First, I want to be very clear that this is exactly how I approach trend following. It is not magic in any way whatsoever. It simply appeals to me as well as many others. There are other ways to trend follow besides the breakout and retracement strategies that I use. My goal is to share with you exactly what I do every workday. When a market does trend, various methodologies can work such as moving average crossovers, Bollinger breakouts, channel breakouts, or even stochastic. There is not one that is better than the other.
There is no holy grail system; rather, there is one that fits your personality.
There is no magic or perfect parameter. Be careful not to try to curve fit or make parameters something they are not. What is more important are the risk measures and the mental plan.
When you trade with a plan, you never have to worry about missing a trade. You only want to try to put on low-risk trades. If you miss a trade, it was not supposed to happen as you would be putting on too much risk.
When you trend follow with a plan, there is no fear that the U.S. dollar will crash, gold will go to $5,000, or the stock market will crash. You stand the possibility somewhere along the line of being able to put on a low-risk trade in which you should not risk more than approximately 1 percent.
I use two approaches in order to attempt to catch and ride trends. They both attempt to put on low-risk trades in the direction of a trend and have various similarities.
■ Trend Breakout and Trend Retracement
Trend Breakout
How to determine what to buy or sell. This is the key to determing the universe to trade.
Step 1: Identify the Universe
When using the trend breakout approach, I liken the thought process and trade process to the idea of a conveyor belt. All potential trades are on a conveyor belt. The first filter I use in my attempt to put on low-risk trades is to identify our universe of potential trends. This is completed by ranking all potential markets by a smoothed rate of change. This was discussed in an earlier section. We look at three rates of change periods on a higher time frame and average them together. We smooth them in order to be free of noise from sudden spikes. All markets that we look at are ranked from strongest to weakest. We want to only focus on the strongest markets with the hope that they will continue to trend and be strong, and vice versa we only want to focus on the weakest markets with the hope that they will continue to trend and be weak.
Step 1 is about identifying the strongest markets and the weakest markets.
Step 2: Look for a Trend Breakout
The idea of the trade breakout was devised by Richard Donchian decades ago. Countless trend followers have based their methodology on Richard Donchian's thinking. Some famous trend followers that have used Donchian's work are William Eckhardt and Richard Dennis from Turtle Trading fame.
The basis of this robust idea is simple: Buy the X day high and sell the Y day low.
Donchian made it very simple: Buy the 20-day high and sell the 10-day low. Richard Donchian lost virtually all of his money during the Great Depression. After analyzing what he did wrong, he came to the conclusion that he would trade with the trend breakout approach. He traded in this exact fashion for decades. I want to reiterate: DECADES!
However, trend following is not easy in any aspect, and repeatedly throughout my career over the last 18 years I have heard that trend following is dead. Even my wife at times has asked me if trend following is over. There will always be periods in which profits are elusive. Some of these periods are longer than we are comfortable with and people give up. I have seen drawdowns lasting greater than two years.
In the 1980s Richard Dennis and William Eckhardt furthered their use of the trend breakout concept when they made a bet that trend following can be taught. This real event was the basis of the movie Trading Places with Eddie Murphy. Richard Dennis and William Eckhardt taught a select group of traders the trend breakout approach and called them Turtles or Turtle Trading. These traders all received the same education and rules from Richard Dennis and William Eckhardt. The learning curve only lasted two weeks. What is most ironic is the difference in returns of the Turtles. They all had the same education, yet they invariably had different returns. There was only one reason why: how they thought and their mental processes.
Trend breakouts are simple yet extremely effective!
Remember, simple does not negate profit potentials!
A proper trend following mindset is more important for success than any methodology!
The trend breakout approach can use a multitude of variables. Richard Donchian as well as the Turtle Traders used a 20-day high with a 10-day low as the breakout for a buy and vice versa for a sell, a 20-day low with a 10-day high as the protection. The actual variable is subjective and depends on the trader. Shortening these parameters will lead to more false breakouts and extending them lessens false breakouts but gets you into trades later. There are always trade-offs when trend following.
Going back to our risk parameter, risk per trade, one measures the dollar risk from the breakout high X to the Y period low to ascertain the risk (the distance from X to Y and what each tick is worth). The trade should be passed if the dollar risk as a percentage of core equity exceeds approximately 1 percent. The idea of 1 percent is my personal opinion. There are others who are willing to entertain more risk and benefit from greater potential reward. However … I want to point out in the strongest of terms that many think they can handle the risk until they go through the inevitable drawdown. When going through this drawdown they go into shock. This is the reason I always look at how much risk I must take on in order to generate reasonable returns.
The signal is the breakout buy of X high with the risk to the Y low. The signal for a breakout sell is vice versa.
In order to calculate the 1 percent risk, you calculate the difference between the X day high to the Y day low. For example, you decide you want to use the breakout parameters of buying the 20-day high and selling the 10-day low. Remember, there are no magic number parameters, and the smaller the parameters, the more trades and more false breakouts. More so, remember that most breakouts do not work and you might be increasing the likelihood of more trades not working. Contrarily, if you use a lower parameter, you will enter earlier and have greater potential profits. Again, there is no free lunch. To further present, for example, the 20-day or X day high you decide on is 20 and the 10-day low or Y low is 16, the difference is 4. You do not want to risk more than 1 percent. For example, you have a $100,000 account and you want to risk only 1 percent or $1,000; therefore you can put on 250 shares. Another point to consider: I would pass if the per share risk was too high. Again, that is a personal decision and there is no exact parameter. It is a number you are comfortable with. More so, in many trading platforms this calculation can be automatic.
In Step 2, you confirm the breakout risk is not more than 1 percent of your core account size; if it is, go to the next step.
Step 3: Trade in the Direction of the MACD
In virtually every trading program or Internet chart software there is a momentum indicator called the MACD. As part of our conveyor belt of trading ideas, I will only consider taking the buy or sell if I am trading in both in the direction of the trend of the MACD. For a buy, I want the MACD to be above the zero line and positively increasing. For a sell, I want the MACD to be below the zero line and negatively decreasing.
Figure 6.1 depicts Google. In this chart, we are buying an X period high, and this is confirmed in the MACD by being above the zero line and increasing.
FIGURE 6.1 Google
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In Figure 6.2, showing HSBC, we would be selling an X period low. We are confirming with the trend that we are currently in a downtrend by the MACD being negative and below the zero line.
FIGURE 6.2 HSBS
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In Figure 6.3, showing Leucadia
, the downtrend is confirmed by the MACD being below the zero line and decreasing. We would have sold the X period low and follow the trend.
FIGURE 6.3 Leucadia
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Figure 6.4 shows a chart of Netflix, in which we are trading with the trend confirmed by the MACD above the zero line and increasing. We would have bought an X period high to see what would happen.
FIGURE 6.4 Netflix
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Step 3 is about trading only in the direction of the MACD. If long, confirm you are above the zero line. If short, confirm you are below the zero line.
Step 4: Limit the Number of Trades in Each Direction
As another filter in order to attempt to mitigate some of the inherent drawdowns, I limit the maximum number of positions I will have at any one point. I have overlapping levels of protection. Again, the number of positions of longs and shorts is subjective. I personally do not want more than 10 longs or 10 shorts at any time. The more positions, the more risk. Going down my conveyor belt idea, I will not take the trade even if the other prior parameters hit if this upcoming trade will put me over 10.
So for Step 4, do not exceed more than 10 longs and 10 shorts. Now on to Step 5.
Step 5: When Trading Commodity Futures Contracts Limit the Maximum Dollar Risk per Contract
As another layer of risk management, limit your total dollar risk per contract. What I experienced was that as my account size grew, 1 percent of $200,000 is a $2,000 risk per contract. However, when my account grew over the years, 1 percent risk on a $500,000 account became a $5,000 risk. As we know that most trades do not work, in my opinion that was too much risk to take. Therefore, I limit my dollar risk per contract. If the risk exceeds my levels, I do not take the trade.
Step 5 says not to take a commodity trade if the dollar risk exceeds $2,500 a contract, regardless of account size.
Step 6: Maximum Risk per Sector
Over the last 18 years I have made repeated mistakes. One of the most glaring mistakes has been allocating too much to a particular sector. Regardless, if I am only taking a small risk per trade when they are concentrated I open myself up to increased risks. What happened was that I would get a signal in the interest rates. They all seemed low risk with risk per trade of approximately 1 percent. However, due to their concentration, I ended up with big drawdowns. I limit my exposure per sector to a maximum risk of 5 percent of my portfolio.
I will not take a trade if I surpass this risk per sector. Sectors are prevalent in the stock market as well as the commodity markets. To further clarify, I will not take another trade in tech stocks, for instance, if my total risk in tech stocks was 5 percent, or if I had an exposure to the grains—wheat, corn, soymeal, soybeans, and so on—that was 5 percent, I would pass on the trade that would put me over this threshold.
Do not take the trade if you have already allocated 5 percent of your account in that sector.
Step 7: Maximum Risk on Total Portfolio
Before I take a new position I verify that I will not surpass a total open trade risk versus my core equity. The reason for this is that the more open positions, the more risk I am taking on.
I have learned over the years that my biggest drawdowns are during periods in which I have the greatest amount of open trade profits. When I get to a point when I have 20 percent open trade profits compared to my core equity, I will take a new trade. This is an attempt to mitigate big drawdowns.
This is very easy to calculate. I simply divide my open profits by my core equity. My core equity is my original equity and closed profits. For example, if I have a current account size of $100,000, I would not let my open trade equity or open equity increase more than $20,000. One could tighten the stops by adjusting the ATR volatility stop or take profits. There is no wrong or right answer. The answer is dependent on your risk tolerance.
Do not take the trade if you have already have 20 percent of your total core equity in open profits.
Quick review of the seven steps to take before entering any trade:
1. Identify the strongest markets and the weakest markets. These should be the only markets in which you look for a trade.
2. When you get a breakout signal, confirm that the breakout risk is not more than 1 percent of your core account size; if so, go to the next step.
3. Trade only in the direction of the MACD. If long, confirm you are above the zero line. If short, confirm you are below the zero line.
4. Do not exceed more than 10 longs and 10 shorts.
5. Do not take a commodity trade if the dollar risk exceeds $2,500 a contract regardless of account size.
6. Do not take the trade if you have already allocated 5 percent of your account in that sector.
7. Do not take the trade if you have already have 20 percent of your total core equity in open profits.
If you have passed all of these criteria, then you can take the trade and see what happens. Do not expect the trade to work.
Any trade is 50/50.
Now that you are in the trade you need to protect yourself and follow the trade if it works.
Stops
You need to protect yourself since most trades do not work. I do this by the usage of two stops. My first stop is my hard stop or initial stop.
If I am long my predefined risk is the Y period low, and if I am short my predefined risk is the X period high.
As an example, if I use parameters such as a 20-day high and a 10-day low, my initial hard stop is the 10-day low. I count back 10 bars and that is my maximum risk level. I do not vacillate! Most trading programs include this feature (lowest low for Y periods or highest high for X periods). The Y day low stop is immediately entered into the market once I have been filled. I do not change it if the price gets close to it. This stop is set in stone. If the stop is hit, then I exit with a small loss and move on to the next trade, no big deal!
On another tangent one can offset these stops slightly by a small parameter, but this is a personal preference and not totally necessary.
An important point from an earlier section is that the last trade has no bearing on the upcoming trade. Every trade is 50/50 and statistically independent. You must take every trade—you cannot pick and choose because you do not know the future!
■ If the Trade Starts Working
If the trade starts working, meaning it starts moving away from my initial hard stop, then the next following or trailing stop kicks in: the ATR trailing stop. There is no perfect indicator; however, I prefer the trailing ATR stop as a trailing stop method.
The ATR stop is based on average true range. Average true range was developed by J. Welles Wilder as an indicator that measures volatility. Welles Wilder developed his concept called true range (TR), which is defined as the greatest of the following:
■ Method 1: Current high less the current low.
■ Method 2: Current high less the previous close (absolute value).
■ Method 3: Current low less the previous close (absolute value).
For those of you who would like to understand the background of the ATR trailing stop, the basic premise is in measuring the distance between two points, not the direction. If the current period's high is above the prior period's high and the low is below the prior period's low, then the current period's high-low range will be used as the true range. This is an outside day that would use Method 1 to calculate the true range. This is pretty straightforward. Methods 2 and 3 are used when there is a gap or an inside day. A gap occurs when the previous close is greater than the current high (signaling a potential gap down or limit move) or the previous close is lower than the current low (signaling a potential gap up or limit move).
Figure 6.5 shows examples when methods 2 and 3 are appropriate.
Example A: A small high/low range formed after a gap up. The TR equals the absolute value of the difference between the current high and th
e previous close.
Example B: A small high/low range formed after a gap down. The TR equals the absolute value of the difference between the current low and the previous close.
Example C: Even though the current close is within the previous high/low range, the current high/low range is quite small. In fact, it is smaller than the absolute value of the difference between the current high and the previous close, which is used to value the true range.
FIGURE 6.5 True Range
■ The Calculation of Average True Range
Basically, the average true range (ATR) is based on X periods, which can be calculated on any period such as intraday (for day traders), a daily, weekly, or monthly basis. For this example, the ATR will be based on daily data. Because there must be a beginning, the first true range value is simply the high minus the low, and the first 14-day ATR is the average of the daily TR values for the last 14 days. After that, Wilder sought to smooth the data by incorporating the previous period's ATR value. The ATR value as well as breakout highs and lows are subjective. I personally like to look at a much longer period. I use a 39 period. I give the trade more room with this parameter, but again there is no magic number.
Most charting packages have average true range and average true range stops built in so there is no need to manually calculate either the average true range or ATR stop.
The trailing ATR stop continually makes adjustments to make sure that the stop is moved in your favor. The ATR stop trails the progress when there is a trend yet gives the trade enough room to work. The ATR trailing stop is one way to limit losses and protect profits. A stop-loss order is set a multiple of the average true range (ATR) away from the current price. If the price moves in the trade's favor, the stop follows along. As with all trailing stops, the ATR trailing stop never exits at the high or a low of a trade. You will always give back some of the profits.
The Trend Following Bible Page 14