Stig Ostgaard on Trend Following

On why trend following is not popular:

One reason for this paucity of early information is suggested by the “following” part of the term “trend following.” The implication is one of passivity, of reaction, rather than of bold, assertive action -- and human nature shows a distinct preference for the latter. Also, trend following appears to be too simple an idea to be taken seriously. Indeed, simple ideas can take a very long time to be accepted – think of the concept of a negative number, or of zero: simple to us, but problematic to our ancestors.

In essence what trend followers do:

These behaviors reinforce the idea that trend following is of a humble, plebeian origin. It is a means by which those who are not members of the economic elite may participate in trading profits by following the transactions of this elite as they act on the basis of their economic intelligence, or conversely, as I would argue, their arrogance and folly.

The animalistic level of trend following:

It is at one level a phenomenon of the human psyche, an expression of the Keynesian “animal spirits” that percolate from the deepest levels of our being. This type of trend following is spontaneous, inductive, adaptive and evolutionary – a burst of conformity to innovations in our immediate environment. At this level the masses have always been trend followers, not only in financial matters, but also in terms of music, art, clothing and basic world-views.

The observing level of trend following:

But the other level of trend following is something else entirely. This is the meta-level, which sits above the tableau of material and psychological cause and effect, allowing participants to observe the behavior of the markets as a whole – and to design intelligent, premeditated responses to market action. This is the level of trend following from which we as traders should – and usually do -- operate.

The three elements of trend following:

They are three: 1) to initiate positions based on the perceived direction of the trend, 2) to hold positions based on the perceived direction of the trend, and 3) to liquidate positions based on the perceived direction of the trend. It is also possibly a fourth thing, as suggested above: it is to do all of these things systematically, on the basis of logical relationships or mathematical formulations. But I do not think that this is an absolute requirement. It is certainly possible to be a subjective trend follower, or to combine systematic and subjective elements in a trend following system. In fact, I believe that some great traders did indeed include subjective elements in their methodologies.

Cutting losses and letting profits run:

As one example, consider the economist and trader David Ricardo, who flourished in the London markets from the 1790s until about 1818. A large trader in Consols (bonds) and stocks, he accumulated a large fortune from his speculations, which afforded him the leisure to focus on his primary interest in life, economics. Exactly what his methodologies were is not known, but it is to him that one of the most famous sayings in all of trading history is attributed: “Cut short your losses; let your profits run on.”

This is good advice, no doubt – it has survived to the present time and is expressed often. Still, there is no detail here, no advice on how to cut losses or how to let profits run on. And while the first part of the maxim says something about some liquidations, nothing is said about initiations. The ending part, however, is a clear exposition of a central tenet of trend following philosophy: as long as the trade is going your way, don’t get out.

For another example, move forward a century and west to another continent. Here is a quotation from the famous grain trader of the Chicago pits, Arthur W. Cutten: “Most of my success has been due to my hanging on while my profits mounted. There is the big secret. Do with it what you will.” Again, Cutten is saying, “stay with the trend.”

In the words of Richard Donchian:

Every good trend-following method should automatically limit the loss on any position, long or short, without limiting the gain. Whenever a trend, once established, reverses quickly, there is always a point, not far above or below the extreme reached prior to the reversal, at which evidence of a trend in the opposite direction is given. At that point any position held in the direction of the original trend should be reversed – or at least closed out – at a limited loss. Profits are not limited because whenever a trend, once established, continues in a sustained fashion without giving any evidence of trend reversal, the trend-following principle requires that a market position be maintained as long as the trend continues.

Source: http://www.michaelcovel.com/pdfs/stig-ostgaard.pdf