Trading conditions continue to be tough as volatility has once again been on the increase. During the past months the market conditions have been fairly extreme and we have had numerous emails from subscribers regarding certain principles of the system. We therefore have decided to cover some very important points in this update. These are important points and we urge you to take the time to read and digest what we have written here.
In this article we are revealing some of the LS Trader system's proprietary methods and concepts for the first time and are doing so that your understanding of our system and the markets is greatly enhanced. Once you have finished reading this article you should almost certainly be a better trader and have additional knowledge and understanding of the markets that will remain with you for the rest of your trading career.
The role of the trader is to either design a trading system that works over the long term or find and follow a system that has a proven long term track record. The system should have set rules which cover when to enter a trade, when to exit a trade, which markets to trade, how much to stake on each trade and various other money management rules.
The system should be designed in such a way that it has an edge, which is a statistical long term advantage. If such is system has an edge and is followed consistently over time, then in the long run the follower of such a system will come out in front, although there will always be some bumps along the road, some losing trades and some losing periods.
Once the trader has his trading system in place his job is to follow the system consistently. In order to do this he must take the signals as and when the system generates them. If he knows that his system has a long term advantage, then he knows that over time the signals that the system generates are correct regardless of the outcome of individual trades.
Since the trader cannot in any way control the markets he must do the next best thing, which is focus on that which he can control, such as following his system. In doing so he knows that he has an advantage which if he keeps trading over time, the system will perform. In psychology, especially performance psychology or sports psychology the individual is taught that he cannot control the outcome of each performance but that he can control his own performance.
For example, Tiger Woods cannot stand on the tee at the 1st hole of a major championship and be certain that he will win the event, but he can focus on what he can control, which in Tiger's case will be following his routine and putting 100% effort in on every shot. Beyond this there is nothing he can do to guarantee he will win as there are numerous factors that he cannot control, such as the performance of his opponents, the weather and the time of day he gets drawn to play. However, Tiger knows that but consistently following his routine and putting his best effort in to each shot, he is giving himself the maximum chance of success, regardless of the outcome.
In the same way, the trader cannot control the markets but he can control the decisions he makes, which should be based on the specific rules that his system has the lead to long term trading success. The successful trader then, knowing that his system works over time, will consistently follow his system regardless of the outcome of individual trades. It is no accident that the most successful traders in the world focus on decisions and not outcomes. This is the way to long term trading success.
An example from this week is that we are entering Rough Rice long. Everything about the trade suggests that it should lead to a profitable trade, because the long term and short term trends are up, last week was the highest weekly close in nearly in a year and the fact that the market has also cleared long term resistance, has done so with an increase in momentum and has also gapped higher. Rough rice is also at its highest price since November last year. Therefore anybody who went short rice during the past 12 months who is still in a short trade must necessarily be sitting on a loss.
This means that as Rice has broken out of a trading range that has held for most of the past 12 months, any short traders are under pressure to cover their short positions. In order to cover their short trades they must buy and this adds to the buying pressure for the market to move higher. At the same time, the traders that have sat on the sidelines in rice for the past 12 months have watched the battle between the bulls and the bears to wait to see who won. As of now, the bulls have won and the market has broken out of its range to the upside. This then brings rice to the attention of all the latent market participants and they then look to get on board, adding to more buying pressure. This obviously increases the chances that rice will continue to move higher.
However, this does not mean that the trade will work out, as with all other trades it still has a 60% chance of becoming a loser. It is still however correct to take the trade regardless of whether it wins or loses. It does not mean that the trade is wrong if it loses only that it did not work out. If one continues to take trades that it is correct to take over the long term, then the odds are very much in his favour that over time he will come out ahead.
This is the basis for entering all our trades, although the timeframe is not often as long as the rice example, but when we enter a trade long, it will always be because the market is moving up. When we enter short it will always be because the market is going down. When you have a trade where the long term and short term direction is the same, this gives the maximum change of the market continuing in the same direction and that is what medium to long term trend following is about.
All of the trades that we have taken this year have been in accordance with an approach that works in the long run, so at the time of taking the trades they were all correct, regardless of whether they worked out of not and should we be faced with the same set ups, we would do exactly the same thing again as doing so gives us the maximum chance of success.
Perhaps the question we get asked most often is why don't we take profits sooner rather than risking the market reversing and taking our profits back. The reasons for this are very simple but this is perhaps the hardest part of trend following to follow. It is difficult to sit by and watch small or even moderate profits evaporate when the markets reverse but this has to happen on some occasions in order for us to be able to capture the big moves.
Overall the markets trend around 40% of the time. This means that 60% of the time the markets will be consolidating, i.e. going sideways, moving counter trend etc. Therefore, in round figures approximately 40% of our trades will be winners and 60% of our trades will be losers. It then follows that since we have more losing trades than winning trades that our winning trades must be larger than our losing trades if we are going to show a profit over time.
This is achieved by 2 key principles:
If one thinks about this properly, by using good money management and containing our losing trades at a small percentage of equity (in the case of the model account of 2% per trade) then this takes care of keeping our losses small. It then follows that we have to get some big winning trades so that we can pay for all the losing trades that the system will generate over the course of a year.
Many people make the mistake of believing that profits should be taken early to avoid the markets taking them back but this is not correct. In fact, one of the biggest myths of Wall Street and one of the most damaging to trader's profits is the belief that 'You can never go broke taking a profit'. People tend to just accept this as gospel and are therefore on the lookout to take profits as quickly as possible and are often perplexed when we do not do so.
The reasons are simple and if we accept the logic that as we will have more losing trades than winning trades (there is no way around this regardless of what anyone tells you as the markets spend less time trending than consolidating) we must have our winners being larger than our losses, so therefore the myth of never going broke by taking a profit is not only wrong, but virtually ensures that you will go broke as small profits can never be enough to cover the losing trades.
To Clarify:
There are only ever 2 reasons for us to place our stops where we do and that is for -:
During the course of a normal year, we will likely get several trades that produce big profits and over the course of a year, these big winning trades normally generate enough profit to pay for the losing trades and leave plenty over for profit.
To understand winning trades it is helpful to think in terms of units. For example:
A unit is a combination of the following:
For example, let us say that we are trading Gold long and that the distance from the entry price to the stop is 30 points. 1 unit is therefore 30 points. 1 unit is also 2% of our account size. Therefore, every move in gold of 30 points will equal 2% of our account size.
If gold moves 30 points against us that is a 1 unit loss, which is a 30 point loss and will equal also a 2% of account size loss. If gold moves for us 60 points, then that is a 2 unit profit and a profit equal to 4% of our account size.
Therefore, if we have a trade that brings in a 10 unit profit, then that is equal to 20% profit of our account size. A 10 unit profit will also by equivalence pay for 10 single unit losses. During the course of an average year, we will normally get a handful of trades that are 10 unit winners, and usually a couple that will pay considerably more. Last year for example, we had a 22 unit winning trade, which was the British Pound short against the Japanese yen. As we said, a 22 unit winning trade would be equal to 44%.
Had we had a 22 unit winning trade this year, that would be the difference between showing a loss for the year so far and being in profit. This is why we stress the importance of not taking profits early. Had we taken profits early on that trade last year we could not have had a 22 unit profit.
In addition to the 22 unit winning trade, we had numerous trades that produced 5-10+ unit winners. These quickly add up to cover all the losses of a year and leave plenty left for profit. This is why on average our system produces the large profits that it does.
The negative impact of high volatility last year (2009) on position sizing
When we calculate our position size, it will be based on our proprietary formula, which will include the risk per trade, the current volatility of the market and chart structure. If volatility is high, we must necessarily use a wider stop to account for the increased daily movement. This is done to avoid being taken out of a trade prematurely. If volatility is low, then we don't have so much risk of being taken out on a large adverse move so can use a tighter stop and a subsequently bigger bet size per point. In trading this is known as 'loading up'.
If we consider another example similar to gold above to explain the impact of volatility let assume that we are trading the British Pound long against the US dollar.
For this example, our stop on the trade will be 600 points away from the entry. Let's assume for ease of example that we are risking £600 per trade. We will therefore have a £1 per point bet size. This would be an example of a high volatility position size and reflective of the markets this year. We now have a trade that has a £1 bet size going for it for every point that the market moves in our favour. If the market moves 1000 our way before we exit the trade we have a 1000 point and £1000 profit.
Let's assume that the markets are not so volatile and are more normal. In this example we can trade with a 300 point stop. Assuming that we are still trading with £600 risk per trade, we can now trade £2 per point. We still have the same risk (300 x £2 is £600) but have twice the profit potential as our bet size is double. Now, the market moves 1000 points our way and we have a £2000 profit from the exact same trade. Or, the market only has to move half as far, say 500 points to bring us the same profit as the first example.
Over the past year or so, many of the markets have had a volatility that has been approximately double that of the historical norm according to our formulas. This means that we have had to use wider stops and smaller bet sizes per point. This necessarily means that the markets have to trend twice as far to bring in the same profits as they would in normal market conditions.
This is why in 2009 some of the trends that we have been in have not generated the same large profits that we would normally get. For example, we have had some trades that went on for a long time, such as Natural Gas earlier in the year, the Dollar index and the New Zealand dollar. Currently we are still in the Australian dollar which has also been a good winning trade. Had the markets not had approximately double the normal historical volatility, we would have had double the best size of each of these trades and consequently double the profit. This would have made a huge difference to our profits for the year.
Nearly all traders, including some so called gurus fail to understand the importance of an initial stop and position size. Place the stop too close to the market and there is too much risk and a big chance of getting stooped out to quickly. Place the stop too far away and the bet size will be so small that if the market does trend, it has to move a long way to bring a profit. On each trade, there is an optimal stop distance. Our proprietary methods work to ensure that we are using the best possible size on each trade.
In 2009 LS Trader didn't have the same number of large winning trades in a year that we normally do. This is down to several factors, such as the huge trends we had in 2008 in so many markets and the almost unprecedented global uncertainty. We have seen almost all of the central banks printing money, debasing their currencies and providing previously unseen levels of economic stimulus. This has led to a huge debate as to whether we are entering inflationary or deflationary periods and consequently, nobody really knows what is going on and this is reflected in the choppiness of the markets and lack of trends.
We have seen a rally in the stock market that is based on nothing really but wishful thinking and illusion. At some point this is likely to reverse and we may see a major correction in stocks. If we do, this will give us a good opportunity to go short and benefit from the drop in stock prices.
The huge trends of 2008 have also led to a prolonged period of consolidation, as the markets cannot (and nor do we expect them to) trend all the time. Therefore, in 2009 we have seen big consolidations, huge uncertainty, and double the normal volatility. These have all combined to make the markets this year as tough as they can be to trade and is the reason why we are not showing our normal healthy level of profit. The fall-off in results of 2009 are due to the markets and not the system. However, this is unlikely to continue for much longer and things should return to a more normal state.
Whilst this year has been an exception for reasons outlined above, over time, the markets do not change. Therefore, approaches that have worked in the past will work again.
The markets are essentially run by the physical elements of supply and demand and the psychological elements of greed and fear. Over time, supply and demand dynamics will always influence the markets and the emotions of greed and fear will always influence the market participants. People do not change over time. Human psychology does not change and people trade the same way now as they always did because overall they behave the same way now as they always did. This means that ultimately, the markets will not change, and will revert back to normal and trend following approaches such as ours will work again in the same way that they have for the past several decades.
Because the markets don't change over time it is very likely that in 50 years time the same principles used by successful traders today will still be used by the best traders in the future.
Those principles on which successful systems are built and that successful traders follow are simply:
Any system or trader that follows the above rules will very likely be successful in the long run as this is the approach that works best and will, in my opinion, always be the best approach.
Going on the backtested results of our system going back to the start of our market database that goes back to 1982, the system has shown that it works. To run a simulation like this we programme the exact rules of the trading system in to the computer and test it against our market database. Now, whilst there will always be differences in actual trading to simulated results, this gives a good indication of how the system would have performed over that period had we taken all the trades.
In addition to the above, the system has also been traded on our own accounts and has also been available to subscribers for the past few years and the results have been roughly in line with what the computer results suggest. Some years have been above the 150% yearly average and some have been below. 2009 was an exception due to several factors that include the almost unprecedented state of the global economy and uncertainty in relation to that, as discussed above.
As we have also previously mentioned, our research shows that there is a period of consolidation following on from good trending periods that is roughly proportionate to the length of the preceding trend. Clearly last year there were some exceptionally big trends in most of the markets and that has added to the choppy market conditions that we have seen this year.
Now, as at today it is looking as though we may be heading for a losing year (even though there is still time for the system to recover). 2009 has been exceptionally tough but the fact remains that the system is based on very sound principles that we know work in the long run. It is very easy during periods such as these to become disheartened and draw the conclusion that our approach no longer works. I personally do not think that is the case due to how vigorous our testing procedure is and the fact that it has been proven to perform over a large sample of data (27 years across all markets is a large sample).
What this all boils down to is that even now, and in spite of the virtually unprecedented market conditions that we have seen this year, the parameters and rules of our trading system still come out the best out of all parameters and system combinations that I have tested when running tests on the markets.
I still do almost constant testing in an attempt to refine and improve our approach but when tested over a long sample of data no improvements have yet been possible. What this means is that even though we can probably tinker with the rules of the system to match them to the market conditions for this year to improve short term performance, if we run those rules over the entire database, performance is considerably worse.
This would also be a curve fitted approach which would essentially be fitting the system to the current market conditions and would also be placing more emphasis on a shorter and less meaningful sample of data than the entire sample that we have available.
To change a system to rely on short term market conditions, which would necessarily be curve fitted to improve short term performance at the expense of long term performance and reliability would in my opinion by very naïve, and we will not do it.
Our approach still comes out the best in all the testing that we have done when we use a large sample (large samples must always be more reliable in the long run as nearly everything that can happen in a market is likely to have happened in 27 years). We will continue to trade in exactly the same way as we have been, knowing that in the long run our approach works.
Therefore, we must look at this year as a blip and remember the long term performance of the system. I know that had I been able to trade this system for the entire 27 years (not possible as I had unfortunately not created it back in 1982) that I would be extremely delighted with the performance returns even if they did include 1 losing year. 26 winning years out of 27 is still exceptional by anybody's standards.
It is no accident that the world's best traders, with very few exceptions, follow a mechanical system in order to beat the markets over time. For the most part, the best mechanical systems are based on trend following since that has proven to be the approach that generates the best returns over time.
Trend following has been around for decades and successful users of this approach range from Richard Donchian, known as the father of trend following, to Richard Dennis, to Ed Seykota, to Bill Dunn and John Henry. The list goes on but the point is that these traders have produced the most amazing stories of success and have accumulated vast fortunes, all using trend following, which is the cornerstone of our trading approach.
Donchain's trust fund still donates money to charity to this day from the money Donchian's trading fund generated, even though it is years since he passed away. Richard Dennis turned approximately $400 into $200 million in 18 years and taught a group of traders his same principles and they also made $175 million in 5 years trading Dennis' money. Ed Seykota has produced astounding returns, which include growing 1 account from $5000 to around $15 million in around 12 years. John Henry's first account was funded with $16000 and over time from trend following he was able to buy the Boston Red Sox for a reported $700 million from his trading profits. If trend following did not work over time, none of these results would have been achieved.
Essentially, we are not doing anything differently this year than what we have done in previous years. The difference has been due to the markets, which have been highly volatile, highly correlated (nearly all markets have been moving together in either a correlated or inversely correlated manner). Obviously volatile markets don't favour trend following. At present, we are down 34% on the year.
Markets can do 3 things, go up, down or sideways. In essence that boils down to 2 things, directional movement or consolidation. When a market is in consolidation for a long time, many traders will stay out of the market and wait for it to break in either direction before taking a position in the direction of the breakout. We have actually researched this a lot and without doubt we see that the longer that the markets consolidate, either individually or collectively, the larger the eventual breakout will be. There are many reasons for this including supply and demand, as well as buy and sell orders sitting in the markets at certain levels. What also happens is that the longer a market consolidates, the more people become aware of this and they begin to focus on that market and wait for a breakout. Once the breakout occurs we see all the latent traders pile in and end up with a big move and often a series of trends as new money continually comes in. Until this happens though the sideways action continues, Because, as we said earlier the markets have been highly correlated, we are seeing this on a large scale and this is evidenced by lighter volume being seen in most markets for quite a long period of time.
When you have a long period of consolidation, which is what we have seen for the past 12 months or so in many markets (not all, as there have been a handful of decent trends still) essentially nobody makes money as there is an ongoing fight between bulls and bears and money is just changing hands and vice versa. This can only go on for so long and we have seen that in the historical data. The past 12 months is probably one of the few times that the markets have been favourable to day traders and day traders may even have made money during this period. Historically though day trading probably works around 1 year in 10 whereas trend following works around 9 years in 10. Clearly it is foolish to put more weight on short term performance of the past year or so and conclude that trend following no longer works when historically it has outperformed all other strategies.
Our approach is based on trend following and this over time has been the most successful approach used by many fund managers and has been used for over 60 years. Clearly, one particular approach will not work continuously and will have periods when it does not work, before things return to normal again. The current period is one of those periods and it will end at some point and give rise to very profitable market conditions again. Until then we have to tough it out. Another thing to consider as that according to our backtesting and actual trading, our historical average is well over 150% per year. When you have a year like we did in 2008 of 1504% it is only natural that a poor year or so will follow to bring the historical mean back to balance.
If you get the chance, pick up a copy of Market Wizards and read the interview by Ed Seykota. Ed is probably the most successful trader running public money on an annual returns basis and he has been using trend following since the early 70s. In that interview he says that every now and then people say that trend following no longer works when there is a losing period, but trends always return to the markets and the systems perform well again. This is actually common sense because when trend following is working well, as it did from 05 to 08, fund managers start putting more money in to it and this reduces its effectiveness as everyone is essentially chasing the same moves. Once a bad year or so follows fund managers give up the approach, withdraw their money from those systems and then the trends return and so it goes on. He says that system performance is cyclical but since we can never know in advance when good and bad times will be we have to continue trading in the same way so that we are in when we get a good period of trending and profit from it.
The only thing that anyone can say with any real certainty is that once this period does end and trends return, we should get some fairly spectacular trends which will more than make up for what has passed recently. On either real trading or the simulated back test results we have never had 2 losing years in succession or even been close to that, so the odds are firmly with this being a good year. In the meantime, we have money management rules in place, which mean that as equity drops we trade smaller in size to protect our capital and ensure that we stay in the game. In this way, when the markets do trend again we will be positioned to take advantage of the big trends and can increase our position size in line with rising equity so that we maximise our profits. In any case, as each day passes, the more likely it is for numerous reasons that good periods are ahead. In the meantime we have to just keep going the same way. For these reasons, someone starting now has a very good chance of landing a big winning year fairly soon. It can turn at any time.
The only conclusion that one can draw from this is the trend following works over time. This is clearly evidenced by the long list of traders that have used this approach for several decades. It therefore also means that over time this same approach is very likely to continue to work.
As Richard Dennis once said when he was trading public funds that people only want to join him when we he is at equity highs and nobody wants to know when he is at equity lows but the best time to get involved is when the system is at equity lows.
If we follow along with Dennis' logic then as we are at equity lows for this year then now would be as good a time as any to begin, but would also be a bad time to quit.
The markets this year have been exceptional and not the norm by any stretch of the imagination and before long, probably sooner rather than later they will return to a more normal state and trends will return to the markets. When they come it is my sincere hope that as many of our subscribers as possible are in a position to take advantage of them and don't fall by the wayside by quitting because they have placed too much emphasis on the shorter term performance of the system rather than looking at the longer term results.
*The past is not a necessarily a guide to the future. Future results may be higher or lower than past results.
More info on The Long Short Trader system including past results, can be found on their website here
