How do I find a trading strategy to follow?

How do I find a trading strategy to follow? In my book ‘Unholy Grails’, we discussed about eight different ways to look at trend following and built systems around that. We investigated things like longer term breakouts, like if you make a new highest high in the last one hundred days, obviously the trend is up. The lowest low in the last hundred days, clearly the trend is down. We looked at other strategies like buying stocks when they hit new all time highs.

A very popular strategy is called the ‘20% Flipper’. The context is very simple. When the price moves from a low point, up 20%, then you buy the stock. If you get a stock that’s going to be up 200% or 500% then it has to travel through 20% first, then you can hop on board. If it reverses by 20%, then you can hop off.

In ‘Unholy Grails’, the strategy that we tested and show very promising results, was an entry using a Bollinger band, and an exit using the opposite Bollinger band. We used three standard deviations for the entry and one standard deviation for the exit, just to keep the trailing stop a little bit tighter. That showed very good results. So something like that is certainly a good way to start.

The benefit comes from applying the strategy over the longer term. I think that is the key difference between professional traders who can build a ten to forty year track record, and people who switch from one strategy to another. I truly believe that simple works best as it’s very easy to understand why the strategy may or might not be working at any given time.

Let’s use an example: A long only equities trend following strategy such as our Growth Portfolio.
The types of conditions when the strategy is not going to work so well would be a very choppy sideways market, or obviously in a downtrend. If you have a simplistic system and you go into drawdown, and you looked at the market that’s trading in a sideways band –you understand why that’s occurring. There’s nothing wrong with the system, that’s just a function of trend following that will chop you around a little bit in a sideways market.

However, if you build a very complex system with many variables, inputs and parameters, then there’s a very high chance you’ve data mined or you’ve curve fitted for a start. Second of all, you don’t quite understand why the strategy is making money, and you probably don’t understand, if it’s not working, why it’s not working.

One of the most important things I try to get across to my clients is, you need to understand why your strategy makes money. Trend following is just a simple robust way to do that, i.e. you create a positive expectancy, because your winners outweigh your losers. That’s the bottom line. If you can’t explain why your strategy makes money, then, when it goes into drawdown, you’re going to find it very difficult to stay with it because you simply don’t know why it’s going into drawdown.