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Trading Strategies, Trend following

Commodity Futures Trend-followers Should Adapt to New Market Realities

You can’t just trade the markets in 2012 with systems developed based on models conceived in the 1980s and 1990s. The markets have changed a lot since then. You can’t just rely on  traditional trend-following systems to catch trends. You have to adopt a broader spectrum of strategies covering a range of payoff ratios. Futures is a zero-sum game and those who adapt fast to changing conditions pocket the losses of those who prefer to complain instead about the changing market environment.

A post in the Attain Capital Management blog yesterday made mention to this statement by Alcoa chief executive Klaus Kleinfeld, reported in the Washington post:

The market today is basically driven by headlines and not market fundamentals…”

Other executives noted that the price of aluminum is not depended on demand and supply but more on latest headlines about central bank actions that affect economic conditions

Well, I am trying to remember a time since I started trading commodity futures back in the 1980s when the market was not moved by headlines. Aren’t headlines suppose to convey information about fundamental conditions? Don’t future economic conditions that are affected by central bank actions in turn affect future demand and supply?

The statements by Alcoa executives sounded weird to me. The major difference between the 1980s and 1990s and the present time is that the speed of information delivery and the target audience have increased dramatically. Back then, information was available on quote terminals to those who paid a high fee to subscribe, which were basically the trend-followers. Nowadays, every speculator, from US to Europe and Russia, from India to China and Australia, gets the same information at a low cost or for free. As a result, the markets are more efficient and discount future conditions faster making it look like they are erratic. Speculators and hedgers look at future economic conditions to take action now.

Why Trend-following is Hard

Trend-following is hard because the future magnitude of trends is unknown and thus one cannot rely on low win rate strategies to profit or even survive. I have presented a mathematical proof for this in another post. But this is also the result of exercising common sense. Actually, trading success relies on proper application of common sense to the realities of the markets. The Attain blog also stated that:

“The Newedge CTA index was up in May, down in June, up in July, down in August… (Dislaimer: past performance is not necessarily indicative of future results). Trends would get started and produce one good month of returns, only to see a snapback that erased those gains in the following month – due in large part to those global economic concerns Kleinfeld was referring to.”

There will always be economic concerns. I remember of no time since I started studying and trading the markets that there were not serious economic but also geopolitical concerns. The issue is how a commodity futures trader can adopt to a changing world. Last year, for example, I warned trend-followers of stock index futures to stay out of the market. It should not take a lot to realize that when the market is choppy there is no money to be made in trying to catch a trend.

The R1R3R7™ Method

The R stands for the payoff ratio, which is equal to the average winning trade divided by the average losing trade. Trend -following systems usually have payoff ratio in the 5-7 range. At the same time, short-term position traders who take advantage of small swings in market prices target a payoff ratio in the 2-3 range. Very short term position traders usually stick to a payoff ratio between 1 and 2. Accordingly, trend-followers generate less trades with low win rate, short-term position systems trade more often and have a higher win rate and very short-term systems trade much more often for smaller gains and need a very high win rate. A possible solution is what I call the R1R3R7™ system, i.e. a system that combines the above three styles to compensate for a lack of trends, or small magnitude trends and/or choppiness in the markets.

An example of an R1 system is the Price Action Lab alerts for 2% target and stop. The DBC trade on October 3, last week, is an example of how such a system operates. Positions usually last 1 to 10 days and the win rate must exceed 70%. The R3 system is a high reward-risk system like the one described in this analysis and the win rate is close to 50%. Finally, the R7 system may be some variation of a system that uses lagging indicators, for example moving averages, like the one described in this post. However, as I have written in the past (“Trend Following Strategies Based on Short-Term Price Patterns”, Traders’ Magazine, June  2006), trend-following can be achieved via a suitable short-term position system. Such system has all the advantages of a trend-following system in terms of capturing trends but not some of its notorious shortcomings like the high drawdown.

Regardless of approach, philosophy or perception, there are emergent new realities in the markets that may affect a large number of trend-followers in the near future who depend on traditional and outdated method with inherent lag, due to the speed of dissemination of market information.

Disclosure: The past performance of any trading system or methodology is not necessarily indicative of future results. Read the full disclaimer here.