Define your trading system properly to increase gains

There are hundreds of trend-following trading systems available but the last mile will always be up to the individual

The “glide path” of inflation is a term often used by the Reserve Bank of India (RBI). It implies inflation has a trend and will “glide” down, or up, as the case may be. Any trend by definition implies predictability. If a trend is in force, and today is up compared to yesterday, tomorrow is likely to be up again, compared to today.

In the case of inflation, data is released on monthly basis so we don’t have many statistical observations. But, when it comes to an index like the Nifty, we can look for trends in a lot of timeframes. Taking the Nifty’s closing values since January 2005, we find that 1,501 sessions were positive in terms of gains over the prior session, and 1,347 were negative, with losses compared to the previous session. Of these, 1,482 were “trending sessions”, the index moved up or down in the same direction for at least two sessions in succession. But, 1,364 were “reversal” sessions in that the index changed direction.

The Nifty trends more often on a weekly or five-session basis. If we look at the changes in price in a given session compared to the price five sessions before, 1,589 weekly changes were positive and 1,252 yielded negative returns. Out of 2,844 rolling observations since January 2005, as many as 2267 weeks were trending in that the price moved the same way as in the week before.  

At the monthly level, the trending nature is also obvious. Out of 2,829 rolling monthly returns, 2,583 sessions were trending, with the gain or loss in the same direction as the previous session’s gain or loss. Of the monthly set of rolling returns, 1,696 were positive, while 1,132 were negative.

For a mechanical trend trader, this information is fairly useful. The odds favour betting that today’s session will go the same way as yesterday's session. The odds also suggest that taking positions with a weekly or monthly perspective is more likely to be successful in terms of the ratio of wins to losses. Overall, going long is more likely to win than going short.

What this data doesn’t tell us is the magnitude of the possible wins and losses. It is possible that one big losing “reversal” session could wipe out many trending sessions worth of gains. In the nature of things, reversal sessions also tend to see bigger changes than normal. There are also sessions when the market opens with a large gap in either direction.

Any trader using a trend-following system must learn how to do several things in order to make money. One is to limit losses whenever there is a reversal, by using stop-losses. Another task is to maximise gains, whenever possible, by letting the winners run for as long as possible. Neither task is easy. A stop-loss must be wide enough to ensure that it does not knock out the position on small swings in the wrong direction. But, it must also be tight enough to ensure that some profits are being retained.

When it comes to maximising returns, sitting and waiting without booking profits is also an art in itself. Using a trailing stop-loss and moving the stop periodically closer to the price can work. But, how often does the trader adjust a trailing stop? This is a tricky practical problem. There is also a behavioural issue since different individuals have different risk appetites. That leads to other tricky questions like the ideal position-size.

There are dozens, or even hundreds, of trend-following trading systems available. None have perfect answers to these questions. Any of these may help to point a trader in the right direction. But, the last mile will always be is up to the individual.
The author is a technical and equity analyst