Ihab Salloum[ad_1]
One of the most common suggestions in the world of futures trading is that in order to be successful, you must employ a mechanical trend following system and trade it with strict discipline. Many of the proponents of such wisdom point to the success of some of the biggest names among past and present commodity trading advisors, such as John W. Henry, who now owns the Boston Red Sox. A number of books have been written about the topic of trend following systems in the last decade. Trading system vendors are constantly developing new systems to sell to the public for hundreds, or even thousands of dollars.
Unfortunately, the fact is, the small trader simply can’t afford to trade a mechanical trend following system in the futures markets. Why? The answer is simple… the drawdowns inherent in trading a mechanical system are simply too great for the small trader to handle emotionally and psychologically. Consider this fact… during his career as a commodity trading advisor who employs a systematic trend following strategy, Bill Dunn of Dunn Capital Management, has experienced drawdowns of over 30% at least seven times during a 40 year career, and two of these instances involved drawdowns over 50%. During that period, his compounded annual return was about 18%.
While the compound annual return of Dunn Capital is certainly impressive, most investors would not be attracted to the drawdowns. A 50% drawdown is the equivalent of watching a stock you purchased at $100 fall to $50. This type of volatility is actually similar to how Apple stock has performed since 1990, with similar returns, but how many people have owned Apple stock since 1990?
Most proponents of systematic trend following will then suggest that losses are simply the cost of doing business. They compare systematic trend following to a casino, which has a long term “edge” over its clientele. This indeed is the case, but it is also clear that trend following systems can go through long periods of significant under performance compared to other assets. Since 2009, this has been the case. Aside from 2010, the last four years have been very difficult for most trend followers in the futures markets.
In fact, one could argue that aside from the years 2008 and 2010, trend following performance has been quite mediocre over the last decade starting in 2004. For instance, John W. Henry actually closed his business as a result of volatile returns over the last ten years. Some suggest that this was due to his entry into the world of Major League Baseball. However, this underperformance is also reflected in the decline in assets under management by former Turtle R. Jerry Parker and his Chesapeake Capital Management. Chesapeake’s assets under management in the futures business peaked at over $1.5 billion in 2007, and now stand at just over $300 million. This is according to the performance record posted at Autumngold.com.
Regardless of this recent performance by many trend followers, proponents will suggest that this is the right time to begin investing in such programs. This is likely true. Weak performance for trend followers is often followed by strong performance periods, and this cycle should continue. However, systematic trend following is still not the answer for the small investor or trader who wants to trade their own account, because there will still be significant drawdowns.
Most proponents of systematic trend following will then refer the small trader to the handful of trading psychologists who will then suggest that the trader needs to learn how to detach themselves emotionally from their trading in order to become successful. In other words, they need to learn how to accept these drawdowns of 30% or more as simply part of the process of building wealth.
I am reminded of the parallels to the golf world. It is not uncommon for a professional golfer who struggles to keep his or her tour card, or finds it difficult to perform well on Sunday afternoon when they are in contention, to hire a sports psychologist. I can’t think of any such golfers who then went on to become dominant players. The best players absolutely hate to lose, and never detach themselves emotionally.
Consider this most recent example. Phil Mickelson just won the British Open after a devastating loss in the U.S. Open just one month before. He indicated that he could hardly get out of bed for two days after that loss, yet he bounced back, and won the Scottish Open and British Open on successive weekends. Meanwhile, Lee Westwood, who has never won a major golf championship, blew another opportunity to win the British Open and then suggested “it’s just a game.” He has never won a major after 62 tries. I suspect he will never win a major with that attitude.
Traders, just like golfers, are constantly in search of the holy grail. What many traders are hoping to find is a mechanical trading system that makes all of the decisions for them, and churns out profits month after month. Golfers are often looking for that golf club, training aid, mental thought, or new move for their golf swing that will transform them into scratch golfers. I find it comical when a 20 handicap golfer turns to mental golf tips as if they will translate their awful golf swing into a ball striking machine.
Another issue with mechanical trend following systems is that they still churn out wildly different trading results. This is why most commodity trading advisors who employ the trend following doctrine will manage their funds with multiple systems in an attempt to smooth out their equity curve. I recently tested two different trading systems on a basket of currency futures. One was a triple moving average system, and the other involved a standard breakout strategy. I tested on data back to 1977 and found eleven years where one system made money and the other actually lost money. In numerous other years, the performances varied substantially even if both made or lost money in the given year.
In other words, there is no one mechanical trend following system that works best, and this is a huge reason why the small trader has a difficult time trading a mechanical system. As soon as a drawdown occurs, the trader switches to another system that may have been shown to have performed better when they were undergoing a drawdown with the other system.
With all this in mind, what is the answer? Discretionary trend following! Discretionary trend following simply means trading a strategy that exploits major trends, but is not followed systematically. In other words, there may be a core system of entry and exit signals, but the trader may pass on some trades if he has a set of discretionary rules that imply that the trades have a lower probability of success. The discretionary trader is not concerned with missing out on some trends, but is concerned with preserving capital and waiting for the best opportunities to trade.
One of the big myths in the futures trading world surrounds the legend of the Turtles. The Turtles were a group of traders trained by legendary traders Richard Dennis and William Eckhardt. Many went on to have successful careers as commodity trading advisors, including the aforementioned R. Jerry Parker. The myth is that these traders were given a mechanical trading system to trade futures markets. In fact, they were simply given a set of rules, including mechanical entry and exit rules AND a set of discretionary rules. These strategies were never meant to be traded mechanically. Dennis even wanted the individual traders to display their own flair when trading. This is why the performance among this group of traders during the program varied greatly, so much so, that it was even suggested that some traders were given a superior system to trade (this is another myth that one of the traders in the program actually accused Dennis of doing this).
Here is the bottom line… successful trading requires very hard work, and the discipline to work hard consistently. Successful trading does not have anything to do with the discipline of following a certain mechanical trend following system as suggested by many authors and traders. Successful trading simply involves having a core set of beliefs, a core strategy if you will, and learning how to beat that core strategy through the use of discretion by learning…
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