Sunday, November 12, 2006

Why It's So Difficult To Be A Trend Follower

The excellent Barchart site contains a great deal of performance information about stocks, sectors, ETFs, etc. Here is my little mashup of some of their findings:

Take a 40-day version of the Commodity Channel Index. When the oscillator moves above 100 (showing good upward price momentum), buy. When it moves back below 100, sell. Similarly, when the Index moves below -100 (showing strong selling momentum), go short. When it moves back above -100, cover shorts.

Let's see how this little system performed for the S&P 500 Index (SPY) over the past two years:

* The system made 48 trades, averaging 7 days per trade. We had 11 winning trades and 37 losers.

* Overall, the system lost a little more than 18 SPY points (the equivalent of 180 points in the futures). This, of course, occurred during a bullish period of market prices.

* The average size of the winning trades was considerably higher than the average size of the losers, but the better than 3:1 ratio of losers:winners kept the system in the red.

Ironically, this might be a great nucleus for a trading system. It's telling us that the market is trading in a countertrend mode. If you had a method to limit your losses and faded the system signals, you'd have a fighting chance to make some good money. After all, a consistently losing system *does* have a potential edge.

Now consider the following:

If we traded that exact same system in GOOG, we'd have had 33 trades averaging 11 days per trade. We'd have had 14 profitable trades and 19 losers, but the system would have made over 134 GOOG points over the last two years by catching trending moves. Almost half of that profit came from a single big trending move.

The examples show how hard it is to be a trend follower. The indices are reversing directional moves, making trend following a losing proposition. Even with good trending stocks, you have to be able to tolerate frequent losing trades. Most of all, you have to be consistent enough to stick with the system for the occasional huge winner. There *are* traders able to succeed with trend following, but shrewd stock/asset class selection and steely discipline are necessary.