Trend Following Primer Series – The Pain Arbitrage of Trend Following –  Part 12

Primer Series Contents

The Pain Arbitrage of Trend Following

We are a weird mob that just don’t seem to apply the same rules to trading as other forms of market participant.

When compared to predictive convergent trading methods, who base their success on instant gratification by targeting a current repetitive market condition, the ‘trend following way’ can be a real drain on the psyche.

We base our philosophy on a market principle that ‘trends can persist’ rather than a predictive pattern, and this distinctive point of difference can take a very long time to play out. Given the inherent tendency of markets to waver between periods of predictive stability only occasionally inter-dispersed with periods of trending transitions, we are wrong most of the time. So we simply switch our brains off in their predictive tendency and apply our price following processes. But, if you want pain, then you have come to the right place if you think with a ‘predictive mind’.

Now I know that you all want this equity curve below of a famous trend follower depicted in Chart 32…but I am going to tell you now, that you cannot have it. Not until you change the way you interpret pain, which means the way you think about how the market behaves. Pain is an illusion associated with a predictive mindset. Let us explore this further.

Chart 32: Dunn Capital Management World Monetary and Agriculture Program (WMA)

You see, what comes with this famous equity curve above is the very necessary pain that is required to achieve this outcome.

Look at Table 12 below. It is a pain summary for Dunn. I have highlighted the painful periods that are a necessary pre-requisite to achieve that glorious equity curve.  A blow-by-blow account of enduring pain experienced over long periods of time only periodically inter-dispersed with periods of jubilance.

Table 12: Dunn Capital Management WMA Monthly Returns

You can see from this example that the Trend Following way is therefore actually a lesson in pain. A lesson that can only be tolerated if you change the way you perceive pain. This can only be accompanied by changing the mind.

Changing the Mind to Embrace Pain

Our process flies in the face of human intuition and is an exceedingly counter-intuitive approach. But it works. In fact, it works so well that there are few rivals in our path to long term wealth but to achieve this ambition, we must learn to embrace pain. To achieve this, we need to change our minds by removing our very natural desire to predict the markets, and to simply go with the flow of it all. It really is as easy as this….but to achieve this, is an incredibly difficult task for an obstinate brain.

Whenever you meet something that is foreign to your mind, you experience pain. Pain is the brain’s way of telling tells you that something has gone wrong and that all is NOT well. Whether that is sticking your finger in a flame, losing a loved one, experiencing frustration, anger, etc……

But we also experience pain when trading these markets. Quite literally. Not the normal type of pain arising from the way we normally think about it, but the pain associated with anxiety, stress, impatience and financial setbacks. This is simply a small sample of some of the symptoms of pain we associate with trading the markets.  All this pain is associated with the pain arising from the brain getting it wrong. It simply screams out…”What is going on. This is the way I interpret these markets and they just aren’t behaving in accordance with my predictions”.

The pain all lies all in our brain and is deeply connected with our desire to predict as participants in a complex system where the complex system has the final say in the matter.

When you commence your trend following journey, be prepared to tolerate pain. Nearly all will fall by the wayside as they fail to take this bull by the horns, but a very few may survive. Not by confronting pain head on like an obstinate bull, but by learning to accept it as a natural consequence of trading the markets.

It requires a ‘mind reset and a re-wiring’ that over a long time with experience in the market will change the way you ‘feel about trading and these markets’ and indeed your life too.

With an altered mind you will no longer interpret drawdowns as ‘pain’ but a necessary consequence arising from hunting for outliers. You will no longer feel the wrath of being wrong most of the time as your risk bets will be naturally configured to trade small leading to ‘midge bites as opposed to massive failures’.

You will find that there is literally no point in listening to the news, hot gossip or staring at the screens as you have a systematic process now that avoids all that, forged from your intense research undertaken before you commit to your live trading experience, and you will find that under systematic application of boring repetition, you have available time to enjoy other more personal pursuits in  life that mean more to you, your partner and family.

You will undergo a metamorphosis as your brain is re-wired to start enjoying life as opposed to fighting it….and then, and only then will you call yourself a ‘trend follower’ as opposed to a trader.

That is the narrative of this Primer. If you want to experience pain, then be my guest and commence your journey into trend following, for it has pain in spades as interpreted from a predictive viewpoint. But in learning to deal with the pain, start to understand that pain is simply an illusion arising from a certain kind of mindset tailored for a different environment.

What is this Pain you Speak of Pilgrim?

There is no ‘fundamental pain in these markets’. It all lies in the mind. Learn to reinterpret this illusion called pain as a natural consequence arising from how we must trade these markets to obtain those glorious equity curves that currently exist just beyond our reach.

For once we learn how to change our mind from experience and learning , then you will find that the trend following processes we apply, no longer holds pain in the historical record. Pain is now medicated for and is viewed by the trend following mind as simply a very natural feature that allows us to achieve our expanded ambitions in both trading and in our lives outside of trading.

Pain Arbitrage

A dear Twitter friend the other day reminded me of a very useful expression that many traders apply to trend following. He referred to the “Pain Arbitrage of Trend Following” suggesting that the reason for the enduring nature of this robust technique, was explicitly connected with the pain that is endured by participants who apply the trend following method.

Such a useful way to describe trend following and so elegantly summed up. Trend Following appears to have such enduring arbitrage due to the pain associated with a certain type of mindset, namely a predictive mindset. The metaphor proposes that predictive methods deliberately avoid pain, whereas trend following methods actively exploit it. Indeed, he may be right.

In this zero-sum game, trend followers’ prey on fruits arising from the predictive mindset when their models break down. So, if predictive models are less painful than trend following methods, then it is natural to conclude that ‘for a predictive mindset’, trend following is thereby more painful.

We all fall victim to a Predictive Mindset

The premise of trend following lies in exploiting unpredictable phenomenon that are known to arise from time to time in the tails of the distribution of market returns.  So how do we exploit this unpredictability with a predictive mindset?

We need to change the way our mind works. This unpredictable element to trend following forces our approach to be the exact antithesis of the more appealing approaches that are preferred by a predictable mindset.

We all suffer from this predilection of prediction as our brains have been moulded over deep time to behave this way shaped by a different complex system, Namely, our natural environment. We therefore all fall victim to the ‘predictable mind’.

But the associated pain we experience when trading a different complex system, namely the financial markets, all arises from this mindset forged in a different domain.

To pinch an eloquent quote used by a Trading legend and Twitter friend who I deeply admire,

“Bubbles are the inevitable outcome of human nature. What part of human nature? We are the ape that imitates. We are the ape that seeks status. We are the ape that tells stories. We always prefer narratives versus facts.”

This whole Primer series that you may have been reading is a purpose-built narrative used to appeal to apes that like stories. It is not designed to appeal to the trend following mindset as it is preaching to the converted, but it is explicitly appealing to the predictive mindset.

It is providing a narrative that hopefully convinces the predictive mind that there may be a better way to approach being a participant in a complex system. A way to turn trading from a stress filled, ego-filled and anxiety ridden enterprise into a process of enjoyment, humility and acceptance.

The tortuous road that a predictive mind may have already experienced in reading this narrative has been a deliberate ploy adopted by me ,as the writer, to perhaps sow the seeds of change in your mindset. To possibly convince you of how ‘wrong’ we stupid apes can be in navigating these financial markets.

The markets are not a get rich quick scheme or cashflow generating solution. This is rarely the case. The ‘predictable moments’ of a stationery market are an ephemeral phenomenon that do not contribute to the greatest price movement. Indeed, the greatest price change arises from the anomalies arising from uncertainty itself that can only be exploited with a long-term wealth building objective.

Markets are exceptionally complex and adaptive systems comprising humans and their algorithmic creations whose partial knowledge embedded in a human mind make them open to large errors in predictive logic when navigating uncertainty.

We are all victims of our own minds. Without this necessary narrative, I cannot expect a reader to jump on board the trend following wagon. But I encourage you to expand the ‘blinkered and limited mind’ to see the trend following process for what it really is. A method that is purpose built to capitalise on market principles that exist in this foreign context from which our brains are not sufficiently equipped to deal with.

It is so hard to convince a human mind to jump on board this ‘gravy train’. Despite the exceptional long term track records for trend following, that everyone wants, when it comes to the very necessary ‘grind’ required to achieve these beautiful equity curves, no one wants to endure the associated pain to achieve it.

Our Brains are not Well Equipped for Trading the Markets

We want it all now, as we are very impatient apes and sucked in by a predictive mindset forged for a different environment. In that environment, our brains have evolved in the most efficient way to go out and get it now through predictive logic that beats the slow reaction time arising from having to wait to receive all required data before we make a decision.

Unfortunately, as traders we play in a very different complex system to the one, we ‘efficiently’ evolved in. This new system we find ourselves playing in is an ‘intelligent market’ full of predictive mindsets and not so simple creatures. If we simply want to go out there and get it now, we are no longer dealing with fruits, vegetables, and the occasional mammoth. We are now dealing with other humans who are just as smart or even much smarter than you. The different regime means that we now find ourselves in a battlefield in which our minds have not evolved to deal with.

We explored in Primer 2 how our brains have evolved inside a different complex system which has allowed us to use illusory heuristic shortcuts that have evolved to meet ‘fitness targets’ as opposed to the reality. We found in our exploration that there is no such fundamental reality of sight and sound. Sound is a symptom of translating air pressure in an eardrum, and sight is a narrow rendition of what our ‘blind’ brains interpret as the reality….What we actually experience is a heuristic illusion rendered between an observer and the observed designed to allow us to survive in a very complex system.

But our brains have never ‘evolved’ in this new complex adaptive system that we call the financial markets. We therefore experience ‘pain as a symptom of suffering by the brain’ in interpreting this foreign arena.

Life for a successful trend follower is characterised by the pain of persistent nagging drawdowns only periodically inter-dispersed with hedonistic joy associated with rapid accelerations to new high-water marks. These rare ‘joyful’ moments are jubilant times but only fleeting in nature…and then it is back to the grind. Day after day….after day…after day.

The Transformation of the Mind that is Necessary to Appreciate Trend Following

When you start of in this game of trend following with a predictive mindset you inevitably incur years of ‘mistakes in application’. This unfortunately is a prolonged but an essential side effect of trend following. It is through these mistakes, that a mind starts to re-wire and transform which allows you to drop any ingrained predictive logic and learn new ways to cope with this pain.

None of us are ‘born trend followers’. We must condition ourselves to become one, through the school of hard knocks. It is through these mistakes that we learn the nuances of our craft and develop the fortitude to keep on keeping on. Persistence and patience is essential but you must participate in the game. You cannot afford to bet big when you start this game. It is essential that you start with baby steps.

Never give the day job away until you can truly validate your track record and build your trading capital to a point that can endure your worst-case scenarios.

As the months and years lapse from this gruelling process, it just starts to get easier, slowly but surely as the brain re-wires.  Before you know it your hardened mental character now starts to view your approach as just a boring repetitive process that just ticks along. Your drawdowns now become just a means to a new high watermark. The boring pursuit then allows your altered mind to see things differently and wider.

With an epiphany you start to realise that trading is just a very small aspect of a bigger system called life. Where your now boring trading life can be filled with other more important pursuits such as spending more time with family and friends, taking up new hobbies and passions and leading a more fulfilling life. Trend following is a process that encourages you to diversify into other aspects of life.

At this point in time, after all the re-wiring, it then just all clicks Your brain literally metamorphoses turning you from a trader into a trend follower.

Trade the Approach that Suits Your Personality….What????

Now you might hear the sage advise from trading mentors that you should trade an approach that suits your personality. Well, I am here to tell you that such advice does not apply to us battle hardened trend following folk. Predictive methods yes, but trend following methods then no. 

It begins as ‘pain central’ for us, but the only thing that makes us stick to the plan in the beginning is our understanding that with no pain, comes no gain.

It is only by conditioning through years of experience with this gruelling process that we can eventually come to accept it.

Given the extreme pain threshold that is a necessary pre-requisite to pave our way to glory, some view this sado-masochistic quality of trend followers as ‘pain arbitrage’, and the reason for why this method has stood the test of time without being arbitraged away through too much ‘crowding’ in this space.

Some Tips that Might Help to Rewire that Brain and lessen the Pain

So how do we tolerate this pain early on in our trend following careers? Here are a few pointers that at least work for me. Of course, every mind will be different and at different stages of development but some of this advice may resonate.

  • Faith in the method. A faith that can only be bestowed through examining the long-term performance records of the Top FM’s in this field, listening to guidance from these experts and then rigorously testing the assumptions yourself through years of repeated back-test application before starting your foray into live trading with trainer wheels on using a small amount of risk capital.
  • Test all assumptions yourself and never rely on hearsay. Be always sceptical and learn to discern between fact and fiction. Learn to trust your own capabilities and up-skill yourself to continuously enhance your skill sets and self-reliance.
  • Embrace drawdowns as they will be an enduring feature of your chosen method and a necessary symptom for wealth building. Always refer to your back-tests as a road-map when things get tough.
  • Never use a backtest as a basis to forecast future returns. A backtest is a method you use to assess risk weakness and define risk benchmarks to observe in the future. If you reach these thresholds, then stop trading and get back to the drawing board.
  • Commitment and perseverance is essential in this game in the early years. Devour books and podcasts on the subject from trusted sources. Trend following is a persistent learning exercise but it does get easier over time.
  • Keep a close eye on industry performance. Continuously assess your performance against industry benchmarks. You must accept that your performance will lie below the long-term metrics of the best professional FM’s in this game. Keep away from the marketers and charlatans that are rife in the industry by being able to discern between realistic expectations, pipe dreams and sales/exploitation tactics.
  • Build a support base around you of like-minded traders and mentors who know this game and defer to them frequently for advice, troubleshooting and friendship and keep your nearest and dearest informed of your progress and stay fully transparent with them. Having a supportive environment is essential for trend following. As tough as you may feel you are, there will be times when your support group will be pulling you out of the mire.
  • Only risk what you can afford to lose. Separate your risk capital from your livelihood. You will be beset with issues when you start this game so expect it. Experience is an essential pre-requisite for a trend following career.
  • Continuously reinvest your profits back into this game. Compounding is the way we build our wealth. The systems we deploy and the edge we enjoy are just a means to this end.
  • Systematic application. Your rules-based process must be automated so you can validate your live performance against your back-tests (your trading plan) and build trust in your systems.
  • Meditative Methods, Sleep and Fitness. Practicing forms of meditative methods, keeping to a good sleep routine and staying fit and healthy to reduce anxiety.
  • Commencing your trading journey with very small bet sizes that allow you to sleep easy at night and reduce the temptation of over-riding your rules-based process with discretionary judgement. It really helps to keep leverage small in the beginning that makes your method become a really boring process. Over time you may find that your pain threshold improves allowing you to progressively scale up your applied leverage….while still sleeping well at night; and
  • Listening to Ed Seykotas ‘whipsaw song’ every night before bed.

If you Stand on the Shoulders of Giants, you Still Need to Change your Mindset

Of course, you can avoid a great deal of the pain by standing on the shoulders of the giants in the industry who have already endured this path of pain. But this assumes that your mind has already been pre-configured to accept this challenging path. This is not necessarily the case and is a central issue surrounding a trend following Fund Managers dilemma in writing their monthly reports to investors.

Investors, like traders who practice the trend following method need to also undergo a significant re-wiring to stay the course in this journey.

Concluding Remark

These Primers are specifically tailored to offer a way forward for traders and investors seeking to change the way they interpret these markets and turn us all into Trend Followers. Direct experience in applying trend following practices is the ultimate training ground to train a foreign mind, but at least a narrative provides a way for a predictive mind to say……

“Hey you guys are really a weird mob, I wonder if there is any substance to the words you say? Most of it is just gibberish”

Planting the seeds of discontent for an enquiring mind is the objective of this Primer series. It might make us see the forest for the trees. Embrace the pain to experience the gain, in all facets of life.

With an expanded mindset you may just see that that the garden of ‘painful’ thorns is actually full of beautiful smelling roses.

Well, that wraps up the philosophy side of trend following. I hope that I have paid it justice. There is just so much too it when you dig deep into the weeds. It is full of interpretational aspects that may not resonate with others that practice this approach, but we never said we all see eye-to-eye on these important matters relating to our craft. But we now need to get stuck into an applied process that transforms this theory into practice. 

In our next installments of this Primer series, we are therefore going to put the philosophy into action. The verbose narrative starts to dissolve into practical application where we develop a diversified trend following portfolio from ground up.

So stay tuned to this series.

Trade well and prosper

The ATS mob

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