One of the big myths in the world of financial trading is that the big hedge fund managers and commodity trading advisors employ some type of magical trading system that churns out big returns year after year. A simple review of the performance of some of these trading companies demonstrates that this could not be further from the truth. In fact, some of the most successful commodity trading advisors have actually struggled mightily over the last several years. We’ll get to the reasons why a little bit later in this article.
The truth of the matter is that these successful traders are no different than the average trader who struggles to even be profitable in the markets. The main difference is that they have developed a disciplined approach to trading where risk management is the primary component. In cases where some traders were wildly successful for a while, and then blew up (Victor Niederhoffer, Long Term Capital Management, etc), there was the thought that they had found the holy grail, but they were exposed by their lack of focus on managing risk.
Many traders approach the markets backwards. The test out many ideas on paper or with their computers without understanding why a certain idea should work. Michael Dever, author of “Jackass Investing,” (you can find his book here ) who also runs Brandywine Asset Management, suggests that traders and investors should first start out by understanding what he refers to as return drivers. To quote Dever, “a return driver is the primary underlying condition that drives the price of a market.”
One example of a return driver is economic growth. When economic growth is strong, portfolios invested in stocks tend to perform well. The concept of trend following is another return driver. When markets are trending due to whatever set of circumstances, trend following strategies perform well.
Most traders and investors tend to approach developing a trading strategy without understanding the return driver that will make the strategy successful when it is present, and make it struggle when it is not present. Most simply come up with an idea, back test it, and if it seems to work over a period of time, they start to trade with it.
To quote Dever again, “a trading strategy is a combination of a system that exploits a return driver with a market that is best suited to capture the returns promised by the return driver.”
A return driver may consist of a technical condition in the markets (trend following) or a fundamental condition (economic growth). It may even consist of a psychological condition, as was the case during the 2008 financial crisis, when there was virtually a global distaste for stocks.
Systematic trend following is an example of a strategy that attempts to capitalize on the return driver of trending markets. At any given time, there should be a few markets that are trending, and over a long period of time, there will be big trends that occur where systematic trend followers can generate significant returns.
However, over the last few years, the markets have displayed a different type of behavior that has confounded many types of quantitative based strategies such as those that employ trend following systems and pattern recognition. The behavior in question is this…the intraday volatility has increased significantly, while the weekly, monthly and yearly volatility have not increased in a corresponding manner.
Most quantitative types of strategies seek to exploit some kind of directional move. However, these directional moves have become shorter in duration, and often violently reverse. As a result, many of these strategies have not performed well over the last several years, including trend following approaches.
What is the return driver that is driving this type of price activity? The likely culprit is the ongoing intervention in the financial markets by central banks. For example, currency markets are usually the best markets for trend followers. Why? Currency prices are generally driven by economic fundamentals along with political concerns. Economic conditions do not generally change overnight. A monetary policy of easing or raising interest rates will often take a couple of years to run its course.
In the current global economic environment, where virtually of the major economies remain fragile, central banks are doing their best to maintain stability in currency markets. As a result, there have been few exploitable trends in these markets over the last several years.
So what does all this mean for the individual who wants to try and make money trading futures? It means that they need to first learn to understand what drives price behavior, and then they need to learn how to develop a methodology that exploits certain price behaviors. What most tend to do is look for tips or some hot trading system that may be performing well without understanding why it is performing well.
In order for anyone to be successful in the business of futures trading, they must conduct significant and thorough research on their own, rather than completely rely on others. Our goal at Trend Following University is to provide the tools necessary for the individual to learn why trend following works over the long run, why it may not in the short run, how to conduct their own research, and how to become consistently profitable.