In part 1 of this series concerning portfolio construction we dealt with one half of the Price Followers mantra derived from David Ricardo in the 1700’s (“to cut losses short and let profits run”). Part 1 related to letting the profits run. The profit expectation of a Price Follower does not relate to any form of predictive method or accurate forecast, but simply arises from the tendency of markets from time to time in delivering outsized rewards that is far more frequent than what an efficient market (or random distribution of returns) implies.
Provided we adopt a ‘rinse and repeat’ rules based process for capturing all possible outlier price moves (which observes the “Price Followers mantra”) from initial entry to final exit, then we have the makings of a trend following (aka price following) strategy. While we recognise that we will be wrong most of the time and miss our prey, a Price Follower is occasionally lucky (only when the market decides) and is able to catch the unpredictable unidirectional tsunami (extended price move) that occasionally occurs from time to time. It is the unknown extent and duration of the extended price move which dictates a Price Followers ultimate success. Price Followers therefore are said to harvest uncertainty itself.
The systems deployed by a Price Follower are therefore more like ‘traps’ which are placed in those zones where outlier moves are known to exist. Filters are used to avoid entering the market until those conditions favourable to outliers exist. This is in direct contrast to predictive strategies that attempt to control the way we would like to see the future unfold. The predictive style of strategy operate within the normal day to day machinations of market activity where conditions are *obviously* more predictable.
A price follower places their emphasis on the market condition to deliver their alpha as opposed to an elaborate system design designed to force an outcome. They achieve this by setting very simple traps to capture as much of the trending condition as they can when price extends into outlier zones of potential. In capturing as much of the trending condition as possible, Price followers need to widely diversify in their system design but at the same time ensure that each system design has the core logic of ‘cutting losses short and letting profits run’ embedded in them. .
In letting profits run, the simplest design rule of all is deployed by the Price Follower by having no rule at all in deciding when to take a profit. We leave the profit outcome unbounded in nature with the appreciation that it is the market which decides when the profit ends….as opposed to the system constraint which dictates terms such as the profit target. Now this does not exclude the use of performance exits…which still allow for unbounded profit, but it does exclude the use of profit targets.
By ensuring an open profit condition that meets the conditional mantra, we are then in a position to lie in wait at a desired ambush point to catch our prey (aka price) when it triggers our asymmetrical open ended traps.
But enough talk has been done about ‘letting the profits’ run…..now it is necessary to focus on the most important aspect of the game for the Price Follower….and that is ‘cutting the losses short’. But it is not a story of separate halves here….the cutting losses short is a necessary pre-requisite when letting profits run. They are closely correlated. This is because in every return stream of every financial asset, there is an interplay between risk and reward. In general, with higher risk comes higher reward. As Price Followers we have no say in our long term profitability as we don’t predict…..but we have every say in managing risk. This is a feature of Price Following that we can directly control.
Now while the Price Follower deliberately simplifies the profit taking condition, they are very specific in ensuring their traps have a very limited adverse risk exposure. The more detailed design principles that restrict possible adverse outcomes for a Price Follower lie in cutting losses short at all times. So when they say that trend followers use primitive simple systems, that is not the actual story at all. The constraints imposed by managing adverse risk events are quite complex and detailed. They are far more rules based and specific than the risk management measures adopted by the Predictive camp of traders.
For the Predictor who believes they can interpret the most likely path of market price into the future, their long term success relates to how long a market remains predictable. The lure of the predictable rhythm that is the bread and butter of a predictor tends to result in the blindsiding of the Predictor to the other essential part of the long term profitability puzzle, namely the risk of being wrong in assuming that markets remain stable and predictive in nature. When market conditions remain predictable, there are no quantitative signs that there is any problem. Traditional risk volatility measures such as Sharpe and MAR used over a defined interval of time that is ‘predictive in general condition’ simply do not account for the risk inherent in switching market regimes.
For example, the mean reverting trader since 2010 given quantitative easing by central banks would probably be sitting on an ever building warchest up to now with the impression that their methods are robust and durable given the current large sample size. This degree of false confidence associated with recency bias is likely to have resulted in extra leverage being applied and a higher trade frequency to express the degree of confidence in their ‘predictive abilities’. Worse still, their trade statistics using some well worn methods such as risk volatility measures (Sharpe, MAR etc.) would be telling them that all is fine and well.
The lure of this false underlying premise results in the build up of intrinsic risk associated with their applied system. This intrinsic risk cannot be quantified and will not be observed by standard statistical treatment.
So what do we mean by intrinsic risk? As we are probably aware…but rarely apply…..risk is simply the likelihood and consequence of an unfavourable event. It is a combination of both the probability of an adverse event happening and the material significance of that possible unfavourable event. In trading circles we use proxy statistics such as volatility measures (aka Sharpe ratio etc.) across defined sample sizes as the methods of quantifying risk….however these measures are misleading as it is the unknown extent and duration of predictive conditions and the unknown extent and duration of unpredictable market conditions that ultimately decide the fate of a speculator.
For example in the HFT environment over a period of say 6 months, we can obtain a huge sample size and a very nice linearly ascending equity carve arising from the exploitation of a predictive market condition. This actually tells you nothing about the risk inherent in that system. It simply tells you how that system performed over that particular market condition itself. Change the market condition for an extended period of time….and that’s when you see who has been swimming naked with a limited understanding of what risk is as the tide goes out.
The warehousing of risk is a term that we use to define this intrinsic risk associated with a lack of an appreciation of uncertainty. We can see symptoms of risk warehousing when we closely look at the unrealised equity curve against the realised equity curve (or balance curve). Risk warehousing is evident in those strategies where the unrealised equity curve can sit well below the realised equity curve. This means that the system is holding risk. If conditions stay unfavourable, the unrealised equity curve continues to deteriorate. It is very much like a pressure cooker where the risk builds up until it is too late to deal with and frequently results in risk of ruin unless addressed.
The only way to release intrinsic risk that builds in your system is to exit that trade. The realised trade forces an outcome where all the inherent risk in that system is fully revealed and released.
Price followers utilise this principle in their strategy design by cutting losses short at all times to fully release risk on a frequent basis and never allowing adverse risk to warehouse in their systems. This is another important reason for not using predictive systems in a diversified portfolio. The risk warehousing that occurs in predictive techniques creates intrinsic risk at the portfolio level. One return stream that has risk warehoused in it can bring down the whole portfolio.
Risk is quite tough to understand as we are not used to dealing with it. We like to feel that we have control over our destiny, but as participants in a system, we fail to understand that risk is actually a result of the factors which lie outside our control. Namely the risk associated with events that can and do exist outside our system rules.
Our systems are what defines the limits of our ability to control outcomes. There actually is no risk in the market itself. The risk is a consequence of the adverse conditions that lie outside our system rules…..so it is our system itself which defines how adverse risk emerges.
A Price Follower understands this and enforces strict risk mitigation rules into their system design to ensure any unfavourable adverse event is strictly managed at all times. The reason for this strict adherence to risk management by the Price Follower is that to be in a position to have your system traps turned on 24/7 to catch the unpredictable outlier, you must be able to preserve your capital for extended periods of time when conditions are not favourable to your strategy. Survival over the long term is an essential pre-requisite when the unpredictable outlier determines your ultimate success.
To be a survivor, you need to dedicate your attention to system robustness. Namely to ensure your system is sufficiently rigorous in mitigating adverse risk events while waiting for the possible biggie.
They achieve this rigour by applying the following broad principles into their system design and their portfolio design.
- Every system deployed by a diversified price follower needs to apply a core principle in their system design. The core design principle is the cutting of losses short and the letting of profits run….the Price Followers mantra;
- Outliers come in a vast array of different shapes, sizes and duration. We must deploy many different styles of trap that respect the Price Followers mantra to capture different aspects of them.
- The complexity to a Price Follower’s system design lie in the methods deployed to manage risk….as opposed to the simple methods deployed to capture profits. This risk management complexity ensures that we get out quickly from every losing trade, but also serves to whipsaw us out of a possible volatile trend. The design therefore creates obstacles to capture only a few forms of trend. We therefore need to achieve wide diversification about this core design principle to capture as many parts as we can of these outlier moves of diverse form and extent.
- We avoid any form of warehousing risk and all adverse moves that are unfavourable to our system are quickly exited. To validate this, we ensure that our unrealised equity curve never builds to a point where it compromises the overall portfolio result. To effectively define where we cut losses short, we need to have an understanding of the average range allowed for by noise (or an efficient market). We obviously avoid an extended unfavourable move, but we need to allow sufficient room for inherent random volatility to exist within our defined stop loss and trailing stop exit condition. Poor design and too tight a stop introduces unnecessary drawdown into our result.
- While an initial stop and trailing stop condition is mandatory for any system we design, this is more to ensure that no single system can adversely effect the risk signature of the overall portfolio. The most effective method that a Price Follower uses to mitigate adverse risk on any single position is to bet small. Under broad diversification, even if your stops and trailing stops are not observed during illiquid market conditions, your small allocation to an individual trade outcome will ensure that your total trading capital is not severely compromised.
- Every system deployed in a diversified portfolio must have positive skew. Large losses are simply not tolerated. We recognise that unfavourable conditions can be of any possible duration and extent. A string of large losses will severely handicap your ability to survive unless strict risk mitigation methods are observed.
- A sign of robustness is not merely the sample size of your trades….but more importantly the range of adverse market conditions you have had to endure. We use sample size as a proxy….but remember this is over the long term and the timeframes we apply our Price Following Techniques are not during the smaller timeframe. So while a 20 year backtest is a powerful way to ensure that your system can deliver positive expectancy over the long term, the really important aspect of this time horizon, is the extent and duration of adverse conditions that have been experienced within it.
- Outliers are not a regular feature of the market condition. They are by definition unpredictable in nature both in size and frequency. We can never expect a single system to offer a nice linear ascending equity curve. Furthermore we must diversify far and wide to participate in as many outliers as we can get our hands on. This therefore requires a design modification where we need to restrict our trade frequency across a single return stream (to avoid the more prevalent noise and predictable condition) but diversify very widely to then up the trade frequency at the portfolio level.
- A steadily rising smooth equity curve of a single return stream is a fiction to the Price Follower. Robust individual equity curves of the portfolio are all volatile and stepped in nature. The steps relate to when market conditions are favourable. Much of the time is spent stagnating or worse still, building unfavourable drawdowns.
- A nice linear ascending return stream can only be achieved at the portfolio level by virtue of how we compile the individual volatile equity curves into a consolidated Portfolio. Stagnation and drawdown are words we recognise and accept at the individual return stream level…but are words we reject at the global portfolio level. Portfolio construction is a process by which we deliberately assemble our robust strategies in a manner to deliver the best bang for buck for our finite capital by achieving limited stagnation and minimal drawdown exposure. This way we can scale up our leverage at the Global Portfolio level to achieve far beyond that which can be achieved by a single return stream.
- Given the fact that our robust equity curves need to possess volatility as a sign of robustness, the use of Monte Carlo methods are useless as a test for robustness for the Price Follower. The best test for robustness available to the Price Follower is this. Can your system maintain positive expectancy over say the last 20 years that have comprised an array of unfavourable market conditions for the price follower? The way we respond to this question in testing for robustness is in testing the validity of our ‘traps’ over as long a data horizon as we can muster. As simple as it sounds, there is no better method. The reason that it is avoided like the plague by the Predictor is that they simply cannot find a system that stacks up in any positive way across such a diverse range of different market conditions. It is therefore an excuse arising from a Predictor who thinks they can predict how long predictable stationery market conditions will last. None of us can predict tomorrow let along then next 20 years. Who are we kidding?
Well….that’s enough for the diatribe. I hope it is helping you to eradicate any propensity to predict a future outcome. You may call this “brain washing”….but I call this “re-wiring”. You see the damage has already been done and that brain washing has already occurred. The biases that exist in us from evolving in a different complex environment significantly shapes the way we tend to attack these complex financial markets….to our peril. We need to re-wire first before we can progress as Price Followers.
Trade Well and Prosper
The ATS mob
Want to know more? Then join us at ATS Trading Solutions. We offer unique services for the retail trader wishing to learn more about the techniques applied by the systematic diversified trend followers to generate wealth building sustainable returns. Membership includes access to all Programs and Trading Tools available in our shop, systematic development and portfolio construction education and practice and participation in our Members Forum.
For a short time only we are offering free access to the exclusive areas of our website reserved for paying members with 100 free vouchers on offer for the first month, so you can have a good look around and get a feel for what we offer. Just go to the membership page of our website and choose the Premium Membership Plan and proceed to checkout. On the Membership Checkout page just click on the discount code and apply the code VIP100 to receive your first month free. So long as you cancel your membership in your first month then you won’t be charged a penny. If you don’t cancel in the first month it will automatically go to $9.99 AUD per month following your first free month.
Looking forward to seeing you over there. So come and join us and participate in our forum with other like minded systematic diversified trend following folk.