One of the most difficult things to understand about trend following is how the returns are achieved. Unfortunately, the financial press has snookered the general public into believing that market returns are as predictable as the sun rising and setting.
Trend following’s returns are not predictable. It seeks to exploit market volatility and in the process you will experience volatility as well. In fact, most great trend following traders are wrong more times than they are right, they lose more times than they win. You may ask, then how do they make money? The answer lies in their money management. You see, trend followers may be wrong 60% or even 70% of the time and still above average achieve returns.
Trading as a trend follower is like rolling 4-sided dice where three of the sides are black and one side is white. Assume you get paid $5.00 each time the dice comes up white and you loose $1.00 each time the dice comes up black. There are 4 possibilities each time the dice is rolled, so your winning percent (in the long run) is 25%. Although there may be short term variations, your long-term winning percent is 25% maximum.
What is your expectation for this game?
E = (win % pct. * win amount) – (lose % pct. * lose amount)
E = (.25 * 5.00) – (.75 * 1.00)
E = 1.25 – 0.75
E = 0.50
Even being right just 25% of the time, this game still expects to profit $0.50 each time you play (on average over the long run). The same exact logic is applicable in trend following trading. Trend followers can be wrong the majority of the time and still achieve great returns. Ever wonder why they don’t address these issues in the media?
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