Keep it simple or pay the price

We constantly hear the question, “Can I trade
trend following methods as a day trader or short-term trader?”
The short
answer is “no,” but consider some recent feedback on “shorter-term” trends
posted on the blog

“I have been exiting some ‘trend-following’
trades more quickly than before, and have, as a result, often ‘saved’
substantial profit that I was previously letting slip away. I share this with
the hope that it might help others who might suffer from the same misconception
that ‘trend following’ has some pre-defined aspect of time built into it. It

Generally, the strategies used by trend-following
traders are long-term. Long-term trend following is how they define themselves
and their trading. There are the few super traders (such as Jim Simons and Toby
Crabel) who trade extremely short time frame trends (or time frames) with
success, but the average trader has virtually no shot with so-called “shorter
trends.” Shorter trends demand far more in terms of execution excellence, as
they force traders to handle often extremely volatile variables, and commission

Furthermore, by shortening your time frame, you
essentially give up participating in large trends�which is exactly what
trend-following strategies help traders do best. For example, take a look at the
July 2006 Copper Chart. The market gave a very clear breakout signal and then
moved substantially higher. Trading with profit targets, or attempting to
shorten your time frame, would have forced you to exit too early, thereby
causing you to give up a substantial amount of potential profit. From the
original breakout to the end of the following chart is worth approximately
$50,000 USD a substantial amount of profit to leave on the table!


The critic’s assertion that he is controlling his
risk and forgoing some profits is not the real world. Maybe you saved a few
points here and there from exiting a trade early thinking you could divine the
“top”, but it creates a circumstance where you miss out on tens of thousands of
dollars of potential profit in the long term.

Premature exits create another problem. They can
increase your risk per trade as the trend extends. When a market first breaks
out, such as the Copper example, it often does so with a small risk per
contract. Risk increases as the trend progresses because the daily ranges
expand. Entering a position late in the trend will force you to use a larger
risk per contract, decreasing unit size of the position as compared to the
initial breakout. The in and out action, or the dissection of the trend will
cause your unit size to go down as the market trends farther. Each subsequent
re-entry will have a smaller unit size, which can slash your potential profits.

The recent trend higher in Gold is another reason
why premature exits can be deadly. Gold traders have been waiting for years for
this opportunity. The explosion in prices drove the market to 25-year highs
making it one of the hottest (and best trending) markets of the last 3 years.
However, traders who used profit targets, or some form of early exit, were left
on the sidelines for much of the rally:


Sugar is another market that recently made a
substantial move higher. Arbitrary profit targets may have left thousands of
profit on the table:


At the peak of these charts, traders who
dissected the trends, or attempted to time the volatility, would have been left
with far fewer contracts than those who left all positions in tact from the
beginning. From a pure profit view, it is better to accept some drawdown and
keep your unit size the same. In the end trying to prevent a percent or two of
drawdown could cost you 10 to 20 percent worth of profit. But the concept of
drawdowns is still confusing to many as evidenced by this feedback:

“It is clear trend following is neither
fundamental analysis nor technical analysis. Trend followers enter the market
when the trend is in the early stage and they quickly exit when the trend
reverses to limit the losses. Yet, the book talks about drawdowns in trend
followers’ portfolios. Does not drawdown mean that the trend went against them?
It (seems) counter-intuitive.”

Janice Dorn, M.D., Ph.D. recently offered some
great feedback to the issue of drawdown:

“The most difficult thing for traders to do is
to sit there and wait. Why? Because, we live in a society that is on a total
dopamine, hypo manic binge. This is never more clearly manifest than by those
who absolutely have to be in the markets at all times, desperately need to be
trading and simply cannot wait. They are human do-ings, rather than human be-ings.”

Her wisdom is spot on. Further adding to that
point, consider views from Brett Steenbarger and Adam Mann on how to manage the
psychological risks of trading:

“The psychologist Donald Meichenbaum
introduced a technique for stress management that he called stress inoculation.
He found that exposing people to low levels of an anticipated stressor helped
them cope with actual stresses when they occurred. Evaluating your
performance–knowing your likely drawdowns, drawups, and flat performances in
advance–is a kind of stress inoculation, preparing you for the outcomes you’re
likely to face even when you trade well. We are well acquainted with how
emotions can disrupt trading; less well appreciated is how trading can play with
our heads! As in medicine, a little inoculation can go a long way toward
preventing major ills.”

Reaction Not Prediction

We are not asserting that you cannot exit a trend
in progress and then re-enter. The market may get you out of any one of these
markets only to re-enter later. But there is a very important distinction here.
If the market pulls back and makes a new low then perhaps your trend following
strategy gets you out of the trend. Let the market tell you when it is time to
leave, don�t be tempted to put an arbitrary price point in place.

All of this logical thinking is still lost on
many though.

There is a small minority who continue to
question trend following’s validity, vehement in their belief that prediction is
an absolute necessity:

“So, in other words, you trade according to a
system the signals of which are not associated with whether price will move both
in the right direction and to a certain minimum extent after the trader has
committed to a prospective entry? Good luck. You’re going to need it.”

That is correct. Trend followers never have
knowledge of some minimum extent move after an entry. How could anyone know the
minimum extent move? However, all this being said, many people still are blind
to the realities as a blog reader wrote complaining trend following is not for

“The problem is you will spend a lot of time
and effort just breaking even on what are presently very stagnant markets. While
it is true