Any proficient poker player knows he will lose money more often than not. If for example, there are six players in a game, they will each tend to receive a winning hand on one out of every six deals.
When a player receives winning cards, he must try to maximise gains to make more on that one winning deal than the total loses on the other five deals. This is where skill enters the picture - a good player will minimise the frequent losses and maximise the occasional gains.
This sort of skewed risk:reward equation is common in the options market, where the trader is often betting on an unlikely event and hoping to make several multiples of the stake on the rare occasions when things go in his favour. The good thing about options is that the equations are cut-and-dried. The option buyer knows the maximum loss. The option seller knows the maximum gain. A spread-user who combines long and short options knows both maximum gains and maximum losses.
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This is where counter-trend trading systems differ from trend-following systems. A counter-trend trader assumes that prices will stay range-bound within their historical limits in a given time period. For example, if the time period is say, one month, the counter-trend trader assumes that the price will not move beyond the high and low prices of the past 20 trading sessions.
The trader goes long when the price is near the low and short when the price is near the high. This is psychologically comfortable and easy to program into a computer since the high and low prices become automatic limits. Counter-trend trades also have a limit on maximum profits, which will equate to the difference between the high and the low.
A trend-follower assumes prices will move beyond set ranges. The high and low points of a given period become triggers. If the time period is a month, the trend-follower will enter long if the price exceeds the 20-session high, or enter short if price falls below the 20-session low.
There are no ways to automatically determine maximum loss or maximum gain. Stop-losses must be set at some human-determined limit. This could, for example, be a 3 per cent move in the "wrong" direction. Such a system is more difficult to program and different traders will accept different cut offs for the loss.
The error margin on trend-following trades is therefore, higher than with a counter-trend trade. What is more, trends develop less often while range-trading patterns persist most of the time. This has a fundamental explanation.
Price is determined by consensus valuations and consensus valuations of the same asset are ranged close together. For example, a stock may be valued at between PE 20 and 22 by different investors, who are making different forward earnings estimates. In that case, the high of the trading range will probably be about 10 per cent above the low.
Trends develop only when there are significant changes in valuation, and that doesn't happen every day. For example, a stock may be re-rated due to better results, or there may be a shift in interest rates, or a disagreement between investors about the potential value of an acquisition. However, when trends do develop, they yield higher returns than counter-trend situations.
Smart traders try to find ways to identify assets (commodities, forex, stocks) which have a greater probability of developing trends as well as to identify time periods and events (like quarterly result reporting, central bank policy reviews) when trends are more likely to develop.
If a trader can identify such a period, or such an asset, the probability of carrying out a winning trend-following trade increases. The rest of the time, it is probably better stick to stodgy stocks with predictable range-trading characteristics.
