Welcome back trend followers. We are now getting to the pointy end of this exercise of determining where the ‘favourable’ bias lies in a variety of different asset classes that are made available to the Retail trader using Forex and CFD derivatives.
So far we have come to the following conclusions.
Given the substantial ‘cost loading’ applied by Brokers to those instruments that are made available to the Retail trader, then the uneven playing field creates a significant obstacle to us ‘small guys’ who want to apply the principles of diversified systematic trend following in our Retail world.
The impact of trading costs, and in particular interest holding costs of leveraged instruments, create such an overall negative bias to expectancy, that you need to unpack this playing field and be selective in those particular asset classes you focus your attention on.
So far in this multi-part series of posts we can see that there is a beneficial bias for trend followers if we:
- Trade Major and Minor Forex currency pairs with positive SWAP only; and
- Trade Equity Indices using CFD’s from the ‘long only’ direction.
The positive SWAP condition applied to a select number of Forex instruments takes advantage of a favourable structural bias in the costing of Forex instruments themselves. The slight extra ‘boost’ to expectancy achieved from this bias helps to shift the distribution of trade returns slightly in your favour over the long term.
The ‘long only’ condition applied to trading equity Indices appears to relate to a bias that is created through the method of Index creation itself plus the overall ‘bullish directional bias’ of the equity markets themselves that has dominated the overall story of equities for the last 20 years.
For a trend follower, we revel in trading diversified markets….and during bull phases, equities certainly appear fairly diversified…..however when equities experience a bear phase, what was previously uncorrelated….suddenly manifests itself in a sea of positive correlation.
If this correction is sharp and ends in a quick retracement, then this form of market adjustment (where all equities ‘turn red’ at the same time) often catches the trend follower (who previously was riding the bull phase with long term trend following systems) with some fairly hefty whipsaws.
You might now be able to understand why some notable diversified systematic trend followers such as Andreas Clenow and Nick Radge prefer trading the ‘long only equities bias’ to avoid some of the more negative aspects of this particular asset class during market corrections.
Now these guys don’t trade the exact same Retail universe as we do. Andreas and Nick trade stocks or futures directly which also point a ‘dirty finger’ to where the bane of our existence lies….namely the cost loading applied to the leveraged instruments that we trade in our Retail world…..but a general principle also appears to be at work in this bias…namely that Forex and Equity Indices bear their own particular market characteristics that make it a more difficult game to play when trading a long/short trend following system to extract alpha from these particular markets.
Now unfortunately it appears that our universe of options as Retail traders to trade both long and short appear to be capped by these restrictions we find in our Retail world…..however don’t lose heart. We still have one other major generic class of instruments to consider which comprise those CFDs which offer us exposure to some important markets which have been a very popular traditional asset class for the diversified systematic trend following community, namely the Managed Futures segment.
This final form of CFD asset class (which has less prevalence in our Retail world) needs to be actively sought out by us trend followers as it has a significant exploitable bias in our favour that suits our trend following styles of both long and short. The markets captured by this particular class of CFD include soft commodities, precious metals, energy markets, treasury instruments and ETFs.
Now there are only a handful of retail brokers which provide a broad range of exposure to this particular asset class via CFDs and most do not allow you to trade these instruments using Metatrader 4 (MT4) but there are some. So you need to do a bit of homework to find them and test them out.
It is definitely within your interests to trade these instruments when you can get your hands on them, as the positive bias to trend following is significant. Furthermore by broad diversification within this asset class you can trade both long and short which assists in achieving a powerful and robust diversified portfolio from a broad class of uncorrelated return streams.
CFDs (Excluding Indices)
Here is our test universe of CFDs made available to us through Avatrade with a small scattering of metals from Dukascopy. Now please note that for the purposes of this test we have included spot metals of gold and silver (XAUUSD and XAGUSD) in our listing as part of a wider sub-class of metals and also spot energies such as Brent Crude Oil (XBRUSD) as part of a wider Energies sub-class.
While this listing is fairly limited, it is in your interests to go as far as you can go in this asset class in terms of diversification to make up for the limited ability to achieve diversification benefits through Forex and Equity Indices.
To increase your diversification you may need to consider extending your systems across multiple broker sources such as IG markets and Avatrade….or indeed consider using alternative platforms made available by some Retail Brokers for Retail traders seeking exposure to CFD’s.
Here are the results of our testing within this selected class of instruments.
The level of beneficial bias for trend following in this asset class is magnificent. A trend followers dream. No wonder there is such an appeal to this asset class from the Managed Futures segment (CTAs).
A strong bias of both long and short direction and also across a broad array of different values for each key parameter. You cannot get much better than this.
All the prior limitations imposed on us from the characteristics of Forex and Equity Indices are now more than compensated for by this particular asset class.
On an after cost basis:
- a tight initial stop is preferred to a more distal relative stop as can be seen by the steady decline in median Net Profit as the stop gets wider;
- a broad range of values for different widths of trailing stop are allowed for creating significant opportunities for system diversification and timeframe diversification; and
- A broad range of values for Donchian Look-back are catered for with a slight preference towards shorter period look-backs given the strong bias that exists in this class. Unlike other asset classes it appears that unfavourable market conditions from noise and /or mean reversion are less pronounced in this sector.
The Top 50 results when combining parameters reveal a reference towards a 300 period Donchian look-back, an initial stop of between 3 and 4 ATR, A trailing stop of between 2 &3 ATR and a BE Multiplier of 6 ATR.
So there we have it. For the Retail Trader that uses MT4 and wishes to participate in the techniques of Diversified Systematic Trend Following….it is in your interests to choose those Broker offering’s that give wide exposure to CFDs with derivative exposure to Futures markets in particular.
If you limit your universe to Forex alone….the bias is very much against you unless you restrict your selection towards those instruments with Positive SWAP . It does not mean that you might not find a suitable trend following solution in this asset class, but it certainly suggests that there are better asset classes to focus your attention on that make this game far easier.
In trading CFDs on Equity Indices….then it is nice to know that if you adopt ‘long-only’ methods then you also have the house edge in your favour.
….but your real joy is going to come from CFDs applied to other asset classes such as Futures markets, where you have the bias on your side and unfettered freedom to choose both long and short solutions to assist your diversification objectives.
Remember it is the ‘quality of ingredients’ that make a powerful diversified portfolio. This series of posts hopefully has helped you in answering that question of ‘which markets are best to focus my attention on as a retail trader’? Within that ‘bias’ lies that better quality ingredient that when compiled into a diversified portfolio, gives you better bang for buck when applied across the Law of Large numbers.
You have arrived at the casino….and now you have assessed where the bias lies. Now it is time to ante-up and start the game. Just don’t get caught by Casino management. They don’t like card counters very much as it beats them at their own game.
Now it is up to you to also test these assumptions we have made.
Remember to never rely on what you hear. Simply attempting to replicate others in this game will not get you very far. So you need to validate these findings yourself. Hopefully we have now provided you with a method that assists you to undertake this due diligence yourself.
By undertaking this process of validation yourself, this will serve to increase your competencies and capabilities and give you the necessary trust in your systems that you will need, particularly when times get tough.
The available edge in these markets that can be exploited by trend following techniques is a very fine one that will only reveal itself with the Law of Large numbers. Understanding this edge is essential to develop the patience and confidence in your system rules.
There will be long periods where it appears that there is no bias working in your favour …..and this is when you need to take confidence from your own research efforts.
It is essential when working with such a fine edge that you never second guess your ‘rules based process’ and attempt to override it….for that time when you decide to override your system’s rules maybe the time that you most regret in the future…
That simple mistake from a general lack of patience in allowing the bias to take full effect may be enough to compromise all your efforts in this game. So trust your system.
Trade well and prosper
The ATS mob