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It’s all just Divergence – In various shapes and forms – Divergent Traders Unite

As humans, we like to categorize things….we all do. It’s just the name applied to different aspects of the same game  that is different.

So for those who have yet to grapple and understand the idea called ‘divergence’ it is tempting to assume that definitions such as absolute momentum and trend following have a life of their own. Well in the dark areas of my lurking mind, I wrestle with this notion.

In a previous blog post we discussed “what is a trend?”, and during the course of that discussion settled on a plural point of view, that a trend is a very relative concept that lies in the eye of the beholder. A ‘you say tomato and I say potato’ sort of discussion.

No matter what your interpretation, what really matters is your ability to apply that relative concept with fidelity….again….. and again…… and again. Bill Dunn has his definition. Bill Dreiss has his definition, Bill No-Name has his definition….and so on and so forth. Have you ever noticed…..there are just so many Bills in this game….but when you inquire further there is but one Bill with many different masks…or is it Richard as in Richard Dennis, Richard Donchian, Richard Brennan…..*sniggers*…you just gotta have a plug once in a while. So the Bill’s and the Richard’s is not the point being expressed here. 🙂

Once you have settled on your preferred definition of what floats your boat, whether it’s Bill’s boat or Richard’s boat,  you just gotta stick to it. The central point of this discussion is to define ‘rules’ which then you apply with persistent patience and determinism.

In doing so, you find that despite the plural viewpoints of what is a trend, the style drift in the broad church of trend following is far smaller than you might think. So if we strip it back a bit further, what we find is that it is the repetitive process that really is important as opposed to the technique itself.

Good….so we have arrived at an important criterion of trend following despite our many different systems used to arrive at this conclusion.

So let’s now strip back our possible bias that might try to distinguish between absolute momentum followers and trend followers. I have followed this thought bubble and now sit comfortably with the notion that once again, there is no ‘real’ material difference apart from a few qualifiers that I would like to discuss in this post. In general, both absolute momentum followers and trend followers can comfortably sit within a very broad church of systematic trader called ‘diversified divergent traders’.

So let’s have a look at the few qualifiers that may help you discern subtle differences between these two subsets in philosophical viewpoint that may help you broaden your own definition. Sometimes it is the definition itself that restricts us from considering different points of view which might lie just outside our world view. In appreciating that which might lie just outside that comfortable place we call home, it can widen our world view which we can then apply to further diversifying our tool kit to bring home more of the bacon.

Now for us small guys it is important to not think like the ‘big guys’ in this game…..because by stating the obvious….size matters in this game….but not necessarily in a good way. Yes….size matters in attracting management fees and performance fees and in attracting ideas to diversify into in the case of Renaissance Technologies…but comes at a cost of what size can bring to the game in terms of your ability to flexibly adapt to changing market conditions. This is important to the trend follower that feeds on ‘following price’ but not necessarily the case for the juggernaut quant firms who predict such as Renaissance, Two Sigma and lately Winton.

For example, size makes your boat big and brings with it inertia that prevents you from nimbly changing course which is a very important feature and benefit of trend following. Size can make you so big that all your efforts are placed on ‘not moving the market’ itself which makes you have to turn to a far narrower subset of available methods, timeframes and instruments to diversify in. This may have led to the big guys having to diversify across ideas as opposed to more traditional trend following or momentum catching methods that can easily diversify provided they trade small and widely diversify.

You can see all this in the performance metrics of the divergent camps. The statement of the big CTA that ‘it is very crowded in here’…is not only a symptom associated with the increase in competition for allocations in the ‘big space’….but also attributed to the fact that the universe that you can play in with this game of trend following and momentum catching gets progressively smaller with size.

While we can learn so much from the big guys in the game, it doesn’t mean we should blindly follow them. We should accept what is offered with grace and always question it for we are similar….but different at the same time.

As a small retail trader myself….I don’t see this ‘trend is dying’ phenomenon that all about me is shouting to the heavens. I just see improving performance metrics that appear to reach to infinity and beyond. I play both the long term game of diversified systematic trend following but also more importantly I also play the shorter term game of absolute momentum….as to me in my world of the small, there is opportunity everywhere I seem to diversify in this landscape of divergence.

So this is how I view the art of absolute momentum and the art of trend following. I see it as a scale dependent perspective.

We all know that trends do not go up and down in a straight line. Trends are fractal like and directionally move in waves. Momentum exists at discreet points in this wave structure which periodically push it further away from a notion of equilibrium. We hope that these momentum impulses are serially correlated to give trends enduring persistence…..but many times they do not and the noise of the lower timeframe is far more prevalent (lower signal to noise ratio)…hence the brief period of auto-correlation of a momentum series evaporates with trends simply ending and reverting back into random noise, equilibrium or reversion (a new form of short term trend back to a prior equilibrium).

Now of course the big guys, can’t afford to interfere with this very natural market cycle as they find that they start altering this delicate balance and before they know it they are actually biasing the participant mix and shaping their own market condition and ‘self cannibalising’ themselves as opposed to harvesting other participants wealth……But the small guys can….without fear of disturbing the market state.

When you drill down into a market, you see how it all starts with a participant interaction. An event between a buyer and a seller tussling over the perceived view of future price. Now of course one participant ‘the buyer’ wants a deep discount and ‘the seller’ wants a fat profit…so we can clearly understand this interaction event and the tug of war that goes on. Some of us therefore wonder why breakout traders and trend followers buy higher and sell lower given this viewpoint…..however we fail to actually observe what is really going on. It is not a single transaction event between a buyer and a seller. It actually is an auction event between many buyers and many sellers. It is the buyer who pays the greatest price and the seller who pays the lowest price who are allowed to participate in this game of value transaction.

That is why the trend trader and the breakout trader in the divergent camp don’t wait for retracements before entry. In doing so, they therefore can miss out on opportunity provided by the signal and delay your action. When you are diversified you simply don’t care about the pin prick of a loss from a failed breakout….but you really really care about lost opportunity. If you do not think of this game as an auction, you will continuously miss the trade event itself and be an observer as opposed to a participant.

So….anyway…..back to looking deep into this market at the level of the auction process. The seeds of this market start with a single auction event between participants and then the game continues at every different price level. Price starts to move in response to these processes…but it is very asymmetrically oriented. It starts as a single seed but expands into an open-ended vast superposition of states as the participant mix increases and more and more transactions occur. If the processes at the small scale manifest into a larger scale emergent feature called momentum, then the absolute momentum trader is onto it, but they need to be far more prescriptive than the trend follower in the way they capture this momentum surge.

Momentum traders use different asymmetrical traps to the trend trader. The momentum surges are far more frequent than the enduring trend and there is far more noise, and hence over-trading in the momentum world can deal a far more deathly blow to the momentum trader than the trend trader. I tend to think of momentum traders as snipers who harvest the momentum anomaly on the shorter timescale with precision than the trend follower who is far less prescriptive in the  manner they tackle trends over the longer term.

A momentum trader is very nimble and precise with wickedly tight stop loss conditions and expertly crafted trade management designs at all points between the entry and exit condition to ensure they get out before they are wiped off the face of the planet in their wrongness. A trend follower on the other hand is loose….. man….and flowing….and smells the roses and pats koalas when they trade. Said the momentum trader to the trend follower…”.wake up man….and smell the thorns…… to which the trend trader just smiled and caressed the petals”

But you can actually have both….and guess what that does? It makes you more diversified. You can be the sniper who operates on the lower timeframe and the tree hugger who languishes in the beauty and relative simplicity  of the long term……. as momentum is always a subset of the trending condition. To have one, means that you need the other. Just another Yin Yang statement in this trading within a complex system.

The point of this blog post is just this. Try not to pigeon hole yourself into any form of neat human categorization as sure enough….soon enough….your world view will start to be shaped by it. Simply open the mind and observe all without creating any labels. Let the Buddhist in you empower you to become better traders.

Trade well and prosper

Rich B

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