Understanding how the Bias influences the Overall Result for Trend Following

So far in this series we have been undertaking fairly extensive research on the suitability of a ‘classic’ but simple trend following model (a Donchian Breakout Strategy) in generating positive expectancy across a range of different asset classes which are readily available to the Retail trader through Forex and CFD offerings (using microlots).

We have been testing 4 important parameters (Initial Stop placement using ATR, Trailing Stop using ATR, Donchian channel period look-back and a Move to breakeven condition using ATR). These critical parameters form the basis of a simple trend following strategy and ensure that we cut losses short and let profits run at all times. We test this model over a broad universe of markets spanning asset classes and across a long data horizon to assess the efficacy of this strategy in generating positive expectancy.

In this research undertaking we are particularly focused on the bias that exists in the data series which leads to a generalised positive expectancy with the Law of Large numbers.

Here is how you should interpret what we are trying to achieve by identifying whether a beneficial bias exists in the underlying instruments we choose to trade.

You are already familiar with the overall long term monthly performance profile of applying the principles of trend following to a diversified array of different markets, timeframes and systems. This profile can be generalised as follows.

Don’t worry about the numbers themselves, but concern yourself with the following features.

A) There  are no negative outlier events in this series as trend followers always trade small bets with wide diversification and always cut losses short and let profits run.

B) The significant positive beneficial outliers that contribute to the ‘blue highlighted’ regions of the table (about 8/240 = approx 4% of the monthly series) cannot be predicted and are applicable to any liquid asset class….These outliers are ultimately responsible for the lions share of total return of the entire series and pay for all the losses of the balance of 96% of the series and then some. These outliers arise simply because we have no profit target and let profits run at all times. This keeps us open to the possibility that there may be undefined and unpredictable moments where we just benefit from an outlier market move….and under wide diversification, we increase our chances of this fortuitous event.

C) The balance of trades (96% of them) are referred to as ‘the necessary churn’ we have to experience in having our systems turned on 24/7 catching any move that has the potential to offer an ‘outlier’ advantage. Effectively this is where ‘the costs’ of our trading style become important to our overall success. We need to reduce the adverse impact of this churn through risk management at all times so that the costs of paying for this churn are limited allowing for us to obtain an increased benefit from the occasional outlier that may head our way. Now rather than dismiss this ‘cost drag’ region of our trading technique…we need to pay close attention to it. If we can tilt the bias in our favour, where the overall bias is in our favour, then much of this 95% of ‘hurt trade’ can be slightly moved towards a position of ‘less hurt’ by trading those markets where the bias is on our side.

So…when talking about the bias of the series….we are not talking about the ability to have a better chance of catching the ‘outlier’, but rather a better chance of reducing the overall cost burden arising from ‘the churn’ to improve the total result of our PL over the long term.

Here is another way of looking at this. The following frequency distribution is a typical representation of profit distribution arising from a simple trend following strategy with positive skew.

You see that red circle which highlights the range of overall profit outcome for the majority of our trades over a long trade sample. With a positive bias, our aim is to shift this portion of the distribution of trade returns slightly to the right. The outliers already highlighted in green remain unaffected in general…but the overall cost impact of 95% of our trades is now slightly more favourable with a small shift to the right. This small beneficial movement from trading a biased data series is enough to significantly contribute to our overall edge.

So we hope you now understand the method in this madness and what we are seeking to achieve. We are therefore looking for asset classes offering a beneficial bias or particular structural bias (such as the impact of positive SWAP) to tilt the odds further in our favour. A more selective posture to how you approach your designated trading universe using bias helps to shift the odds slightly in your favour. This is particularly relevant to Retail traders where the ‘costs of trading’ leveraged products such as Forex and CFDs’ are far higher than what could be offered through trading futures (on margin) or equities (with no leverage) using trend trading principles.

We would like to not have to adopt a selective posture to this game. Ideally we would prefer an equal weighted ‘asset class’ view where no selective choice was being used. After all outliers cannot be predicted and occur everywhere and everywhence….but unfortunately in this Retail world…the ‘real world’ limitations imposed on us by this very unequal playing field forces us into a corner. We therefore need to be more selective in our choice of universe by assessing the bias in those products made available to us by the Retail Broker.

So now that we are on the same page with what we are trying to achieve here…let’s get back to our analysis of Bias.

Equity Indices

In our last post, we assessed Spot Forex and came to the disappointing conclusion that the bias is on your side only when trading Major and Minor spot Forex instruments with Positive SWAP.

This conclusion was quite a downer to us Forex traders…..but what it means is that our backs are really against the wall when dealing with Spot Forex in the Retail market.

In our particular retail world we are at the mercy of the market makers who ensure that all the edge is stripped out of the market through instrument pricing….’cause what do us simple Retail Traders know anyway?’.

Unless we do this form of extensive data crunching exercise…we just won’t see it. After all, these poor Brokers in our Retail world need to pay for their antique collection of cars anyway….and a little bit taken here and there won’t be missed by us simple retail folk. These are just rounding errors gents.

So let’s see what we get with trading CFDs on underlying equity indices. Hopefully there is some beneficial bias in this asset class for us trend followers?

Here is our test universe of Indices made available by CFD’s through Dukascopy and Avatrade.

….and here are the Performance Results when we apply our simple trend following long/short strategy to these markets using a broad range of values for each ‘critical’ Parameter.

Now the first thing to notice is that on a before cost basis, there is a very strong beneficial bias towards trading Indices using simple trend following methods. This is great news at last ….however to add salt to this story, now look at the result on an after cost basis.

You will see that a lot of this bias has been stripped away through the cost impact. It is not all sad however as there is still beneficial bias in the series but once again the interest holding costs (the SWAP) makes this game far tougher in our retail world.

However to give you some hope, we have delved further by assessing whether Indices suit Long only or Short Only methods…..and we now find that the story for Indices are fully revealed for trend following models in this Retail space.

The beneficial bias in trading the trend on indices available to the retail trader lies with ‘Long only’ methods as opposed to ‘Short only’ methods. 

Have a look at this baby. There is beneficial positive bias written all over the Long Only trend following technique.

On a before cost basis a tight initial stop is favoured rather than a wider stop however any of these initial stops has a favourable bias. A long trail is favoured to a short trailing method, A tighter Donchian is preferred to a longer period Donchian…and a move to BE at say 2 ATR is preferred for this technique.

This starts to make sense. For Equity Indices, the overall market condition is generally very favourable for long only techniques that hold for extended periods of time. After all Equity Indices are effectively a long only system strategy in construction method that is pretty similar to trend following principles.

On an after cost basis the impacts of cost loading have a limited impact on this overall very favourable bias. That means the Brokers can be fed and us Trend Traders can be fed as well.

When we look at the Top 50 best results of 3000 possible permutations of combination possible, there is a strong profitable sweet-spot with a Donchian Look-back of 100 daily bars, an initial SL of 8xATR, a trailing stop of between 9-10 xz ATR and a BE Multiplier of between 5-6 x ATR.

This is great news. We now have a bias that we can exploit for Equity Indices.

Conclusions

So far we have reached some pretty awesome conclusions that assists us in defining the markets we trade and the biases we exploit. There has been some sad news in relation to the application of a general trend following principle across all liquid trade-able instruments….but a better news story if we are bit selective in the markets we choose to trade through trend following in our retail world.

So far we know that for our Retail trading world we are at the mercy of the Broker’s pricing methods but we have found that:

1. Trading Major and Minor currencies with Positive SWAP using simple trend following models  holds some beneficial bias that will assist us in improving our overall PL result; and
2. Trading Indices made available through CFDs holds promise provided we are prepared to adopt a “long only” posture to this particular asset class.

So we are almost there. Only one more major asset class to assess. This is the CFD universe that offers derivatives to a range of different underlying instruments such as metals, bonds, soft commodities, energies and ETF’s.

Now this is a very happy story and I have left this till last….so stay tuned to our next instalment of this series where we shed some joy amongst us trend following folk that inhabit this retail space.

Trade well and prosper

The ATS mob