Tuesday, March 13, 2012

MetaStock Monitor MAR - APR 12: Main Article

Creating and Compounding Wealth via Trend Following
Contributed by Andrew Abraham

I started trading (in particular trend following) in 1994. I was overwhelmed with all the books and courses offering so called “magical success” and millionaire traders who really weren’t. I wanted to know who was succeeding and what they were doing. My broker told me the most successful client of his company was a dentist. He was not a Harvard graduate nor a partner in Morgan Stanley. Yes, he was a dentist! I was told he invested $200,000 in a robust trend following concept in 1979. He let that money compound over time. He currently has an account of $5,000,000 plus he has made over $12,000,000 from trading the markets over the years.

The dentist was the exception. Most clients of the brokerage did not make money. Most clients actually lost money. The difference between the majority of the clients that lost money and the dentist was he had a trading plan with risk management and he followed it with patience and discipline. Even with his plan he always had numerous loses, went through drawdowns and even long periods of time when he did not make money. However, he did not give up or start to look for a new methodology.

He did not have any magical holy grail formula. He is a trend follower who had a simple robust methodology and, more importantly, knew how to properly condition his thought processes to get through all the tough drawdowns and long periods when he was not making money. What encouraged me over the years was if the dentist can do this, so can I. Another example to me was Richard Donchian who traded his trend following breakout strategy into his 90’s. If the dentist can do this and Richard Donchian can do this, so can you!

There is nothing perfect in this world. There are no perfect systems or even traders. Every system and methodology has drawdowns and losses. Traders need to accept losses as a natural process of trading. Those that cannot accept losses jump from one system or one indicator to the next seeking the elusive holy grail. Traders need to realize success in trading is a process and takes time. They need to have patience with themselves and apply themselves to a methodology fitting their personality. Doctors do not become proficient overnight. Neither do lawyers.

I want to share with you one of the methodologies I have traded over the last 18 years. Trend following can be simple, but don’t make the mistake of thinking it is easy! We seem to convolute it via our fear and greed. There are countless websites and late night infomercials trying to tell you differently. They make you think you just have to read a few pages or attend an online class, and then, magically you’ll become a successful trader.

Don’t be misled!

Trend following is not retirement in a box! You need to do your work!

One of my methodologies is very simple and robust. It works on all platforms, time frames and markets. It is one of two general approaches in order to attempt to catch and ride trends I utilize. They both attempt to put on low risk trades in the direction of a trend and have various similarities.

Trend Break Out and Trend Retracement

For the sake of this article I am going to focus on one issue: Trend Retracement. The concept of trend retracement is that we are already witnessing a trend and we are looking for a low risk method in order to participate and enter in the direction of the trend. I believe in keeping things very simple as when we are trading we know what we must do and we have a well thought out plan in advance. Do not confuse the word simple with unsophisticated or not possible to generate money. This methodology is used by many successful traders.

This Trend Retracement is a four bar setup:

1. Identify a strong trend either by a high RSI or an ADX which is above 30.
2. We want to see a retracement against that trend where we have 3 lower lows.
3. On Bar 4 we will simply buy a breakout of the Bar 3 high.
4. If we do not have a breakout buy on Bar 3 – Buy the breakout of Bar 4 as demonstrated below.



As you can see in this hypothetical example one would have bought the breakout of Bar 4.

There is more to just the Trend Retracement Entry. One needs to think of how many shares to put on. What I suggest is looking at the range from the high to the low of the 4th bar to determine how many shares we can put on. The high of the 4th bar was $610.01 and the low was $607.68. The difference is $2.33. What one needs to do is look at their account size and how much of that account size are they willing to risk on anyone trade. For example if I was trading a $30,000 account and wanted to risk 1% on any trade I could risk and potentially lose $300 on a trade. If I wanted to risk 2% on a trade I could risk and potentially lose $600. The more risk per trade the more potential profit as well as the more potential loss. Let’s examine what would have transpired in this hypothetical example with Google running to its high of $619.77. (Clearly we would not have gotten out at the top, but we can use it as a reference to just highlight the difference in position sizing and position percentage risk).

Entry $610.01 to $619.77; difference is $9.76.

1. Risking 1% of $30,000 was $300 risk allowed us to purchase 128 shares X $9.76 = $1249.28.
2. Risking 2% of $30,000 was $600 risk allowed us to purchase 257 shares x $9.76 = $2508.32.

As you can clearly see there is more entailed than just using a specific setup. One needs to think about risk per trade.

Please also realize any trade is 50/50. After this nice trade there could have been another trade as there were 4 down bars with a breakout that did not work as this trade did.

There are only four potential out comes when we trade.

1. Big losses - however we had an immediate stop placed to prevent.
2. Small losses - these will happen all the time.
3. Small profits - these also will happen all the time and cancel out the small losses.
4. Big profits - These are rare and make up for all the small losses are small profits do not offset.

Too many times system sellers & promoters just give you a setup. It is paramount to know where to exit either with a loss or a profit. Too much emphasis is placed on setups, patterns, and entries. In order for trading success one needs a complete trading plan that states when to enter, how much to buy/sell, when to exit with a profit and loss. On a slightly more deep level one also needs to know what to trade which I detail in my courses.

I like to keep my exit rules simple. An easy exit rule in where you lock in profits when trades work and exit you when trades do not work is a trailing 3 bar low as an exit when you buy and a 3 bar high when you go short.



Trend followers do not worry what the markets are going to do tomorrow. They have an exact plan with all contingencies thought out ahead of time. Trend followers are like surfers and look to ride the waves.

Trend followers have an exact plan. This plan is based on objective and automated set of rules.

Trend followers follow their plan without second guessing it. A trading plan makes life easier by eliminating emotions from trading decisions. A trading plan forces discipline. If you do not follow the trading plan you will not succeed. Do not even start if you cannot follow the plan. The above examples are not complicated yet they are an effective way of taking money out of the markets.

Trend following entails having a defined plan and strategy to put money into trade to achieve one and only goal: PROFIT!

About Andrew Abraham

Andrew Abraham has been investing in commodities and managed futures since 1994. He adheres to the philosophy of trend following. Trend following stresses a disciplined approach to commodity/futures trading. Successful trend following and commodity futures investing requires patience, discipline and actively managing the risk. What sets Andrew's strategy apart from other traders is that he is not only concerned about the return on investment but also with how much risk should be tolerated to achieve goals. For more information, contact Andrew via his website (TrendfollowingMentor.com), email, or Skype: Abraham Investment Management.

***Past performance is not necessarily indicative of future performance. The risk of loss in trading futures contracts, commodity options or forex can be substantial, and therefore investors should understand the risks involved in taking leveraged positions and must assume responsibility for the risks associated with such investments and for their results. You should carefully consider whether such trading is suitable for you in light of your circumstances and financial resources.

HYPOTHETICAL PERFORMANCE RESULTS HAVE MANY INHERENT LIMITATIONS, SOME OF WHICH ARE DESCRIBED BELOW. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN. IN FACT, THERE ARE FREQUENTLY SHARP DIFFERENCES BETWEEN HYPOTHETICAL PERFORMANCE RESULTS AND THE ACTUAL RESULTS SUBSEQUENTLY ACHIEVED BY ANY PARTICULAR TRADING PROGRAM. ONE OF THE LIMITATIONS OF HYPOTHETICAL PERFORMANCE RESULTS IS THAT THEY ARE GENERALLY PREPARED WITH THE BENEFIT OF HINDSIGHT.

IN ADDITION, HYPOTHETICAL TRADING DOES NOT INVOLVE FINANCIAL RISK, AND NO HYPOTHETICAL TRADING RECORD CAN COMPLETELY ACCOUNT FOR THE IMPACT OF FINANCIAL RISK IN ACTUAL TRADING. FOR EXAMPLE, THE ABILITY TO WITHSTAND LOSSES OR TO ADHERE TO A PARTICULAR TRADING PROGRAM IN SPITE OF TRADING LOSSES ARE MATERIAL POINTS WHICH CAN ALSO ADVERSELY AFFECT ACTUAL TRADING RESULTS. THERE ARE NUMEROUS OTHER FACTORS RELATED TO THE MARKETS IN GENERAL OR TO THE IMPLEMENTATION OF ANY SPECIFIC TRADING PROGRAM WHICH CANNOT BE FULLY ACCOUNTED FOR IN THE PREPARATION OF HYPOTHETICAL PERFORMANCE RESULTS AND ALL OF WHICH CAN ADVERSELY AFFECT ACTUAL TRADING RESULTS. ALL TRADING DECISIONS ARE SOLELY YOUR RESPONSIBILITY.

THE MATERIAL IS INTENDED FOR EDUCATIONAL PURPOSES ONLY.
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