The Trend Following Bible
Page 15
Only liars get out at the highs or lows of a trade.
Giving back part of your profits is reality and nothing to fear.
The real hard part of using an average true range stop is where the need for a proper mindset is paramount. One needs both the patience and discipline to see what happens and let the trade unfold both with a potential profit as well as a potential loss. Many traders get nervous when a trade does not start to work and simply exit.
They did not follow the plan.
To their astonishment after they exit, the trade starts trending. Then there are those who see open profit and cannot contain themselves and want to grab that profit. The problem with that is possibly the trend continues and they did not follow their plan. You need these rare big winners to offset all the small losses you will encounter. You need to believe in the plan. As simple as it is, it is robust and can give you the power to compound money over time.
Simple proprietary robust ideas that I use in my daily trading with a strong measure of risk as well the proper mindset are the pillars of successful trend following.
■ Trend Retracement Rules
The concept of trend retracement can be applied in various ways. There are times when for numerous reasons you are not in a trade, you prefer the trend retracement to the trend breakout, or you want to increase your position by pyramiding. There is no right or wrong and each has its own set of rules. The basis is the same; you are trading with the trend and you are only taking low-risk trades.
The reality is also the same that you will have many trades that simply do not work. You will have small losses, small profits, and rare big winners. This is trend following. For aggressive traders you even want to pyramid. Pyramiding is adding to positions. This is a personal issue and left to the discretion of the trader. Greater profits can be created as well as greater drawdowns. It is important to bear in mind that there is a drawdown out there that can stop you from trading.
■ Just Do It
I know many aspiring traders who have read countless books, have learned or developed their own trading strategies, and who have analyzed a number of markets; but they've failed to pull the trigger when it comes to real-time trading. As you know, part of your education is your knowledge and your experience. If you want to make money with trading, then eventually you have to take the plunge and get started.
CHAPTER 7
Trend Breakouts
Remember that hypothetical trades have severe limitations and are used for educational purposes only. The following examples are hypothetical and should not be utilized to provide historical data or make real-life predictions.
■ ArthroCare Corporation
ArthroCare Corporation was a high-momentum stock that was one of the strongest at the time of the signal (Figure 7.1). Going through the conveyor belt of checklist items, it hit all the criteria.
FIGURE 7.1 ArthroCare Corporation
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Review
1. Strongest via smoothed rate of change.
2. Not more than 1 percent risk of total account size.
3. MACD positive and above zero line.
4. Not more than 5 percent of the portfolio was allocated to health care and medical appliances.
5. Did not have 20 percent open trade equity versus core equity.
6. Experienced a breakout trade of X days.
7. No more than 10 longs at the time.
8. After entry the shares started to progress and the hard stop of Y days ago was replaced by the average true range stop. This trade worked; however, as discussed repeatedly, most trades will not work.
■ Baidu
Baidu (Figure 7.2) is a Chinese Web services and search engine company that is often likened to Google.
FIGURE 7.2 Baidu
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Review
1. Strongest.
2. Not more than 1 percent risk of total account size.
3. MACD positive and above zero line.
4. Not more than 5 percent of the portfolio was allocated to China or Internet.
5. Did not have 20 percent open trade equity versus core equity.
6. Experienced a breakout trade of X days.
7. No more than 10 longs at the time.
8. After entry the shares started to progress and the hard stop of Y days ago was replaced by the average true range stop. This trade worked; however, as discussed repeatedly, most trades will not work. The reason I wanted to present this idea was to show the patience that is needed in order to succeed. Those who were not patient or disciplined and did not let the trade work would lose. The average true range stop is not perfect as any methodology is not perfect but does a very good job keeping you in trades when they work. More so, the average true range also is good to get you out of trades that do not work.
■ The 30-Year U.S. Government Bond
Typically, U.S. government bonds (Figure 7.3) are considered safe long-term investments.
FIGURE 7.3 30-Year U.S. Government Bond
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1. Strongest via smoothed rate of change.
2. Not more than 1 percent risk of total account size.
3. MACD positive and above zero line.
4. Not more than 5 percent of the portfolio was allocated to interest rates or government bonds.
5. Did not have 20 percent open trade equity versus core equity.
6. Experienced a breakout trade of X days.
7. No more than 10 longs at the time.
8. We have an additional check when trading futures that the dollar risk per contract does not exceed $2,000.
9. After entry the contract started to progress and the hard stop of Y days ago was replaced by the average true range stop. This trade worked; however, as discussed repeatedly, most trades will not work.
■ The Canadian Dollar
I selected this example to exemplify the reality of trend following. In the prior examples I presented many trades that worked. However, in the real world this is not the case as there will be many trades in which you will have small losses, small profits, and on rare times big profits. Figure 7.4 is a great presentation for this.
FIGURE 7.4 The Canadian Dollar
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You will see the first trade was a loss (dashed lines). The second trade also was a loss. However, the third trade was a profit. Successful trend followers take every trade. They have no idea if the trade will work or not. They just keep on putting on low-risk trades and then see what happens. They have the patience to let the trades work over time as long as they are working.
1. Strongest via smoothed rate of change.
2. Not more than 1 percent risk of total account size.
3. MACD positive and above zero line.
4. Not more than 5 percent of the portfolio was allocated to currencies.
5. Did not have 20 percent open trade equity versus core equity.
6. Experienced a breakout trade of X days.
7. No more than 10 longs at the time.
8. We have an additional check when trading futures that the dollar risk per contract does not exceed $2,000.
■ Feeder Cattle
Feeder cattle, shown in Figure 7.5, is an interesting example. The first trade worked and there was a profit. What I have seen from inexperienced traders is that they would debate taking the next signal thinking that possibly the trade couldn't go higher. They could have been reinforced with this wrong thinking when the trade did not work. It did not work not just once but twice! Two small losses followed. However, on the next trade the feeder cattle trade started working. The point here is that we must be disciplined 110 percent when trend following. We must take every signal. We do not know the future. Anything can happen. The only thing in our control is how we approach risk. This is
why risk management is so important.
FIGURE 7.5 Feeder Cattle
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Reviewing the trade thought process . . .
1. Strongest via smoothed rate of change.
2. Not more than 1 percent risk of total account size.
3. MACD positive and above zero line.
4. Not more than 5 percent of the portfolio was allocated to meats.
5. Did not have 20 percent open trade equity versus core equity.
6. Experienced a breakout trade of X days.
7. No more than 10 longs at the time.
8. We have an additional check when trading futures that the dollar risk per contract does not exceed $2,000.
■ International Flavors and Fragrances
Figure 7.6 is an example of a short trade.
FIGURE 7.6 Short Trade Example
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The concept I want to show is that money can be made both in bull markets and bear markets. It does not matter. The key is to put on low-risk trades. Have the discipline and patience to put the trades on when you have a signal, and when/if they work, have the patience to follow them via the average true range stops. This trade was for 70 bars or days. Too often greed sets in and traders want to take the quick profits. However, as Jesse Livermore pointed out, the greatest profits are made by doing nothing and being patient.
Another point is that it does not matter if you are trading daily bars or hourly bars. The concepts that I have presented are viable on all time frames.
1. Weakest via smoothed rate of change.
2. Not more than 1 percent risk of total account size.
3. MACD negative and below zero line.
4. Not more than 5 percent of the portfolio was allocated to specialty chemicals.
5. Did not have 20 percent open trade equity versus core equity.
6. Experienced a breakout trade of X days.
7. No more than 10 shorts at the time.
8. After entry the shares started to progress and the hard stop of Y days ago was replaced by the average true range stop. This trade worked; however, as discussed repeatedly, most trades will not work.
■ Royal Bank of Canada
Figure 7.7 is another stock example, this time examining the Royal Bank of Canada.
FIGURE 7.7 Royal Bank of Canada
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You never know how long a trade will continue. You need to be flexible in expectations and rigid in your rules. This hypothetical trade lasted for 36 bars. When the trades work, we want to be taken out only by the average true range stop. If the trade does not work, we have our hard stop, which is our Y day's stop, which protects it, and if the trade does start working, we simply follow it and follow our rules. The rules are very simple yet robust and powerful.
1. Strongest via smoothed rate of change.
2. Not more than 1 percent risk of total account size.
3. MACD positive and above zero line.
4. Not more than 5 percent of the portfolio was allocated to banking sector.
5. Did not have 20 percent open trade equity versus core equity.
6. Experienced a breakout trade of X days.
7. No more than 10 longs at the time.
8. After entry the shares started to progress and the hard stop of Y days ago was replaced by the average true range stop. This trade worked; however, as discussed repeatedly, most trades will not work.
■ TJX Companies
The TJX Companies trade is a great example of being flexible and still having trades not work. As you can see, there was a short. This short trade did not work and a small loss was incurred. Luckily the short was covered as the shares rallied and big losses could have been incurred. Several months later a buy signal was received. As Murphy's Law would have it, the trade did not work after a short period of time. Traders at this point would have experienced two small losses in a row and frustration could set in. There is nothing to get upset about.
This is the trend shown in Figure 7.8. You will have countless losses. If you can't take the losses, you should not trend follow. The most important reason for your potential success is how you think or your mental state. You have to just keep on putting on the trades and follow the plan. Hopefully at this point you have internalized that anything can happen. You will have rare big profits at times. You need to have the patience to let them work. These big rare profits more than make up for ALL the losses you will incur. This is why the losses need to be kept small.
FIGURE 7.8 TJX Companies
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Successful trend following boils down to having a simple and robust plan, strong discipline, and the patience to let it work over time.
There will be long periods when you do not make money. At this point you will question yourself and ask yourself if trend following does not work anymore. I can tell you from my own personal experience, I have been there, but the years of successful trading have reinforced me. In addition, there have been generations of successful trend followers. Richard Donchian trend followed for decades.
If Richard Donchian can do it,
If the dentist can do it,
So can you!
■ Cotton Trade
You can see in Figure 7.9 there are two short trades. Initially on the first short one could have gotten nervous. The short was entered and almost immediately the trade reversed. An inexperienced trader or a trader who is not following the exact plan could have panicked and closed the position. However, the trade soon reversed and started moving in the direction of the short. When we are trend following in the proprietary methodology I am teaching, you have two seatbelts to protect you, so there should not be any fear. When you drive a car you wear a seatbelt and do not have fear! You need to believe in the viability of the plan and mostly understand this is not a get rich quick overnight plan.
FIGURE 7.9 Cotton Trade Example
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It is truly a marathon and takes a great deal of endurance to get through all the periods that are very tough and all the trades that do not work.
■ Eurodollar Chart
Figure 7.10 is interesting. The question can come up why the trade seemed to have occurred late. It would have seemed that the trade hit the X day high yet the trade was hit.
FIGURE 7.10 Eurodollar Chart
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This is a hypothetical example but there will be many reasons in the real world. It could have been that you had more than 10 longs at the time and you did not have permission to take the trade. Maybe one of those longs exited and you had a slot open. Another reason could have been that you exceeded your sector risk of 5 percent. You were allowed to take this trade because another trade in that sector dropped out. Another possible situation could have been that you had too much open trade equity versus your core equity. (Do not take trades when you have 20 percent OTE versus your core equity.)
The irony could be that once you finally do enter, almost immediately the trade does not work and incurs a loss. This is trend following. We do not know the future. Most trades do not work! We take low-risk bets and put ourselves in a position to be carried in when trades do actually work. Forget about the concept of win percentages. What is critical for your success is the profit percentage when the trades do work.
■ Sugar
See Figure 7.11 for a commodity example dealing with sugar.
FIGURE 7.11 Sugar Example
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Many times when we are trend following we will have initial profits. However, we give the trade enough room to work via the average true range stop we utilize. In the real world, there will be countle
ss times when you have some small initial profit; however, you end up giving up some of it and, at best, having a small profit. The other reality, however, is that in the real world there will be times that these small open profits even turn into small losses. This is the price we as trend followers have to pay in order to put ourselves in a position over time to compound money.
■ Silver
An interesting example of the necessity of taking every trade is exemplified with the silver chart shown in Figure 7.12. As you can vividly see, you had two small losses one after the other (green vertical lines). If you had not followed the plan and taken the third trade, you would have beaten yourself up. This is why you need to take every trade without question. Neither you nor I know the future. Forget about all the so-called analysts and gurus. They do not know the future either. The only thing we know is that we will have numerous small losses, numerous small profits, and at rare times big profits of trades that surpass our expectations.
FIGURE 7.12 Silver Example
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With my help as your mentor you will be consistent. Consistent does not mean every trade has to work. Consistent means you follow the plan and let the odds work over time.