Originally published July 5, 2016
Many successful traders have read a book written in 1923 called Reminiscences of a Stock Operator. This book, by Edwin Lefèvre, is based on the life of Jesse Livermore, one of the greatest traders of all time. Livermore was a colorful character who was able to trade quickly and at times he would be trading too fast for the old-style ticker tape machine to keep up with him. While Livermore loved to trade, he also loved to think about trading and that old book contains some of the most important ideas about trading ever written down.
One of the best pieces of advice Livermore offered explained how to make the greatest possible profit on a trade:
"It never was my thinking that made the big money for me. It always was my sitting. Got that? My sitting tight! It is no trick at all to be right on the market. You always find lots of early bulls in bull markets and early bears in bear markets. I've known many men who were right at exactly the right time, and began buying or selling stocks when prices were at the very level which should show the greatest profit. And their experience invariably matched mine-that is, they made no real money out of it. Men who can both be right and sit tight are uncommon."
These words were written more than 90 years ago so it needs some updating to be more inclusive. The lesson Livermore learned from many large losses was that "Men or women who can both be right and sit tight are uncommon." In other words, patience can be an asset for traders.
Livermore knew patience was an asset but he didn't always follow his own advice. In fact, Livermore repeatedly went bankrupt over the course of his career and tragically took his own life after struggling with the highs and lows of his lifestyle. We will never know for sure, but he may have done better if he had been trading with a system designed to follow trends.
Trend following strategies have been well researched and the conclusion is they work, with "work" being defined as delivering profits in the long run. Perry Kaufman in his 2013 book Trading Systems and Methods offered several reasons why trend following systems work. He explained that they benefit from the long-term price moves caused by fundamental factors. The long-term uptrend in earnings, for example, is responsible for the steady gains in the stock market seen over many years. He also noted that money moves markets and trends accelerate as other traders notice the trend and buy to benefit from the price move.
While trends are responsible for large gains, they are relatively rare. Their rarity makes it difficult for many traders to stick with a trend following strategy. Let's look at the results of a typical strategy.
Like any other trading strategy, trend following systems can be simple or complex. Among the simplest strategies is a set of rules to buy when prices cross above a moving average (MA) and sell when prices fall below the MA. With a long-term MA, these rules guarantee you will be on the right side of all major trends, holding stocks in extended bull markets and cash in deep bear markets. The chart below shows the results of all trades for a 40-day MA strategy trading the S&P 500 since 1988. Overall, the strategy gave 304 buy signals and just 27.6% of trades were winners. Despite the low win rate, the system was profitable because it caught all of the big trends. Large spikes show there were some large wins but most trades were small losses. Those big wins are important. Missing the 4 best trades would have resulted in a loss instead of a gain over the 28-year test period.
These results are typical of trend following systems. Kaufman found the percentage of winning trades is always low, often less than 20%. Many small losses are offset by a few large winners. Winners are held much longer than losing trades and it is common to have extended periods of times with losses, lasting years in some cases.
Losing 70% of the time or more is a problem and many system developers have tried to find a solution to this problem. Some systems add indicators to confirm the trend, for example requiring a volume-based indicator like on balance volume to confirm the trend. Some traders use oscillators like MACD or RSI to confirm the trend but these indicators are calculated with price data and include MAs in their calculation. Using these indicators to confirm a trend following indicator is simply using the same data to confirm what you already know.
In addition to using MAs, trends can be defined with indicators like Bollinger Bands or other channel indicators. As an example of this strategy, traders could buy when prices move above the upper Bollinger Band and sell when the price falls to the middle of the Band. The same problems apply to these strategies with low win rates.
Rather than focusing on win rates for trend following systems, Kaufman advises looking at the profit factor (PF) of the trading strategy. The PF is the ratio of gross profits divided by the gross losses for the entire test period. A PF greater than 1 indicates the system is profitable in the long run. A good strategy often has a PF greater than 2.
Our simple 40-day MA strategy has a PF of 1.28. The PF allows us to quickly evaluate the impact of changing system parameters. For example, a 20-day MA reduces the PF to 1.18. The table below shows how the PF changes as the length of the MA changes. Commissions of $5 per trade are deducted to make the results realistic.
In general, as the length of the MA increases the PF improves. This demonstrates Livermore was right, sitting tight can be better than hyperactive trading.
Kaufman also looked at using multiple MAs. For example, a two-MA strategy buys when the shorter MA crosses above the longer MA. We could think of the closing price a 1-day MA so the two-MA strategy is simply slowing the trading signals. This strategy could use a 40-day MA and an 80-day MA, buying when the 40-day MA moves above the 80-day MA.
Systems with two MAs tend to deliver performance that's between the two MAs. For example, he showed a system using 40-day and 80-day MAs did better than a 40-day MA system but worse than an 80-day MA. His work leads to the conclusion that two MAs aren't a significant improvement but systems with three MAs are worth exploring.
As an example, we could use a 20-day, 40-day and 80-day MA. Kaufman found adding a third MA reduced the number of trades and generally improves the system performance. Rules for this strategy are still relatively simple:
- Buy when the shortest MA is above the other two MAs. In this case, buy when MA(20) is greater than MA(40) and MA(80).
- Sell when the shortest MA falls below either MA or when MA(20) is less than MA(40) or MA(80).
This results in a PF of 1.91, less than the simple 80-day MA strategy but the win rate improves to 48.4%. Some traders like high win rates and might be willing to sacrifice some profits to be right more often. Other traders would rather make money than be right and are willing to accept low win rates.
The best system depends on your answer to the question "would you rather be right or make money?" If being right is important, consider using three MAs. If making money is more important, a simple MA system is probably best.
Either way, you are likely to enjoy profits in the long run. Research consistently confirms trend-following systems are almost always profitable over long periods of time. However, they are difficult to follow for the long run. The low win rate is one problem. Another problem is that the systems will underperform a buy and hold strategy for years at a time. While the system is underperforming, many traders abandon it. Then they miss out on the gains that eventually follow.
After a great deal of testing, the conclusion is obvious - there is no perfect trend following strategy. That doesn't mean there isn't a useful trend following strategy. One way to use this tool is an input to your investing. If the trend is up, buy aggressive stocks. When the trend is down, wait to invest new money or buy more conservative stocks.
Perhaps most importantly, wait for up trends to end before moving to cash. If you sell out of positions too early you will miss out on the big money. Sitting tight and letting gains build could be the best way to grow wealth and it is certainly among the simplest ways to improve your investment results.