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You can think of trend following as fishing: imagine that you have a small fishing boat and you specialize in catching tuna. You know that large schools of tuna pass nearby from time to time and when they do, you can land a few tons of fish. But you don’t know when that might be and to catch them you must go out to sea and cast your nets every day.

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This costs you some effort and expense – but you expect to recover all this when you land the next catch. Likewise, to capture profits from a large price move you need to continually position your bets in direction of the anticipated trend.

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No pain, no gain

Trends don’t announce themselves in advance. To profit from a price trend, you need to be in the right position at the right time and this positioning involves risk-taking and incurring some losses until a price trend takes off. This is what our oil trading chart illustrates: it was a compelling success story for trend following.

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But what the chart can’t convey is the psychological aspect of the process: taking positions and sustaining losses during an 8 month period is difficult for even the most disciplined of traders, especially as we never know when a trend might emerge and redeem our losses. Still, not taking a position would be the equivalent of failing to cast your nets the day a large school of tuna passes within your reach.

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Isn’t there an easier way?

We’d all like to find some gimmick giving us instant trading gratification and predictable profits without much risk of losses. This desire is met with a flood of offers promising very large returns on investment, risk-free trading, 80% accurate forecasts, etc. Such claims will usually prove false. We know that most speculators lose money.

 

In some jurisdictions, retail brokers are obliged to disclose the percentage of their customers who lose money. Here are a few such disclosures:

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• ETX Capital: 75.6% lose money

• IG Group: 74% lose money

• Ava Trade: 71% lose money

• Plus 500: 76% lose money

 

QUANT CONTESTS: 79% LOSE MONEY

One company’s experience provides a valuable empirical case: in December 2006, world’s most popular trading platform provider MetaQuotes organized an Automated Trading Competition.

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The $80,000 prize attracted 258 developers of quantitative strategies. More of them joined over the following six years and through 2012, MetaQuotes’ challenge attracted a total of 2,726 participants – all highly motivated to win the prize and sophisticated enough to formulate and test quantitative strategies they hoped would win the competition.

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However, only 567 (21%) of them finished their competitions in the black while all others – 79% of them, lost money.[1] This data speaks to the unrealistic claims of many providers of quantitative systems: they all look great on paper but usually prove less useful in reality.

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How is trend following different?

Trends are the product of human psychology and the collective action of market participants. Our psychology is the one constant in all markets that’s not likely to change any time soon, which is why we can observe price trends in any market throughout history.

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Here’s how the trending dynamic emerges: in making investments, our rational goal is to obtain the best possible return with the least risk necessary. If we buy some asset, we want to receive a stream of rents or dividends and have the opportunity to sell that security for a higher price than what we paid. Since those outcomes depend on other market participants, we are obliged to reflect on what they might do. Thus, if the price of some asset is rising, we may conclude that it is attractive to other investors, and that the rising demand would push prices even higher.

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Informed by the actions of others, we might accept inflated asset prices and proceed with the investment anyway. In one form or another, this dynamic is at work in every market where people speculate and transact – it is simply a matter of human nature.

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Risk taking: a matter of belief and necessity

The belief: ultimately, the justification in any risk-taking rests on a belief. The fisherman’s endeavor is warranted by his belief that tuna will periodically pass within the reach of his nets. For the trend follower, the belief is that markets move in trends.

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The necessity: The willingness to take risks is ultimately motivated by necessities of life. Fishing is necessary as a source of sustenance for the fisherman and his customers. Trading is predicated on the necessity to generate return on one’s capital, including cash. If cash is idle, it predictably loses purchasing power over time.

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The need to keep capital working productively was perhaps best captured by St. Thomas Aquinas when he said that, “If the highest aim of a captain were to preserve his ship, he would keep it in port forever.” Of course, people do not build ships in order to preserve them, but to put them to work. The same is true for other forms of capital.

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Speculation is inevitable

Productive use of capital inevitably involves speculation, as do many ordinary decisions in life: do I buy a home, or do I rent? Do I get a job after school or do I go to university? Should I keep my job or start a business? Shall I save up to buy a tractor in cash, or do I lease it without delay? To the extent that such decisions deal in the present with uncertain future outcomes, they are speculative.

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But more controversial aspects of speculation emerge when we engage in financial transactions for profit. The desire to gain in such transactions intensifies the emotional experiences like fear and greed and often leads to unfortunate outcomes. To avoid this, it is essential that we moderate our actions with judicious risk management and unwavering discipline.

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Finally, taking the systematic approach to ensure that we can venture forward with a disciplined adherence to predefined and tested decision-making rules.

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[1] Robson, Ben. “Currency Kings” – McGraw-Hill Education, 2017.