Fighting fear in trend-following strategies

The hardest thing about following a trend follower strategy is getting the right mindset. Trend-following strategies require patience because you have to follow the trend and allow the trade to run for long periods.

I only use trend-following strategies in higher time frames, from the daily up. A weekly timeframe is better most times. By setting up a trend follower strategy in a daily time frame, you’ll always do swing trading.

Many “trading gurus” recommend using a profit/loss ratio higher than one to two. The higher the profit/loss ratio, the more profitable the strategy will be. When analyzing a trading system, we must evaluate the “Profit Factor”. The higher the profit factor, the greater the profit compared to the losses.

Getting a high-profit factor in discretionary trading requires a correct attitude that novice traders rarely have. Some psychological weaknesses common to many investors and traders make long-term trend-follower strategies unprofitable.

Feeling impatient, afraid will make you throw in the towel and stop following a trend-following strategy.

Evaluating a trading system seems simple until you put real money on the line. Once we open a trade, we get nervous and make dumb mistakes. Individually, these mistakes may not appear so serious, like closing a winning trade early in profit. Analyzing the long-term results, we could discover that we have not followed the trend.

Let’s reflect on the crucial mistakes made based on the different moods when a trade is open.

Trend following and negative feelings

In this paragraph, we analyze what positive and negative feelings emerge during a trend follower strategy. In the following few paragraphs, I’ll explain how to deal with these feelings using techniques that make us more analytical.

When we enter the market with a buy-order, we are optimistic and expect future profits. Optimism can be a good thing, but it can also trick us and cause us to make mistakes. For example, optimism could cause us to open too large a position.

However, as soon as we put our money at risk, our mentality changes dramatically. Unfortunately, it changes mainly because of performing the trade. If a trade goes in the opposite direction, fear and insecurity will take over.

If the trade goes in the right direction, we will feel euphoric. This good feeling can change quickly and turn into a fear of losing the virtual gains already achieved. Euphoria can also turn into greed when we stay in a trade longer than necessary to make more profit.

In these situations, we could make two mistakes. We could close the trade early for fear of retracement and lose the future movement. Or, we could stay too long in a trade, when the trend has run out, in the belief that it will continue forever.

It’s not just the direction of the trade that makes us change our minds and feel negative about it. Many things can affect our minds and make us mess up our trend-following strategies.

The daily news and analysis can cause doubt and change our views about the trend direction. The compulsion to read every stock news we have in our portfolio can be a problem. Once the strategy’s been set, we should ignore analysts’ opinions.

Fighting fear with money management

I consider the fear of losing the most harmful emotion, but it’s easily eliminated through a positive mindset and correct money management.

To deal with the fear of a loss during a trade, you should consider the loss before opening the trade. The big question is: am I willing to take this loss? Imagine that you’ve already cashed it and then open the trade, then prepare for the worst and hope for the best.

intelligent investor Graham quote about pessimists and optimists in the market
Image from thegoodgiver.com

Being a pessimist helps a lot in the financial markets; eternal optimists rarely last long. It’s best to prepare for a loss before opening a trade mentally. I’m not talking about setting a stop loss because the stop loss is purely technical.

Once we know how much we’re willing to lose before getting frustrated, we can decide whether or not to use a stop. Behind the decision to introduce a stop-loss, there are other mental traps.

We could invest in a blue-chip stock at a maximum loss of 20% or 30%, or even higher. We could make a small-cap stock or penny stock purchase by calculating the entire amount purchased as the maximum loss. Check out this article if you want to learn more. Small-cap and blue-chip investment requires different approaches.

Anxiety for a trend reversal

Trend following has a long time horizon. The price of a financial instrument will rise and fall randomly in the short term.

Potentially a trade that follows the trend could last for a long time; you stay inside as long as the trend persists or until the future outlook on the market changes.

However, an uptrend always goes through phases of retracement or lateralization.

The over ten-year trend in the stock market that we are experiencing has also had its moments of retracement.

S&P500 chart in the last 15 years bull trend
S&P 500 Index Chart

Looking at the S&P 500 chart today, we are not afraid; we think “it has been going up for over ten years”.

But imagine those who found themselves in March 2020, and despite being in profit, they saw their accumulated profit fall quickly in a short time. Close the trade and collect the profit or stay in the trade?

Here, the answer depends on the investor’s fresh starting point. A trader who opens a trade for technical reasons will have to decide when the trend he’s following is considered exhausted.

Handling with technical analysis

As I wrote several times, technical analysis is not fundamental. I only use a couple of indicators and some patterns that I think are reliable to improve entry and exit timing.

To fight fear, I recommend using technical analysis to exit a trade. It can help you make your decisions more aim and less sensitive to momentary feelings of anxiety or frustration. I prefer using technical analysis rather than setting a stop loss or a fixed take profit. I don’t like to use a fixed stop loss for my long-term investments.

You can use moving averages to help you determine when you should get out of a trade. Waiting for the long-term moving average to cross with the price, you could disconnect the trade’s exit from the feelings and problems associated with the mindset. This makes everything more aim and limits discretion somewhat.

But this is a silly way to exit a trade that you made based on fundamental analysis. For example, say you invested in a specific sector for macro reasons that haven’t changed, but the stock fell because of a selloff. Here, it wouldn’t make much sense to go out to cross the moving average price.

The technical analysis will also be used to calculate the volatility of the financial instrument, so we can adjust the risk. Understanding volatility is also another important factor that helps keep fear in control in the worst times.

The latest useful tips

In the last paragraph, I’ll list a few tips that will help you avoid many common mistakes.

The biggest mistake you can make is to change the reference time frame after opening the trade. If you’re following a weekly trend, the reference trend will stay weekly for the entire duration of the trade.

Fear of losing money or reducing profits induces traders to reduce the timeframe to find a valid reason to close the trade quickly.

Exiting the trade prematurely, we transform a trend follower strategy into swing trading, which irreparably harms long-term results.

Another big mistake to avoid is the daily search for information to support our trade. We can find thousands of analyses on any financial instrument; following the news will keep us constantly on the roller coaster of emotions. The start analysis needs to be clear, and we need to know in advance what can change our idea of the price trend.

For example, if we predict that interest rates will go down and they go up instead, we’ve probably made a wrong prediction. So we should probably get out of the market.

We have to change our idea about the trend only due to aim events and not forecasts or news.

The most important thing to remember is to apply money management and position sizing. You can only manage your fears through proper loss management. People react to losses differently and value money differently. No one can tell you what’s a reasonable risk to take in a trade. To have the right mindset and get rid of fear, you need to take emotionally manageable risks.

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