How To Decide Which Trading Strategy Is Right

A common trait among beginning and unsuccessful traders is the fickle abandonment of trading strategies that delivered a string of losses. And I am absolutely guilty for as long as I can remember. The underlying motivation is sound.  You want to improve your results and not trade a system that does not work in the long run. So which trading strategy is right?

All Strategies Suck

It’s inherent to all systems to deliver strings of winners and losers. In that sense all strategies suck. That makes finding something that fits your personality both harder and easier. Why? If they all suck it means you have to decide for yourself how to approach the markets. And there lies the crux. If you have the confidence to decide and persist with your decision chances are you will eventually make that approach profitable. Lesson? Make a choice and stick with it. And I don’t mean to religiously stick with the tactical parameters of your approach and now fine-tune them. But stick to your paradigm of choice.

My Choice

So here’s the deal for myself. I am drawn to a trend following approach to the markets, it is my choice. I like it, I am too dumb to interpret fundamental data better than others. It’s an easy traffic-light-type style indication for the market, up down or sideways. Trend following allows me to trade the markets without any knowledge about fundamentals whatsoever. If sound, I will be trading on the side of the insiders and experts who anticipate the trends. And there is strong empirical evidence that trend following works. For details I refer you to Michael Covel’s book Trend Following on Amazon. Get the book and blow your mind with what’s possible.

The Point

So the point is, how do you decide which approach is right for you? The question to ask yourself is very basic.

Say you are looking at trend following. The central question to answer would be: Do trends exist?

Say you want to trade fundamental macro. Ask yourself if macro data determines market prices?

Likewise with any other approach. If you can put a check mark behind that basic question of validity then for god’s sake stick with that approach and make it work for you. Force it to work for you.

Has The Market Correction Ended? Dow Jones Chart Analysis

The recent stock market correction was one of the biggest and fiercest corrections in the history of American capitalism (point-wise), with its selling climax last Monday. Yet the recovery rally seems equally strong. Tuesday’s and Wednesday’s price already negated half of the sharp decline. What’s next?

Status Quo

I don’t have a crystal ball and neither do I believe anybody else has one. (If you do, please get in touch!) As I mentioned before, the best we can do is find situations in which the probabilities are tilted in our favor. Let’s take a look at what the charts show us and if we can potentially take advantage or protect from further losses.

Dow

It’s clear that the market correction has damaged the trend on faster timeframes. But make no mistake, we have intact bullish trends in the DJIA charts on the weekly and monthly timeframe. The weekly actually presented a beautiful long setup to buy the dip which paid off handsomely. Hence it is not at all clear that the selloff marks the end of the multi-year bull market.

On the other hand I notice the recovery rally does not nearly show the same strength as the previous selloff. We are slowly grinding higher.

Level To Watch

What particularly catches my eye is the 4 hour chart. As painted on the image above, I expect at least a temporary resistance at about the 25460 level.

If you think the selloff has meaning and continued downside then pay attention at that level. I will be taking profits on longs and possibly enter a short if we get there.

Let me know in the comments what you see happening.

Please always remember, I am not a financial professional and give no financial or trading advice. I present my opinion, that’s it. Do your own analysis and take responsibility!

Top 2 Reasons Why Trend Trading Is So Hard For Me

Trading and speculation in the financial markets is an appealing endeavor for many people. And so it is for me. But the percentage of people that find success is rather small. 95% of traders reportedly drop out of the game as losers. One of the most popular trading strategies is trend following. Arguably it is also one of the most successful (to learn more about trend following and how some of the richest traders on this planet milk money read Michael Covel’s excellent book Trend Following (Amazon Link)). So why is trend trading so hard?

What Is Trend Following?

Before answering why trading a trend is so difficult we first have to define what it is. So let us break it apart. The term consists of two words, “trend” and “following”. Let’s look at the first one.

Trend

So to be able to follow a trend we have to know what a trend is. It is one of those terms that intuitively makes sense but taking a closer look the devil is in the details. A trend is a sustained movement of prices in one direction, either up or down. Yes, we can all agree. But when does a trend start and when does it end? As with so many things in trading there is no one definite answer. A trend is pretty much anything that you define to be a trend. You can look at highs and lows, you can use the inclination of moving averages, you can use moving average crossovers, you can utilize trendlines or whatever else is out there. None of these tools is going to give you a satisfactory result in all circumstances. Because honestly the market does not care about your definition of a trend. It will always create moves and price action which will fake you out because your definition of a trend has been violated.

Following

The second term is “following”. The meaning of this is that when you apply a trend following strategy you will always be looking to trade in the direction of a trend that has already been established. The basic tenet of trend following is that a market will continue to move in the direction it is already heading. Well, that is not quite correct. As traders we are not actually assuming or making predictions. All we do is find trade setups that give us a favorable reward to risk ratio. (That is the tenet all trading strategies have in common by the way.) So trend followers find favorable setups in the continuation of trends. As a consequence a trend follower will never be the first to enter a trend manifesting in the markets. A trend follower will never buy the bottom or sell the top. In this sense, trend following is a reactionary strategy.

Entries Are Counterintuitive

So trend following means your strategy will never allow you to buy market bottoms or sell market tops. But what does our brain tell us we have to do to make money in the market? Exactly, it wants us to buy at a low price and sell at a high price. And the lower the price of an instrument falls the higher it can rise later the more money we will make with less risk. Right? Wrong, wrong, wrong. In trading it is all about reward to risk. It does not matter whether we buy low and sell high and make 500 pips or whether we buy high and sell a little higher and make only 100 pips only to watch the market rise another 100 or 200. All we have to consider is the reward/risk ratio (and our winning percentage, see my post about why trading strategies work). The trend following trade which takes 100 pips of “the meat in the middle” with a 33 pip stop-loss is superior to the trade grabbing 500 pips with a risk of 250 pips. As simple as that. But this is against what human nature and our brain want us to do!!! You always think you are late. And you will always look stupid if a trade does not work out, because your brain sees that the trend had started way earlier and you were just late with your entry. You would have made money had you entered the trend earlier. So there you go, this is one of the top reasons why trend trading is tough as hell.

Contradictory Data

The other top reason why trend trading is hard is that for any definition of a trend you will have contradictory data. If you are like me at least. Whenever I trade I do my due diligence and analyse markets top down. I look at monthly charts all the way down to 15 minute charts if need be. The nature of charts is that whichever instrument you look at in 99% of the cases you will find contradictory trends depending on which time frame you look at. Here is an example of cable ($GBPUSD):

What is the trend? My (arbitrary) definition of a trend is the 89 period exponential moving average and looking at these charts the answer to the question is “it depends”. We have a monthly downtrend, a weekly transition from down to up, a strong daily uptrend, same for the 4h, the 1h is choppy sideways and the 15 min has fallen strongly to establish a downtrend. So again, you can let this contradictory information paralyze you or you take a stand, follow your rules and look stupid when your trade goes sour. Why look stupid? Let say I trade the uptrend on the 4h for a trend continuation and get stopped out then my brain will see the 15 min and tell my what an idiot I was to enter long. The 15 min trend was clearly down!!!

Oh yeah, you might decide to wait until all timeframes line up in the same direction. This is of course possible, but unless you want to wait for record breaking markets like the $SPX500 or bitcoin each time you trade you will have to make some compromise with the circumstances.

Trading Countertrend

There you have it, those are my top two reasons why trend following is so damn difficult! And at the same time that explains why trading against the trend, buying a falling market or selling a rising market is so appealing. Because in those cases, all timeframes are aligned to give the same signal. What looks oversold on the monthly and weekly will definitely look oversold on the daily, 4h and 1h. That comforts our brain and lures us into counter trend positions that are often the wrong decision. And it animates us to double down when prices falls even further because what was oversold before us then mega-oversold, right? But a weak market is usually weak for very good reasons and no one knows when the decline will stop. It might go to zero and destroy your capital. The only protection that traders have is to know when their idea is wrong and get out of the trade, at the risk of looking stupid when the market turns right back in its original direction.

Even though the rules we define for ourselves are arbitrary they are the only option we have. If you have no rules you will sooner or later have no money because you take the mother of all losses and get margin called.

I hope this is useful. What are your thoughts on trend following and this article? Please let me know in the comments below.

Understand Why A Trading Strategy Works

Whatever The Input To Your Trading Strategy

There is a very simple fundamental truth to any trading strategy out there. Whether you are a discretionary trader, a fundamental trader, a quant, a mechanical technical trader, or maybe you simply trade your gut feel or let your monkey throw darts. Whatever it is, your strategy is somewhere on the following graph.

The Reward-Risk-Ratio vs. Win Percentage Continuum

The Two Parameters For Any Trading Strategy

Two parameters determine the profitability of your strategy: the win percentage in combination with your reward-to-risk ratio (RRR). The win percentage is the average number of profitable trades out of 100. The RRR is the average size of each winner compared to its initial risk. Say you have a very simple strategy where each of your trades has a predetermined entry, stop loss and profit target price. And your potential profit on each trade is exactly the same amount of pips as your potential loss, so your RRR is 1. What follows is, that you will break even as a trader if you win percentage is 50%. The classical coin flip.

So Which Trading Strategies Work?

In the above chart you will be on the dark blue line with a strategy resembling the classical coin flip of 50% winners and 1:1 RRR.  The dark blue line describes all combinations of win percentage and RRR that break even. Any strategy with a combination of win percentage and RRR which puts you below the dark blue line (in the lighter blue area) and you are losing money. So you absolutely must have a tuple of win percentage and RRR that puts you above the blue line, safely in the promised land of profitability. The further you can move away from the blue area the closer you are to the “holy grail” of trading. It’s that simple!