Although many think the entry is the most important part of a Trend Following system, the exits and position sizing are more important. Also, many think having a good system is more important than the psychological aspects of trading however if you cannot or will not keep with a successful system, it cannot make you profits. Thorough testing can give you confidence in your system but human nature can overcome that confidence. Bruce Babcock details 6 reasons why people fail at trading in The Guide to Trading Systems:
- Lack of Understanding - not realizing your reasons for trading beyond making money. Do not let your ego, the need to be right (do not try to predict) or the thrill of trading to cause your system to fail
- Lack of Capital - taking positions with high risk even though position sizing calculations result in no position. Trading with too much leverage. Using borrowed or nonrisk capital that you are unable to lose or replace. If you have to win with the capital you are using, the market will not be forgiving
- Unrealistic Expectations - thinking you will get rich quick, expecting high returns every month, or not have any losses
- Lack of Patience - trading too much and risking too much trying to make profits quicker than is designed into the system
- Lack of Discipline - for systematic trading this happens when you trade outside your rules or go against a system rule
- High Risk Aversion - being unwilling to take the small losses to get the big gains. Inability to get through a drawdown period on the way to a new equity high
An example of a drawdown is when your system achieves a new equity high. You've made money. Then you have a losing streak with multiple small losses in a row to lower your equity level. This low from your last equity high is a drawdown. If your equity drops 20% before it begins to rise and make a new high, it is known as a 20% drawdown. With Trend Following you need to continue through the drawdown periods since Trend Following is about long term profits and getting through the short term noise.
Follow the rules. Breaking or making exceptions to your rules will most likely end in a loss or taking excessive risk. Being consistent and having the discipline to follow the system rules you create is key. You cannot afford to ignore an entry signal as you will make most of your profit on a few big trends. If you miss the big trend, you may not end up profitable for a period.
This is only the beginning. The next page has additional resources to help you continue learning about Trend Following.