Trend Following | Portfolio Yoga

Misunderstanding of Absolute Returns

In school, I never wanted to be scolded / hit / made to stand on bench by the teacher and while I was never a meritorious boy, I did enough to ensure that I never got on the wrong side. By the time I finished studies, I was sure I wanted to get into business and not a job. Why? Well, you never get scolded by your boss while you can easily (or at least those were the thoughts in those days) make as much or even better by being your own boss.

I read stories of the successful men and women who went to the top starting with not much than a Garage and a few ideas (I don’t remember reading too many Indian Entrepreneur stories). Then again, no one told me that failure was plenty in business and very few actually made it through.

Its been 20 years now since I went on my own and its been a journey of up and down’s and like in markets, have always used the stairs to climb while lady luck (why blame myself) pushed me back through the elevator vault to nearly where I came from (with only experiences to carry forward). On the other hand, the 1 year I did work under some one else was a revelation and a thoroughly enjoyable experience. Talk about getting misled by faulty opinions.

Being a trader I talk with a lot of people and the one common refrain I hear (especially among trend following friends) is that the reason they chose this method over others is their belief that only this method provides them with “Absolute Returns”. But digging a bit deep, it seems for majority of the folks, Absolute Returns = (Strong) Positive Returns regardless of where the market has done.

Much of the literature too tries to showcase how trend followers blew our their competitors in 2008 even as much of the competition just packed up and left. But that is just half the story. Lets start with one of the most famous trend followers and CTA – Dunn Capital Management.

Draft DUNN Information September 2016.xls — Dunn Capital – Equity Curve

The chart (Click to Expand) showcases 2 things – the out performance of Dunn Capital over the S&P 500 as well as the major draw-downs it had during the course of the journey. [A note here, Dunn trades more than just S&P 500 and hence the comparison maybe down right faulty]

When one looks at charts such as these, its easy for the mind to assume that we would be more than happy to have similar kind of returns.

But then again, that is due to the visual nature of the chart which leaves out a large part of the information.

Take for example their draw-down of 63% (heart breaking for anyone regardless of how well his previous returns have been) that seems to have been touched in late 2007.

Let me expand on that a bit. You are down 63% on your capital (measured from your peak) even as markets have bit a new all time high. While the rest of the world (your friends basically) are partying, you are left wiping up the ashes your system seems to have left behind.

This draw-down started not in 2007 or 2006 or even 2005 but in 2003 / 04. Remember, that was the start of a great bull run that ended in 2008 even in US. Can you really live with that kind of performance number.

I don’t know about you, but I personally would have long died (not financially but due to the emotional hit that such draw-downs create) long before the next peak in my equity curve arose .

When folks talk about “Absolute Returns” they aren’t meaning returns that are different in nature from the S&P. What they mean (in their view) is returns that are positive regardless of the state of the market. In other words, they are looking for the Utopian dream of “Permanent Returns”, something that can be achieved only by the much abused (by market folks) Fixed Deposit.

For long I have been a votary of Trend following and have given talks on the same to showcase why people should give a thought to this kind of strategy. But the question that I hadn’t focused was whether it was suitable to everyone I preached. An even more important question I left asking (to myself) was whether I was willing to take the pain of short term draw-downs and be able to live with it.

Most trading systems I have come across don’t beat market returns (if you measure / compare correctly). They do beat over short to medium time frames, but over the long term, very few are able to consistently beat and compound the returns.

For many, the way out is to leverage. If your system generates say 10% vs Nifty move of 12%, a leverage of 3 times should provide you with 30% returns. Easy right? But then again, draw-downs are thrice what your historical draw-downs will be and given the fact that leverage means paying up the margin / marked to market losses means that the risk is that rather than seeing yourself with 3x returns, you will have a much higher probability of seeing your capital deplete by 65% or even more.

“Bulls make money, bears make money, pigs get slaughtered” is an old Wall Street saying that warns investors against excessive greed. As traders, I wonder whether we ever think that we could be the pigs (majority of us since few will always be there with mind boggling returns). Food for thought, eh?

Travails of a Trend Follower

Over the last few decades, Trend following has really taken off with a lot of believers flooding the streets so as to say. After all, if I were to sell you with charts like the one below, why would you not be convinced about its benefit

But then again, I choose that particular chart out of the 1000’s available because I could use it to show what I wanted to show. Selection Bias / Survivor Bias and what not come into picture the moment I select a single or even multiple instruments from a set of data.

But trend following is tough and this makes one starting to question premises even when we can show from history that what is happening is exactly something that has happened in the past and will happen in the future as well. But, past is the past and the future is unknown. Present is the key and our emotions aren’t really concerned with either the past or the future but the moment on hand.

Yesterday for instance I had a debacle day for me. In the morning my stops got stopped out and I went long. Well before the close though, I once again got stopped out and went back to the original short mode. But markets had not ended and while I did not get any fresh signal markets did move a lot higher than the point that my longs got stopped out and I went short once again.

This is a rarity for my system with system exiting 2 trades in a single day being just 5% of the time, but it hurts and not surprisingly is the costliest (per trade) whipsaws as the chart below will showcase

What is striking in the above chart is that whenever the trend ends fairly soon, you end with negative results that are the primary contributor to the adverse win-loss ratio most trend following systems have. In the above system for example, if you are in the trade for more than 7 days, the probability that you shall still end up in a loss is pretty low. The chart below plots the same

Its amazing to see how not a single trade (out of 365 in above example) could close in +ve if the reversal happened in the first couple of days. Once that hurdle is crossed, the probability keeps going lower until it hits zero and stays there.

Since 1996, Nifty has moved up by around 8000 points. But if you were a trader, you could have gained that 8000 points by being rightly positioned on just 36 days (which is just 0.70% of the total number of trading days). If you were having a trading system that traded daily, if you slept for the first 10 years (1996 – 2006) and applied your theory on just those 36 days, you will have in theory outperformed all 99.3% of the other days (all this being theory, but please bear it with me for a moment).

In other words, you could have been long since 1996 and gained exactly the same points as some one who entered and exited daily on just 36 occasions. Of course, if only we knew about these 36 days in ahead, why would we bother would be the question in your mind and you are absolutely right.

But think on the contrary you were long for all the time and yet were out of the market on those 36 days. What would you be staring at? You would be looking at having the same capital as you did 20 years ago.

Now, lets take a trend following system equity curve. What is the cost of missing a few trades (which inadvertently turn out to be the best trades you could have taken)?

As can be seen above, more the trades you miss, lower the returns. Since the number of trades scrutinized above is around 365, missing 15 trades is missing only 5% of the Signals and yet the returns can be disastrous. You could always argue that maybe the trades you missed weren’t the best but the worst and hence the returns actually are better. But if you could do that in real time, your success rate will be closer to 100% since you can easily over ride all bad trades similar to the way many advisors just remove their bad calls while showcasing their good ones.

So, given this relationship, why do traders still try to skip few trades in the hope that those skipped will be a loser and hence be advantageous. Think of a coin toss. Theoretically odds of a fair coin falling either on its head or tail is 50:50. But if you were to toss the coin n number of times, you can get streaks of heads or tails. But does that change the probability of the next coin toss to something like 40:60? Of course not.

Trend following systems have a average winning of 40 trades vs losers of 60 in a sample of 100. But that doesn’t mean anything since you can have 10 or 12 or even 20 consecutive losers without one single intermittent win. But does that really change the overall ratio? I say Nope. It still remains 40:60 in favor of Losers.

I keep hearing various remarks about how you should know when to ride the system and when to over-ride, how one should not take a trade before a big event (which is actually of a lower risk compared to the risk of the Unknown event we take when we carry positions home everyday), how January is not a good month for longs among various other theories.

When you have a loser after loser, its easy to believe a lot of nonsense that gets sprouted. But as showcased above, data indicates that missing can cause more harm than participating in each and every trade. All we can control is Risk and that is better controlled by modifying our position size than by skipping a few trades.

Trend following & the Greek Referendum

One of the reasons I am a strong believer in trend following is that I have observed that in all cases where markets were supposed to be caught by surprise by an event that shook the markets, the trend was already down. I have in the past given presentations and talks using examples such as the Kobe earthquake, September 11 attacks, our Election results among others. Every time, the trend was already established in line with the future unfolding.

To that extent, this day’s opening gap down of 1.6% was definitely a surprise since markets seems to have had the least amount of any such anxiety going into Friday’s close. In fact, even the Greece markets seemed to have missed any clues as it closed in the Green on Friday.

The non believers though seem to have been having a field day

So Greece was not priced in?

— zerohedge (@zerohedge) June 29, 2015

So, I decided to see, how often this is the case – the case of the short-term trend being up and markets opening down 1.6% or greater. For the short-term trend filter, I used a 15 day EMA.

Since 1999, we have had just 4 such instances with the last event being on 16th July 2013. And other than the 1999 event day, every other day, we actually closed above the open price though on no occasion did the markets close in positive territory (and that includes today obviously).

The table below showcases the performance of the markets for the next 5 days post such events

Based on historical evidence, t+1 which is tomorrow, seems to have an edge in terms of a positive close. But more interesting is that other than in 1999, the bullish trend of the past seems to have held on with this day being an aberration of some sort and not a deal breaker (given the low number of instances).

Support, Resistances and Trend Following

Support and Resistances are the key tools of technical analysts who rely on the chart for making their assumptions. The key concept here is that of human psychology. A support is a place where the markets have made a bullish reversal earlier and one where one can expect fresh buying to come in and a resistance is a point where the price had taken a bearish reversal and hence when the markets came back to the same point next time around, you should see some amount of selling.

Rather than re-write what has been written in multiple books, I shall instead reproduce here what Jeremy Du Plessis writes in his authoratitive book on Point and Figure.

The price is in a downtrend. It pauses, reacts back up to point A, and then falls to point B.Technical Analysts do not reason why it did this; it is simply understood that supply and demand caused the price to move in this way. At point A, buyers were not prepared to pay any more and so the price declined to B, where the buyers were prepared to start buying again.

You have to remember that the market is made up of lots of participants with differing views and obj ectives. Buyers who bought at point B may take profits at point C. However, there is another group who bought at point A, are pleased that the price has risen back to the same level at point C, and are pleased to get out of their position. This collective view causes a resistance level at point C and causes the price to move down from point C.

Remember, buyers at point B made a good gain when they sold at point C, and so when itgets down to point D they start buying again. This creates a support level, where buyers are prepared to take an interest again. This demand pushes the price back up again. Once again, at point E, they start selling, reinforcing the resistance level at that level. This causes the priceto decline again until it reaches support at point F, where the same short-term traders, who have bought at B and D before, start buying again.

Point G is as far as the price gets again because the short-term traders have become confident that it will not go higher, and so the resistance at that level gets stronger. It declines again to point H and, once again, the buyers come back again, creating support for the price. The price bounces to point I and then falls back to point J. The same buyers who bought at point H are pleased that they now have a second chance to buy at the same price at point J, but this time, the sellers are in charge and force the price below point J. It is important to consider how the participants feel about this. Buyers had become confident buying at the same level and
making a profit, so much so, that they probably were buying increasingly more each time.

For the first time, they are in a losing position. Some will sell their positions immediately, creating a selling frenzy that pushes the price down. Others will, however, hope and pray that the price will rise back to the price they paid. Point K is the point where the price has become oversold. That is, it has fallen too far too quickly, and short-term traders looking for a quick profit start buying. This forces the price back up to point L briefly, where the new buyers take a quick profit and some of the B, D, F,H and J buyers sell to break even. The move to point L is short-lived as so many sellers appear. So, the level at point L, which was a support level, now becomes a resistance level.The price falls to point M.

There is no reason why the price stops at point M. It could be at any level. It is simply a point where demand exceeds supply and the price is driven back up again. It is important to pause and consider the psychological make-up of the participants. There will be a large group who bought at the B, D, F, H and J levels and are still holding their positions. What is going through their minds is ‘if only the price can reach the price I paid, I will sell out and never buy another thing again’ ! This creates even more resistance at the L level, which is the same level as the previous support. So, when the price does eventually rise back to that level, those who have been praying start selling at point N, reinforcing the resistance level and forcing the price down again to point or lower. The level at points L and N will remain a strong resistance until there are no sellers left at that level.

The important point about this scenario is to understand that levels of support and resistance do occur on charts and that they occur for psychological, not fundamental reasons. When support is broken, it is important to recognise and understand that support becomes resistance to any up movement and that this is also caused by psychological reasons. Although not shown in the diagram, resistance, once broken becomes support to any down movement. So support and resistance alternate.

Trend following on the other hand does not concern with Supports and Resistances as those defined in the chart above. What Trend following looks for is a reversal of the current trend. So, at none of the points mentioned does a trend follower get a signal to reverse his existing position.

Trend following is always a late comer since it first waits for evidence of the fact that the trend has really turned around to Bullish / Bearish. Only once the confirmation (based on whatever approach you have), does one get a signal to reverse the signals and bet on markets moving the other way.

When you assume markets to reverse from a support or resistance point, you are in affect claiming the power of prediction where none exists. At any resistance / support level, what is the probability of a reversal happening? I would say its 50-50. It may happen, It may not. But if the whole probability is just 50%, why are Support / Resistance lines looked upon with such flavor?

The reason in my view is that this happens due to the fact that we see what we want to see. Lets use a real example, the Daily chart of Nifty.

I have marked all previous tops as they occurred. As you can seem only once or twice was the next low in line with the previous top. Most times, it made a low where there is theoretically no supports or made a high where there was no resistance (the Dotted line for instance).

Markets being a game of probabilities, do you really want to go with nothing but a theory that is seen as good just because we can find evidences of it working (Selection Bias anyone?).

Nowadays everyone calls himself a trend follower as trend following has become the faith to be seen in (just like all folks on the fundamental investing side want to be seen as Value Investing, even when they are investing in stocks like Bosch 😉 ), but true trend followers never trade based on rules that cannot be tested historically using a automated program.

After all, its well known that the mind has the ability to see patterns where none exist and similarly, we are adept at seeing support and resistances where they worked while if you were to codify it, you shall see that its a strategy that does not have a Edge.

Nowadays I am starting to agree with the philosophy of “Whatever Works”. If it works for you great, but do remember not to confuse strategies just because some one says they are one and the same.

The reason Asrtrology / Vastu and even Homeopathy is looked down upon is not because it has not been proven to be right ever. Search enough and you shall spot enough folks who shall swear by it. The reason why they are not accepted by the scientific community is due to the fact that they cannot pass tests designed to remove the human bias and behavior pattern for instance.

In Technical Analysis, unless you remove the bias of the self, any pattern / any strategy can be seen as one with excellent characters where none may exist. In a way, its amazing that while we understand the reason why lottery ticket buying is a waste of money given the low probabilities of it working for us, we fail to reason out similarly low probability strategies that are abound in the market.

Until you are able to sieve the wheat from the chaff, the results will always be sub-par – something that you could have got without having to go into all that trouble in the first instance. Food for though. eh? 🙂

Betting on Elections – Gambling or Trading

On Twitter, its amazing to see the number of winners who seem to be right in whatever trade they report (mostly after the move) and in an attempt to get them to commit to something, commented that I was going into the election result day with “Long Nifty” positions.

Good friend, Nitin of Alpha Ideas replied back with a quote by “Paul Tudor Jones” and I quote the same here

“I don’t risk significant amounts of money in front of key reports, since that is gambling, not trading”

Now, unlike the hundreds of quotes available, this is from a guy who is seen as one of the Top Technical Analysts ever (Link) and hence something that cannot be dismissed off hand (as I generally tend to do). This guy has some serious skin in the game (as against the guy who invented that term but seems to spend more time talking than trading – but that is for later:) ).

In many ways, trading is generally seen as Gambling though the gulf between gambling and trading is as wide as the Brahmaputra at its widest point. A gambler is one who takes risk with not much of a risk management and generally in a place where the odds of winning are pretty low.

The big question out here is, If I am positioned for the election result – am I gambling or this is as normal a trade as any other I take? To answer that, let me give you the thought process that made me willing to bet (and I generally bet as much as I can afford – no half measures out here) and why I believe that if one looks at history (and TA is all about the history repeating itself), betting on the long side is the way to go.

I am a believer in positional systematic trading and believe that intra-day trading or discretionary trading (gut based or based on ideas that cannot be historically tested to see its accuracy) is not the way to go. I am also a strong believer in trend following since evidence has shown that all said and done, for some reason that is as yet not explained, trends do persist more often than they are supposed be.

The big profits of a trend follower come from the outlier’s – moves that are 3 / 4 or even 5 standard deviation from the mean and which theoretically should not occur in decades or centuries but which happen more often that not. Its the outlier that ensures the profitability (extra Alpha if I may say) of a trend following system since it generally has more loss making trades than profit making and these one off trades more than compensate for all the losses.

Outliers can occur due to various reasons – Known events and Unknown events. Election results are a known event since regardless of what happens, results will be out by day’s end. On the other hand, a attack on the World Trade Towers in 2001 was an Unknown event since no one knew such a thing could happen.

A couple of years back, I had given a talk on Trend Following and showcased as to how markets seemed to be perfectly aligned with the post event trend even though in case of unknown events, the very event was a surprise. Let me take you through some of the examples I provided in that talk

1. Fall of BJP led NDA Govt in 2004

As can be seen, in the run up to the results, despite the euphoria of “India Shining”, the markets were considerably weak. Markets closed with small gains on result day and tumbled in the next couple of days.

2. UPA wins the election in 2009

Now, this was supposed to be so big a surprise (especially that of Congress along mopping up >200 seats) that Index froze higher. But look at the chart and say that the trend was anything other than bullish

3. Terrorist Attack on World Trade Towers

Now, this was a unknown unknown event of a magnitude not seen in a very long time and yet, Dow was strongly bearish before the event and the only thing that this did was accelerate the fall when markets re-opened.

4. Great Hanshin earthquake, Kobe Earthquake

Japan was rattled by the Kobe earthquake and in a in-direct way was the cause of the fall of Barings Bank (Nick Leeson). One look at the Nikkei chart above, the trend was already present and in fact, it was only 2 days after the earth quake happened that Nikkei started to crack strongly.

5. Russia Bond Default

Russia in 1998 defaulted on its own loan and this in a way shook the world markets then. The default was the key catalyst to the end of one of the biggest hedge funds of that time – Long Term Capital Management. Look at the trend and say that the markets had no clue about it

I believe if one were to dig deep, one can find even more examples of how the markets were most of the time in line with the trend well before the event and the event in itself was not a surprise to anyone other than maybe those in the media.

My own bet on the markets today has been based on a system I trade and has been tested both historically and in real time for quite some time now. Add to it, unlike 2009, this time around, the trends and the results will be during market time and shall not be a surprise at the open.

Its easy to rationalize as to why one should not trade before key events, but as I have shown in the examples above, if you are with the trend, there is little to fear about.

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