Basics of Portfolio Construction for Price Followers – Introduction Part 3 – The Filter

Well so far in Parts 1 and 2 of this introduction to portfolio construction for Price Followers, we have provided some context about the subtle nuances surrounding the Price Followers Mantra of “to cut losses short and let profits run”. So far this introduction has focused on aspects that need to be considered in the design stage for the creation of any trading system that possesses the open ended profit potential and necessary rigour to be classified as a Price Following model.

Long term success in the trend following space requires a critical focus on capital preservation while waiting to hopefully exploit any possible unidirectional anomaly that comes your way. Remember that long term success in a complex system riddled with uncertainty and without luck involved, necessitates an approach that appreciates the significance of the outlier in terms of its impact on your long term performance.

The most successful traders in the world recognise that their success can be attributed to a very few but very large outlier events that they are unlikely to have predicted. While the more modest among these successful speculators would owe this to luck, namely being in the right place at the right time….there is a principle going on here that we need to spell out. There is a bit more to it than luck.

To be in the right time and the right place, you need two things going on. You need to be always available for the unpredictable opportunity (the right time), and you need to be located in a space where outlier events are more likely to occur (the right place).

The right time is easy. You just need a method where your traps are laid for the unpredictable opportunity 24/7. The right place is a bit tougher as you need to define that location where the impact of the outlier will dominate the impacts of being wrong in your trade entry.

Let’s assume our outliers are defined by long term unidirectional trends that come in a variety of different shapes and sizes. How do we apply this principle of being in the right place at the right time? Now rather than thinking of this spacio-temporal riddle as two separate elements, once again, they need to be thought of as co-integrated solutions. One requires the other.

To be able to ensure that the favourable outlier dominates your long term performance results, you need to avoid the everyday churn where the outlier does not dominate and focus on that location where outliers express a more dominant impact in terms of overall performance contribution to your PL. While you need to be available to the outlier event 24/7, there is a way we can tilt the odds in our favour in hunting them. You diversify widely with asymmetrical trend following traps that are locked and loaded 24/7 but restrict those traps from operating until the possible outlier emerges from the noise.

In more simple terms, you avoid catching a trend during the infant stages of trend evolution and wait to strike the meat of the trend when it emerges from the noise. You are therefore always late to entry but critically you have avoided that noisy zone where whipsaws are more prevalent and general noise will create many whipsaws that detract from your long term performance. Now this does not mean that the trend that emerges from the noisy range of the market will necessarily equate to an outlier, but it does mean that you have significantly  tilted the odds in your favour that an outlier is more likely in this more extreme zone of price movement. Once again, you are the casino here tilting the odds in your favour using the house edge.

Now if you manage to catch the outlier in this zone and take a ride on the wave to some extended future price point with an open profit condition, there will come a time when your system rules of a trailing stop and/or performance exit dictate when that wave has ended. You might need to jump back on that board and go again, but ideally you have a swathe of different styles of surfer in your portfolio solution who can take over when these outlier moves once again extend towards an unknown future.

So in a nutshell, to catch the anomaly, your systems need to be ready to pounce 24/7. There is no prediction involved. You simply have laid specific asymmetrical traps that allow you to capitalise on the unpredictable event which are often few and far between…..and most importantly these traps are laid down in zones where the outliers tend to dominate over noise and predictive oscillations.

To achieve this we need to deploy a filter to define that zone where outliers occur. Anyone can catch a trend by simply taking all trending opportunities, but the real skill and your ability to survive long term is in your selective ability to discern which trends are more significant than others…..otherwise the market will have the last laugh and eat you to death with it’s noise.

The broad principles you apply to any form of Price Following Filter to catch those anomalies are as follows:

1. Trade in the direction of the primary trend. To define that primary trend you need to define the highest timeframe available (eg. MN or W1) and use some form of regression measure to identify the directional drift. The reason we opt for a statistical measure as opposed to a visual measure is that everyone visually sees things slightly differently, Statistical measures such as lines of regression tend to avoid subjectivity. For example open up any price chart on your Metatrader platform and do the following on the D1 timeframe.  Ensure your lookback history is greater than say 200 days.

Now apply a 200 SMA to the price series or a regression channel such as the standard deviation channel (SDC) with a 300 bar lookback and  1.0 deviation to the price series.

200SMA Example on GBPUSD D1

Note how price is currently below the SMA and the overall current slope of the 200 SMA in red is down. The primary trend (as defined by a 200 day lookback) is down.

300 Bar Lookback SDC with 1.0 deviations

Notice how the central regression line of the SDC is clearly pointing down. The overall drift or bias of the price series is down. Now to all those that know me, you know I love the SDC as an indicator. It holds just so much meaning that can be used for a Price Follower….but we all have our favourites.

Now in determining the overall primary trend direction, there are many different quantitative methods you can apply so don’t get caught up in which is better etc. The important thing to do here is to simply identify the overall direction of the drift in the price series that is representative of the trend direction in the longest timeframe. A directional indication at the M1 or M5 timeframe holds no significance to the direction of price in the long term….so make sure you use a long term statistical measure to assess the general directional price tendency of the series.

In catching the meat of the trends, our definition that strikes at the heart of the anomaly precludes us from picking tops and bottoms of price movement. We therefore need a directional filter that catches the meat of the overall directional price movement. An anomalous move may go the other  way entirely, but we have risk mitigation mechanisms in our traps to ensure we get out of the adverse anomaly in quick time with limited impact to the overall portfolio.

Applying a directional measure therefore allows us to attack the meat of an  anomaly that is profitable w.r.t our designed system constraints.

2. Define that zone that lies outside the normal volatility of the market. What this does is reduce the likelihood that you over-trade any trend whether random or more enduring, and only strike when price moves are extreme and in the direction of the primary trend. It restricts the possibilities of entry to those times when outliers dominate the noise.

Let’s go back to that SDC example and define the zones where you deploy your diverse range of asymmetrical traps.

You may now say….look at the move that I have missed out on by not entering on the retracement. I say to that nugget….stop predicting guys. By predicting that a retracement will return back into the direction of the primary trend, you will occasionally miss the outlier. We want to catch all of them. A breakout method in the anomaly zone is the only way we ensure that we never miss the potential outlier.

We accept a lower win rate and disregard normal trends ’cause they just don’t add up in the long term to being significant to our PL. In fact that is what actually detracts from our long term performance. Trends are less frequent than volatile random noise which is omnipresent in the market. If you focus on trading within the noise of the market….you will lose in the long term…..simple as that.

So where do we place our initial stop and trailing stop condition in the context of this model? Once again we can use the other side of the SDC channel (as it is a multi-tool) to define where normal volatility in a trending condition exists. So the chart below defines a suitable zone in which to place our initial stop and trailing stop condition that suits this particular directional price bias

But there are a host of other suitable filters we can use to define zones that exist outside normal volatility limits……and we want to diversify with as many different less correlated techniques as we can to achieve wide system diversification and catch as many aspects of a trending condition as possible.

For example we could use a long term lookback Donchian Channel. Here is an example below using a 50 period Donchian Channel where in the context of that filter, we can define anomalous zones and areas to place our initial stop and trailing stop.

These are just two simple examples in a plethora of possible methods to ensure we only attack a trending condition using a breakout technique when it has emerged from the noise.

3. Make sure building momentum is on your side. The added condition of building momentum is used to give us a bit of a nudge when striking at an anomaly and hopefully pushing us quickly away from the noise where our trailing stop condition can reach breakeven (BE) or above as quickly as possible. It also serves to reduce the frequency of trade entries to hopefully avoid the false breakout relating to the propensity for maximum price excursions at the edge of the ‘normal’ zone to revert back to the mean of normal volatility. It can come at a cost however as anomalies with low moment do arise from time to time…but we find that when we miss this style of anomaly, we catch them a bit later when the anomalous surging condition is more evident.

So lets go back to the Donchian breakout example to see what form this momentum surge can take. If you refer to chart below, you will notice that the stepped movements are of varying descent. Strike only when there is a relatively large stepped movement. So you need a pending entry defined a relatively large step distance away from the most recent horizontal line of the Donchian channel.

Now this is just one method in a vast array of different methods to define building short term momentum.

Let’s look at the SDC example again. We could use a short term SDC to evaluate the more recent drift of the price series suggesting that more recent price has momentum towards the downside in the direction of the anomalous zone.

….so there are many ways we can define momentum fairly objectively in a consistent manner to give us some logic we can apply in giving us that extra nudge into the anomaly and reduce the probability of failed breakout and whipsaw impact on our PL.

Now the reality is that the assumptions used with this momentum push may be all BS as any form of prediction for detecting the emergence of an unpredictable anomaly is highly questionable….but what this momentum filter does is to further reduce our propensity to over-trade. Anomalies are rare unpredictable beasts and the majority of the time you will be wrong and your traps won’t work. This momentum filter simply reduces the number of times it doesn’t work to preserve capital. You will however be a bit later to the table of the anomaly if your momentum filter precludes you from taking that entry which turns into a winner…..but “swings and round abouts” again folks.

In summary, here are a few takeouts to appreciate in relation to the use of a filter that restricts activities to the outlier zone of trading opportunity which enhances your PL:

  1. You need to diversify very widely in this outlier zone as trade frequency is low and unpredictable in nature…..however because you are deliberately selective in not catching every trend you see, your Pwin% is typically higher than the average trend following system that attempts to catch em’ all. If you are good at it, it should lie between 40% -50% Pwin% based on a 20 year history using very wide diversification as opposed to the expected 20%-40% for a classic trend following system. Remember that random trends still manage to sneak into this zone so part of your trade result is classic old simple luck but a greater proportion of your trades attack the outlier; and
  2. Your R:R is also very high but you have sacrificed a bit more of the trend to be able to catch the outlier as opposed to a random trend of no substance. Your average win however is far higher than traditional trend following methods and your average loss is still of a similar nature.

The combination of these points above bring us to another common statement you may hear in the Price Following Universe that is the basis of ‘the edge’ in this technique. That is the mantra of a Price Follower in a fat tailed market environment….“if you take care of the losses, then the profits take care of themselves”.

Well that is about it for ‘filters’ and why they are so essential for the Price Following equation.

Trade Well and Prosper

The ATS mob

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