘catch trends’. We should begin with defining precisely what a trend is:

The first thing to realize is that trends exist only as we define them. There is no such thing as [B]the[/B] trend. One trader can look at a monthly chart and see an uptrend, while another (less patient) trader can look at an hourly chart and see a downtrend.

This may be a subtle difference, but it is an important one. To think that trends exist out there on their own can lead you to seek out shiny indicators to better find these trends before anyone else. Realizing that you are the one creating the trend with your very definition will lead you the realization that the indicator you use makes little difference.

I use simple Donchian rules with a directional filter. In other words, I first determine if the long-term trend is up or down, then, using a shorter-term trend definition, I get in and out in that direction only.

This is a possible example:

If current price > highest high in 200 days LONG TREND IS UP
If current price < lowest low in 200 days LONG TREND IS DOWN

If the long trend is up:

If current price > highest high in 30 days ENTER LONG
with a protective stop at the lowest low in 30 days

If the long trend is down:

If current price < lowest low in 30 days ENTER SHORT
with a protective stop at the highest high in 30 days

I the next post, we will go about the work of determining the optimal values for our “indicator”. That is, we need to figure out the amount of days we use to determine both the long and the short term trend

For our first test, I used daily USD/JPY data from 1994-2008. Using the entry/exit rules from the previous post and using 5% of available equity on each trade, these are the results:


Long Trend (days) 120
Short Trend (days) 15
Position Size 5.00%
Starting Equity $10,000.00

Growth Rate 2.64%
Max Draw-Down 26.96%
Ending Equity $14,905.40

Max_W: $2,431.19
Max_L: -$803.18
Avg_W: $626.15
Avg_L: -$410.14
Total Wins: 36
Total Losses: 43
Win%: 45.57%
Consec. Wins: 5
Consec. Losses: 5

The factors to focus on here are the Max Draw-Down and the Growth Rate. That is, we can evaluate a system by looking at its risk/reward. The lower the Max DD with the higher Growth Rate the better.

As you can see, though not particularly impressive, this system was at least profitable. Of course, there are better ways of making $4905.40 in 14 years.

In the next post, I will show how to improve on these results.

isn’t there a mistake here? protective stop at lowest low for both longs and shorts? Or am I being picky?

If current price > highest high in 30 days ENTER LONG
with a protective stop at the lowest low in 30 days

If the long trend is down:

If current price < lowest low in 30 days ENTER SHORT
with a protective stop at the lowest low in 30 days

Two of the variables we can control in our previous test are the amount of days we use to define each of our two trends (long and short term)

Changing these variables has the effect of changing when we enter/exit the market.

We can optimize these values by running our system over and over again, each time changing the values and recording the results.

I’ve attached a spreadsheet showing exactly that, with long term values from 20 to 300 days, and short term values from 10 - 100 days.

As you can see, best results are achieved using 180 days period for our long term filter, and 20 days for our entries/exits.

Here are the complete results with our new values:


Long T: 180
Short T: 20
Pos_Size: 5.00%
Start_Eq: $10,000.00

Gr_Rate: 6.86%
DrDn: 15.73%
End_Eq: $28,175.10

Max_W: $5,711.98
Max_L: -$959.51
Avg_W: $1,002.81
Avg_L: -$341.50
Num_W: 28
Num_L: 29
Win%: 49.12%
Cons_W: 8
Cons_L: 6

These results compare favorably with our initial ones.

Thanks for the catch. Yes, in a short trade, we would place our stop at the highest high.

The post now stands corrected.

Yes, the Turtles, and many other Trend-Followers used breakouts as well.

What we’ve added here is a method for optimizing the amount of days in the period. I hope readers can appreciate the difference in the two examples between selecting numbers at random (or because someone said they were good) and using historical data to test what numbers actually work best.

Ultimately, my point is that the method you use isn’t important. I could’ve chosen a moving average crossover with similar results. What is important is knowing how to use your indicator.

I will add a few more wrinkles to improve the profitability. But one step at a time. :slight_smile:

Right, I don’t use profit targets. The stop-loss also functions as a trailing stop when a trade becomes profitable.

Notice that this seemingly simple system inherently incorporates volatility in:

  1. Position sizing (I am covering that in the next few posts)
  2. Exit timing

I have experimented with the exits by varying the amount of days. At first, I tried shortening the period. So if I entered long on a 20 day breakout, I would exit on a 10 day low. I wanted to take the profit early. What tests have shown me is that this way is actually less profitable with Trend Following systems. I’ve also lengthened the period with some success in some markets, but ultimately, I didn’t know if I could actually trade such a system live. Trader psychology (knowing yourself) is also important in system design.

I’m enjoying your thread; I look forward to it’s continuation.

Happy trading,

Thanks, Art. It’s good to know I’m not just talking to myself. :slight_smile:

I’ll post the next topic within the next few days. It will cover how money-management can improve our profitability.

Moving on to items:

  1. What instrument(s) to trade.
  2. What my risk is.

It turns out, these are related. But first, a little background.

In TF, we focus on things we can control. We can control when to get in and out of positions, but we cannot control price fluctuations. Therefore, refining our entries and exits can only get us so far.

What we can control, always and every time, is risk. Many traders, myself included, at first overlook this concept. It’s so obvious and seemingly unrelated to profits. A lot of work and many simulations later, however, and I can honestly say that I have not come across a more effective way to improve a system’s performance.

This bears repeating: [B]How you size your positions has a much greater effect on your system’s performance than how you choose when to enter and exit your positions.[/B]

I’ll show you some results shortly, but first some basics:

  1. The idea in TF is to benefit from large market moves. We don’t care in what particular market they happen, we just try to be in when they do happen. These large market moves don’t happen every day, every week, or every month in any particular market.

  2. If the size of our positions is too big, we will wipe out our trading account. If the size of our positions is too small, we will miss out on potential profits.

We can further refine this in the following way:

  1. If we scan as many markets as possible, we increase our chances of being in a strongly trending market at any particular time.

  2. If we bet the same percentage of our equity on each trade, we position ourselves to benefit from exponential growth and reduce our chances of wiping out our accounts. We can optimize this percentage to achieve best risk/reward ratio

In the next few posts, I will show simulations of each point to illustrate exactly how influential they really are.

PS: I’m looking for the best way to display results from my excel spreadsheets. If anyone has a suggestion, I’m all ears. Thanks.