Trend following in bear markets

Commit smaller amounts and set stop-loss targets to minimise loss.

The Efficient Markets Hypothesis (EMH) has much evidence in its favour. The passive index fund industry relies upon it. The EMH says that, if everyone is given equal access to information and the ability to trade with equal efficiency, it is very difficult for anyone to beat the return from benchmark indices. In a perfectly efficient market, it should be impossible to beat the indices consistently.

The most telling evidence in favour of EMH is the performance of active mutual funds. Fund managers are backed by research teams and they have access to managements. Yet, very few consistently beat the indices and some of the outperformance is due to plain luck.

But some active investors do beat the market consistently. A very few have done so over decades. As Warren Buffett once pointed out, if there are common factors to the methods employed by consistent winners, then there is a way to beat the benchmarks, despite the evidence for EMH.

No market is totally efficient. There are times when stocks are under-valued. Buffett's own methods seek out stable predictable businesses with consistent growth prospects and he buys them when under-valuations are visible. It’s worked for him and for others, who employ similar methods.

The EMH also implies that is incredibly difficult for a trader to beat the market. Prices move almost randomly in the near-term in efficient markets. But some traders do beat the market and a very few do so consistently.

Are there any common factors in the methods consistently winning traders use? Indeed there are. Ed Seykota was one of the pioneers of computerised trading and he has been consistently among the most successful traders of the past five decades. Seykota is the guru of trend-following systems. He specialises in identifying situations where price movements are trending. He trades with the trend until his methods tell him the trend has either failed, or reversed.

Trend-followers like him are among the most consistently successful traders. They use many different systems. Quite a few develop proprietorial “black-box” algorithms. Some use simple moving-average-based methods. All the systems are designed to find situations when prices have developed a trend.

Unlike Buffett, Seykota and his chelas are uninterested in what they’re trading and the direction of the trend. They don't care if they’re long or short, or seek fundamental explanations for what is happening. Most trend-followers seek exposures in futures markets, chasing underlying stock indices, commodities and forex with attendant high leverage, rather than picking stocks.

Most of the systems have high failure rates. Typically, less than half of the positions end up profitable. However, when they are profitable, they are immensely profitable. Winning positions often run for months at a time and sometimes for years, which is unusual in the trading context. While the strike rates of winners to losers are low, the return to loss ratios are high enough to over-compensate.

The critical edge of trend following methods does not seem to lie in the identification of promising trends. The high failure rates suggest that there is no particularly effective way to do that. But all successful trend-following systems are allied to systems of rigid trading rules.

When to trade? How much to trade? When to reverse a trade? Critical decisions such as these are all taken on the basis of rules that remove human bias. The underlying philosophy of successful trend-following systems is to minimise loss whenever the trend fails, since that will happen pretty often.

By never committing more than a small percentage of available capital to a given trade, and by using trailing stop-losses that cut off a failed trade, these system try and ensure that all losses are minimised. This is allied to the concept of letting winning trades run as long as such trades continue to generate profits.

All this is difficult to implement psychologically and requires a lot of self-control. The temptation to intervene and break the rules will always be high. A good trend-follower usually does back-testing to tweak the setting of position sizes and of stop-losses. Often, months of dummy trading are required before implementing a new system of trading rules.

The advantage is that a trend-follower with a good system of trading rules can make money across both bull markets as well as bear markets. In fact, trend-followers are a rare subspecies, who seem to make massive profits in bear markets. In the Indian context of fairly inefficient markets and highly liquid stock futures, the chances of such systems working is higher. All it takes is discipline and self-control. But those qualities are so rare that winning traders are thin on the ground.