Thursday, July 24, 2014

Why I don't Stop Buying Small & MidCap Stocks: The Anatomy of a Trend Following Trade Plan

This year we have had some issues with small and mid cap stocks.  It seems like every time we buy them they end up under performing large cap stocks.  The problem has been that small and mid caps have been extremely choppy this year.  They will have a period of out performance causing us to get in and then a period of under performance causing us to get out.

This has happened a couple of times this year and someone recently asked me why we don't start ignoring the buy signals for small and mid caps.  The reason we don't goes into the anatomy of how a trend following trade plan actually works.  In any trend following trade plan you are going to have a certain amount of trades.  A percentage of these trades will be profitable and a percentage will be losers.  As long as your expected return per trade (average return over all trades) is positive it doesn't really matter what your percent of winners vs. losers is.   Also, if you look at a distribution of all trades you will typically see most of the profits come from a very small amount of trades, with the rest tending to be small gains or small losses.  So in a well designed trend following trade plan you know that the monster trades are out there and you know that your expected return per trade over time is profitable, you don't know the outcome of any one trade.  It could be a loser or it could be a monster profit.

Where trend traders often fail is they have a string of the loser trades and instead of focusing on the long term, they decide to pick and choose the signals they will take, often resulting in the missing of a monster trade.  The story of the Turtles illustrates this well.  Two successful futures traders made a bet about whether ordinary people could be taught to be traders.  They hired people from all walks of life and gave them a very successful trend following trading system that relied on a few monster trades for the bulk of profits.  All they had to do is take the signals and over time they would do very well.  With all of that, some of the hires failed.  They had a string of losers and starting picking and choosing what trades to take, causing them to miss the monster trades that would have made up the bulk of profits and turning profitable systems into losers.

The moral of the story is that if you have a well thought out trend following methodology, where you are constantly evaluating it and looking to improve it and where your expected return is positive, then you cannot pick and choose what signals you are going to take.

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