When we boil our trading philosophies down to bare essentials we can classify our trading styles into two broad camps…..the price followers and the price predictors. When you compare and contrast these two broad styles, you quickly realise that they are almost the antithesis of each other.
It took me a long time to understand the distinction between price following and price prediction. After all aren’t all forms of trading predictive to the extent that we use historical price as a basis to predict the future? Well this is where it pays to dig into the nuance to understand the subtle but very important differences which lead to diametrically opposed outcomes in approach.
In understanding the notion of ‘price following’ we assume that current price represents the ‘now’ and we closely follow it’s movement a few steps behind like a shadow. We simply follow the ‘now’ with a tight trailing stop that is configured to trail just beyond the everyday volatility of price to never let our trade position wander to far away into loss territory.
The definition is couched in the principle of risk management. What we are doing is managing our trade risk at all times by shadowing current price to ensure that our unrealised position never builds a significant loss position. We are ambivalent to the future direction but just understand that sometimes, if we simply follow this process of ‘follow the leader’ that occasionally we will catch the outlier which pays for all the whipsaws of being wrong.
To follow price is a forward looking statement in that we do not use historical price to predict a future, but rather we simply use current price as our leader and follow it like a shadow into the future. As a result the strategies price followers develop are agnostic with respect to which market is traded. Provided that the market is liquid, then under this philosophy all markets should be traded the same way…with an open profit condition and a trailing stop so we hug current price.
Now we all can play the game follow the leader as it requires no analysis apart from understanding how to keep away from the volatile noise of the ‘now’. By being ambivalent towards future price and simply playing ‘follow the leader’, we can place all our emphasis towards risk management which is an aspect of trading that we can directly control.
On the other hand, when we predict future price we are prepared to weaken our stance towards risk management and rather project our hopes on a future outcome of price trajectory based on our assumed knowledge of the past and the way price has historically behaved. For example we project a future based on our understanding on where price is currently now, and our analysis of where it will end up shortly. As a result, predictors like to pick certain markets that exhibit recurrent patterns and use this as a basis to project into the future.
Playing the game of prediction requires us to analyse the past and make an inference about what price is going to do tomorrow. The method is always ‘curve fit’ to a degree unlike price following which is ambivalent towards the way price has behaved in the past. With our emphasis placed on what price is likely to do in the future, we have to loosen our grip on that which we can directly control, namely risk management as it will take an unknown amount of time for our prediction to be realised, and take a predictive punt about the future.
The difference between price following and prediction is a subtle but important one and lies in our emphasis placed towards either risk management with an unbounded expectation of future price or profit projection with a bounded projection of future price.
Price followers are uncertain about the future and operate off the principle that complex systems such as our financial markets exhibit ‘fat tails’ or long/short price extended anomalies which occur more frequently than what a Gaussian distribution would imply. Under this general principle, the application of a repetitive trading system that only is active during more extreme market conditions and simply cuts losses short at all times and let profits run will, in the long run and with the Law of Large Numbers capitalise on these ‘trending anomalies’. Price following is a less popular form of trading style given it’s behavioural difficulty in application and practiced by systematic diversified trend following/momentum breakout approaches.
This style of system is characterised by the following broad criteria:
- This philosophy is forward looking in that recent history is not regarded as a basis to project future returns. The future is unknown and uncertain. As a result, these traders simply follow price and do not attempt to predict it.
- This type of system cuts losses short and lets profits run and creates an asymmetrical open ended return profile that is positioned at all times to capture extended price moves in the long or short direction. This technique cuts short the possibility of encountering ‘black swan events’ and capitalizes on the potential to capture alpha from ‘white swan events’. As a result, this style of technique possesses strong positive skew (many small losses with occasional very large wins).
- This style of strategy is unsuccessful during stable market conditions ……but tends to be successful when market conditions change/adapt. As a result, this style of trading strategy has an infinite shelf life as the technique simply requires market transitions that ultimately are ubiquitous to all liquid markets over time. The success of this approach is therefore couched in terms of survivability and risk management while unfavourable stable market conditions persist. To participate in this technique you need to be available at all times to the unpredictable event….but preserve the capital during the meantime while waiting for the divergent condition.
- In this style of system the entries are far less important than the exits. Alpha is generated by the extreme but unpredictable positive outlier event where only a handful of trades pay for the vast majority of small losses or effective breakeven trading results. For example, the top 5% of trades create the alpha. The unbounded profit condition is the key factor responsible for the success of this style of system….hence why we regard the exit condition as being the alpha generator and the trailing stop as the basis for the long term success of this style of approach. Examples have been demonstrated by Tom Basso where random entries combined with a trailing condition and solid money management principles can lead to sustainable long term returns.
- Price following requires the systematic application of trading rules 24/7 where type 2 trading errors are regarded as serious errors (missing the positive outlier event). Given the unpredictable and relatively infrequent nature of these anomalous events, you cannot afford to miss them. As a result, breakout entries are preferred to catch them all as opposed to selective entries into a trend on retracement.
- Price following requires divergent market conditions and relies on the principle that liquid markets occasionally and unpredictably diverge away from stationery predictive conditions. Their success is predicated on trending market conditions or market transitions that occasionally punctuate more stationery market conditions of equilibrium where markets are deemed to be more efficient. During these ‘unusual times’ the mass behaviour of the ‘disturbed’ price predictors becomes more coordinated through behavioural tendencies of fear and greed resulting in ‘extended’ price trends while this coordinated behaviour persists.
- Price followers accept that liquid markets are generally ‘efficient’ in nature leading to random outcomes in general, however this philosophy predates on non-efficient periods of disturbed equilibrium when ‘real’ trending anomalies exist attributed to collective ‘herd’ behaviour of dominant market participants.
- The sustainability of this trading approach necessitates diversification given the unpredictable nature of the ‘when’ and relative infrequency of these unusual events. Furthermore diversification of uncorrelated return streams is critical to allow for the neutralisation of more ‘efficient’ market conditions by dampening random outcomes. Diversification amplifies the signal to noise ratio of uncorrelated superimposed return streams. In other words….by superimposing return streams through diversification, the impacts of random outcome are lessened by destructive interference of random signals.
- Drawdowns with this style of approach are persistent (as most of the time you are in one) but take considerable time to build during unfavourable (non-trending) market conditions where losses are many BUT SMALL….and quickly evaporate with favorable market conditions as winners can be LARGE.
- These techniques have volatile equity curves over their lifetimes given the long periods that may arise between favorable divergent market conditions but are far more robust and long lasting than their ‘predictive cousins’. As counter-intuitive as it sounds, a volatile equity curve is a characteristic associated with strategies that do not warehouse risk and is fundamental to robustness.
- This style of trading requires far less adaption in general design principles over time as they simply follow price with an asymmetrically configured simple system designed to take advantage of market transitions.
- The Pwin% of these styles range between 20% – 40% hence most of the time you are wrong….however the Reward:Risk ratio is typically >1.5 allowing for positive expectancy over the long term.
- This style of trading is difficult to stick to as it is counter-intuitive to our psychology to let profits run and cut losses short. Furthermore the continual wrestling with being in drawdown make this a very difficult technique to accept given our human biases. This is what makes the edge in this style of technique so long lasting and why arbitrage is so persistent.
- This approach is considered to be a wealth building approach that is long term in nature. A regular cashflow can never be predicted but this approach relies on the Law of Large Numbers combined with a slight positive expectancy and an emphasis on capital preservation.
- This style of trading adopts the mantra that ‘history may not repeat…but it does rhyme’.
Predictors are more certain about future expectations and operate off the principle that complex systems such as our financial markets exhibit repeatable patterns or behaviour than what a Gaussian distribution would imply. Under this general principle, the application of a repetitive trading system that responds to repeated price behaviour will take advantage of any arbitrage present in this repeatable event. This philosophy assumes that price reaching a future target or expectation is more prevalent than what a random outcome would deliver. For example based on recent history of price action , price is considered to be overbought or oversold and hence revert back to an estimated historic mean or expectation. Predictors are characterised by techniques such as mean reversion systems, price action techniques, TA traders, grid trading styles, martingale styles and fundamental investment techniques.
As a result, this style of system is characterised by the following broad criteria:
- This philosophy is backwards looking in that recent history is regarded as a basis to project future returns. The recent past is representative of current market conditions where a repeating signal is likely to project into the future with a degree of certainty.
- This type of system typically uses profit targets associated with where price is anticipated to move to in the near future, and has relatively wide stops or no stops based on the degree of certainty placed on the expectation for future price movement. The degree of confidence in the future prediction encourages this style of trader to give room for the strategy to breath in response to random price gyrations and results in an asymmetrical bounded profile with wide stops and tight profit targets. As a result the tendency is for these systems to possess negative skew. (many small wins with less frequent large losses).
- This style of strategy is very successful while current market conditions persist……but fail when market conditions change/adapt (where the repetitive price signals no longer occur with the same frequency). As a result, this style of trading strategy has a finite shelf life of varying duration (while market conditions remain in force). The success in trading these styles relies on the ability of the trader to detect new repetitive anomalies to replace those strategies where arbitrage no longer exists and to prevent significant capital deterioration with strategies that no longer work. In other words, success is couched in terms of the traders ability to adapt to new forms of arbitrage with altering market conditions and success in determining when to ‘turn off’ under performing strategies.
- In this style of system the entries are far more important than the exits. Alpha is generated by the ability of the trader to identify overbought/oversold conditions which are anticipated to revert to an estimated future price. Sniper entries of precision are required. This style of system predates on the arbitrage present in the leptokurtic peak of the market return distribution as opposed to the ‘fat tail’ of the distribution. The alpha lies in the vast number of successful small wins (predictive ability) that surpass the large losses accompanying the negatively skewed return profile. Time based stops or profit targets tend to work well with this style of strategy.
- Prediction requires the selective application of trading rules where type 2 trading errors are regarded as insignificant errors (as another frequent opportunity will present itself). Given the predictable nature of these signals, you can afford to miss them and wait for the next signal. For example, those that wait for retracement entries into a trend are regarded as predictive traders.
- Prediction requires convergent market conditions and relies on the principle that liquid markets tend to exhibit prolonged periods of stability (equilibrium) where predictable (repetitive) patterns emerge. Their success is predicated on relatively stationery market conditions where markets are deemed to be more efficient and the participant mix and activity lead to repeatable price behaviour.
- Predictors accept that liquid markets can occasionally be divergent in nature where existing models no longer work ……but predate on the extended periods of market equilibrium when persistent anomalies exist for an unknown period of time. During periods of prolonged market stability, predictive techniques can be very successful…..but during market instability, the negative skew quickly leads to risk of ruin unless unsuccessful strategies and identified quickly and turned off.
- The sustainability of this trading approach necessitates concentration as opposed to diversification. Each liquid market possesses it’s own characteristic predictive signature during stable market regimes. A tailored approach is therefore required to trade each particular liquid market. Diversification across liquid markets with the same strategy is typically unsuccessful.
- Drawdowns with this style of approach are limited while stable market conditions persist but quickly arise during divergent market conditions given the negative skew of these system styles and take a long time to recover.
- These techniques have less volatile equity curves over their far shorter lifetimes. As market conditions change and arbitrage of price patterns are ephemeral in nature, the use by date of this style of strategy is very limited compared to price following styles. A fairly straight linear equity curve can be said to effectively warehouse risk….as it is representative of only a single market condition or does not truly reflect the unrealised equity curve of the strategy. Inherent to every robust equity curve is the need for volatility which is representative of the fact that market conditions change over time. The reason why this style of system has fairly linear equity curves is that the system has only been applied to a single market condition. Over a greater cross-section of market conditions, a stationery predictive solution quickly departs from linear ascension into risk of ruin.
- This style of trading requires regular adaption in general design principles over time with changing market conditions and the ability to determine when strategies are no longer working. This leads to intense strategy hopping over time in response to seeking new arbitrage opportunities as old opportunities wither.
- The Pwin% of these styles range above 60% hence most of the time you are right….however the Reward:Risk ratio is typically <1.0 as losses tend to be larger than winners.
- This style of trading is easy to stick to as you are more right than wrong and profit taking is encouraged. During periods of stable market condition where price action is more repetitive than random action, equity curves are far less volatile than their price following cousins, but when conditions change can quickly lead to risk of ruin. Despite the appeal of this style of strategy they have a sting in their tail over the long term. The arbitrage with this style of opportunity is more fleeting in nature and your success if couched in your ability to adapt and your understanding of when to turn off under-performing systems that no longer work.
- This approach is considered to be a short term cash flow generation exercise as opposed to a long term wealth generator. A regular cashflow is estimated over periods of predictable regime….but as a long term wealth building exercise, fortunes can widely vary and is based on your ability to successfully adapt to changing market conditions.
- This style of trading adopts the mantra that ‘history repeats’.
So which philosophy floats your boat? As you can see, the underlying philosophy of how the markets work significantly shapes the way a trader attempts to tackle them.
Trade well and prosper