You Are What the System Is Filtering
The same strategy can ask very different things of you, depending on when the losses come.
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Next: Episode 10, The Discomfort Is Load-Bearing
Imagine two managers who start with $10 million each and trade the same trend following rules. The first catches a big trend early. By the time the losing trades start to pile up, that winner has given the account some breathing room.
The second manager gets the losing stretch first. For six months, markets break out and turn back. Several positions lose together. By the time those trades are closed, the account is down 12 per cent, from $10 million to $8.8 million. Then an investor withdraws $2 million.
That leaves $6.8 million. The manager still has to keep enough cash in reserve and may have to trade smaller. When the big trend finally comes, the rules can give both managers the same signal. The second manager can still take it, but at a size that earns fewer dollars from the same move.
The withdrawal is separate from the trading loss. It matters because it changes what the manager can do next. The loss came first. The decision it prompted changed what the next winner was worth to the account.
The next signal still has to be taken
A backtest can show every loss in the order it occurred. It can also show what the rules would have earned if the account had been able to take every trade at the planned size. That last condition is easy to pass over when I already know how the chart ends.
In live trading, I don’t know that the big winner is coming. I know only that the last few breakouts have failed and another signal has arrived. Perhaps a different strategy has had a good year. Perhaps a client wants cash back. Even when I trade my own money, I may need it for something that cannot wait for the next trend.
The historical research gives me a reason to take trend following seriously. [1] It cannot tell me how long I’ll have to wait for a move my own rules can capture. The next outlier has no appointment. The people whose money I manage often do.
This is where a market result becomes part of what happens next. Losses can prompt a withdrawal. The withdrawal changes how much the manager can trade. That changes what the account earns if a winner arrives. The rules can stay exactly as written while the strategy people actually experience takes a different course.
What the losses do to me
After several failed breakouts, I can find good reasons to wait on the next one. I tell myself I’d like to see a little more strength before I enter. If the trade does start making money, I’m tempted to take the profit while it’s there. Both ideas sound sensible when I’m tired of seeing gains disappear.
I find it useful to write down the impulse while I’m still feeling it. I wanted to skip today’s signal after the last three trades reversed. Later I can check what I actually did and see how often that same situation came up. Some of those signals will have led to another loss. One might have led to the move I’d been waiting for. A note made on the day gives me something to compare with the story I tell myself afterwards.
Sometimes the discomfort points to a real problem. I may be trading too large for the capital available. Costs may have risen. Or I may simply be tired of paying for attempts that have gone nowhere. Those possibilities call for different responses.
The people still trading a method years later may have learned to live with its losses. They may also have started with smaller positions, had investors who could wait, or caught a winner early. The first manager in my example had an easier start. I can’t infer from that alone who had more discipline.
Three questions when returns disappoint
Did I trade the strategy I intended to trade? I check the signals, the sizes and the exits. If I skipped valid trades or took profits early, I need to know that before I draw conclusions about the rules.
Does the evidence still support the strategy? I look beyond the latest trades. Perhaps trading costs have risen enough to weaken the original case. Perhaps the losses resemble earlier stretches the rules were designed to carry. The review may leave some doubt, but at least I know what I’m investigating.
Can I still afford to trade it this way? A strategy may have a credible case and still ask more of the account than the owner can bear. If a withdrawal or a change in obligations leaves less room for losses, smaller positions may be the right decision. If the evidence for the rules has weakened, that is a separate reason to reconsider them.
Episode 8 asked how I judge a decision when a good trade can lose. Here the question is what those losses leave me able to do. A method can look convincing across twenty years and still be too much for someone who needs the money in year two.
Looking down the row
The rows in the photograph are bare. Someone who knows the place can tell me what is usual for this time of year, what happened last season and what needs attention now. From the photograph alone, I can’t tell whether there is any trouble at all.
I try to bring the same patience to a run of losses. Before I commit capital, I want to know what the strategy might ask of the people funding it while they wait. During a difficult stretch, I want to know whether those people can still carry it, and whether the evidence still gives them a reason to.
That is what I mean by you are what the system is filtering. Over time, the same losses that test the rules also test whether I have the capital, the time and the willingness to keep trading them. Some of that I can arrange before the first trade. The rest I discover in the order it happens.
Before I ask what a strategy would have earned, I ask what it would have taken to still be there when it earned it.
Episode 10 asks why that wait can still be uncomfortable after years of experience, and what the discomfort can tell me.
Previous: Episode 8, Process Is the Only Refuge
Next: Episode 10, The Discomfort Is Load-Bearing
Sources and notes
[1] Brian Hurst, Yao Hua Ooi and Lasse Heje Pedersen, A Century of Evidence on Trend-Following Investing, Journal of Portfolio Management 44, no. 1 (2017): 15–29.
[2] Ole Peters and Alexander Adamou, The time interpretation of expected utility theory, working paper (2018), on ensemble and time averages in particular wealth dynamics.
Richard Brennan writes on systematic trading, complex adaptive markets, and the philosophical foundations of trend following at atstradingsolutions.com. His published books include The Fractals of Finance, Complex Adaptive Markets, Carved by Impossibility, and The Aussie Turtles Trend Following Guide, co-authored with Adam Havryliv. His forthcoming book, The Trend Following Manifesto, co-authored with Niels Kaastrup-Larsen, is coming soon.
You do not need to predict the future. You need a process that keeps you present for the rare moves that matter.
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