There are many types of trend following algorithms that are used by money managers with different timeframes (intraday to long term) and different techniques using indicators (moving averages, support and resistance, Bollinger bands, Donchian channels, parabolic SAR, ADX, etc). However, any strong trend following algo will have the following 7 characteristics.
1) Lets Winners Run
Any strong trend following algorithm will feature average winners that are a multiple of average losers in absolute terms, and our systems tend to be slightly over 2 to 1 in this respect. I know that it can be extremely tempting to “take the money and run”, especially if you are a manual trader. In this case though, automated trading systems give us perfect patience and discipline, so we only need to write the best rules that we can for it execute a “let the winners run” philosophy. There are many ways to achieve this, but philosophically we would never prematurely exit a profitable trade without some degree of evidence of adverse price action.
2) Cuts Losers Short
Cutting losers short in trading is effectively your risk management, and it is vital to have in a strong trend following strategy. Just how short should you cut off losers? I will let you figure that out, but I would suggest to make it dependent on the potential of the trade opportunity at hand. Not only is it important to cut short losers on a per trade basis, but it is also important to do so on a per trading day basis, especially if you have an intraday system. If you are a manual trader, the last thing that you want to do is to hold on to a loser for too long (whether it be a losing trade or a losing trading day) just because you’re being stubborn and suffering from market bias. An automated trading system doesn’t have the problem of being stubborn, or the problem of any negative human emotion for that matter.
Also as an additional point, “martingale” systems (i.e. doubling down after a losing trade) run counter to the cutting losers short philosophy regardless of what a recent backtest says, and this approach represents a ticking time bomb for the implosion of your or your client’s trading account. No legitimate money manager with a good reputation would utilize a martingale system, so avoid these types of systems if you want to be taken seriously.
3) Reduces Fake Outs
“Fake outs” (which are the opposite of price breakouts) are when price reaches a significant level and is thought to be the beginning (or even middle) of a strong trend, but the trade almost immediately turns against you. Avoiding “fake outs” to the best degree possible is perhaps the biggest challenge for any developer of trend following algorithms. Whatever indicator(s) that you use to generate your buy or sell signals for entry, know that there will be times in which these signals frequently reverse or contradict themselves. While I won’t get into our exact methodology to reduce “fake outs”, it might be advantageous to use more selective criteria in identifying a potential trend opportunity. We have a special custom “ranging market” indicator (it’s really an indicator of indicators) that makes the entry criteria much more stringent for trend following opportunities in a ranging market. Whatever methodology that an algorithm developer uses to deal with the issue of “fake outs”, just keep in mind that no solution will eliminate this problem 100% of the time. The goal is to simply reduce “fake outs” as much as possible, since completely eliminating them is impossible.
4) Diversifies Opportunities
Diversifying your trend following opportunities is absolutely vital in creating a truly robust system. Diversification in trend following can occur by adding different timeframes (short term to long term), adding different entries on a per market basis, or by adding different markets and asset classes. The best out of the 3 options is likely adding different markets and asset classes, but you can use all 3 approaches if you choose to do so. The important concept to keep in mind when adding different markets to your strategy is that the added markets are uncorrelated to your current markets, thus providing the diversification you are looking for.
Futures contracts are really great in this respect (equities can also be with certain commodity ETFs as well) since there is not a great deal of correlation among equity futures, currency futures, energy futures, metal futures, interest rate futures, and agricultural futures (grains and softs). In comparison, creating a truly robust trend following strategy in forex is limited in its ability to diversify since you are only dealing with currencies, even though some currency pairs are more sensitive to movements in commodities (Australian and Canadian dollar for example) than others.
5) Avoids Curve Fitting
“Curve fitting” is what happens when algorithm developers tailor the parameters and assumptions of their systems to too great of a degree to historical data in order to maximize backtested profitability. Curve fitting tends to make systems ineffective in trading going forward since market conditions are constantly evolving. To avoid curve fitting, make sure that the parameters and assumptions in your system are as unspecific as possible on a per instrument or market basis. If your system can be effective in multiple timeframes and markets in your backtests, while limiting specific assumptions for each timeframe and market, then you are likely avoiding curve fitting and likely have a fairly decent system in your possession.
6) Balances Backtested Profitability With Simplicity
Truly strong automated trading systems are always going to be complex to some degree, but minimizing the complexity while optimizing the backtested profitability will be beneficial for a few reasons. First of all, simpler algorithms are easier to maintain in the event that you want to change some aspects of your system, and they are also easier to troubleshoot if you are encountering issues. Secondly, simpler systems are easier to explain to others, including potential clients and partners, which is quite important. Lastly, complexity for the sake of complexity doesn’t really ultimately impress anyone, and there is a beauty in seeing a more simple, yet very effective and profitable system. Does this mean you should just go for a simple moving average crossover system and call it a day? No, of course not because such a simple system will likely not be that profitable in testing. However, you should make every effort possible to make your system as simple as it can be while still maintaining a high degree of backtested profitability.
7) Acknowledges Slippage And Capacity Going Forward
Intraday or day trading systems can provide very large returns and a great degree of risk management since risk can be controlled on a daily basis. However, there is one problem that these systems face once there is a fairly significant amount of assets under management, and that is slippage. Slippage is the difference between the expected price of a trade, and the price that the trade actually executes at when using a market order. One way to counteract this is to totally or partially use limit orders in your trend following algorithm. Another thing to be mindful of is the reduction in profitability of your system per an additional $10, $20, etc. of slippage per contract per round turn. If your system suffers greatly as the amount of assumed slippage increases, that’s fine, just have a plan or another system readily available (such as a swing trading system) that will not have this issue going forward once your assets under management reaches a fairly high level. Realistically recognizing the capacity limits of your algorithms shows others, particularly institutional investors, that you are planning ahead, responsible, and can be trusted.
Bonus: Adds A Complementary Strategy To Reduce Drawdown (Not Absolutely Necessary, But Helpful)
All trading algorithms eventually demonstrate weakness in the form of drawdowns, and trend following systems are no different. While not vital for a strong trend following system, adding a complementary strategy can significantly reduce drawdown and add to profitability to some degree. Trend following systems tend to underperform when the vast majority of markets are ranging, or moving side to side within a range. Therefore, adding a minor ranging strategy to your trend following system can help. Just keep in mind that adding this secondary aspect to your trend following system is not intended to improve profitability a great deal (although it should improve profitability to some degree), but it is more intended to reduce drawdown during the times in which the primary part of your system, trend following, is underperforming.
I hope that you enjoyed this post and found it to be informative. If you could like, comment, or share this on social media, it would be greatly appreciated.
Regardless of if you trade manually or systematically, and regardless of the trading strategy that you employ, I hope that you trade with Acumen.
Futures trading involves risk of loss and is not suitable for everyone. Past performance is not necessarily indicative of future results.