Trend following for small portfolios, part 1
• Hedge fund business now an industry giant
• Futures offers many advantages
• Solid returns, not quick killings, are the name of the game
The most common question I am asked is how to apply professional trend following models on smaller portfolios for individual traders. This can be a tricky subject and I'll be devoting a few separate articles to explain the possibilities and the pitfalls.
I'm going to start by explaining some of the potential problems that the standard trend following approach can run into with smaller accounts. It's important to understand the issues before looking for the solutions. I'll then continue, in following articles, to explain some of the methods to alleviate these concerns. There are many roadblocks in the way but if you're aware of where they are and how to move around them you should come out just fine.
Why trend following is tougher on small portfolios
Most professional trend followers operate primarily with futures. In fact, the managed futures hedge fund industry, which is primarily trend following, now has in excess of USD 300 billion under management. This once niche strategy has grown into an established industry giant.
Futures has many advantages, such as the low margin requirement, but it also has one large downside for smaller accounts. The smallest unit you can trade with futures is, of course, one contract. A single contract is, even for the mini-futures, considerably larger than one share of most companies. You can construct a portfolio with 50 stocks using a capital of only a few hundred dollars but it wouldn't be possible to do the same with futures.
Diversified trend followers trade a large number of markets, and commonly have 30-50 positions open at any given time. If you want to take on 50 futures positions, they would each all have to represent quite a low risk to the portfolio. Using the built in leverage potential of futures, you could, of course, take on massive risks on a small portfolio but we're talking about professional trading here, not gambling.
A common way to size positions is using the Average True Range (ATR) to target a certain daily portfolio impact. To target a daily impact of 20 basis points, using a 90-day ATR value would work like this:
Desired Impact = Risk Factor * PortfolioSize
Daily Contract Impact = ATR * PointValue
Contracts to Trade = Desired Impact / Daily Contract Impact
If you're dealing in different currencies, you'll have to adjust all amounts to a common currency, of course.
ATR Example Chart - ESH4
This is quite easy maths. Let's say that you have a portfolio of USD 500,000 and you're looking to buy the SP mini contract. That contract has a point value of 50 (you gain or lose USD 50 for every full point move). We'll use a 50-day ATR in this instance, and you can chart these values in SaxoTrader under the Oscillator menu (yes, it's not an oscillator but that's where you'll find it). The current value of the 50-day ATR is 18.80. Put those values in the formula above and you'll end up with:
0.002 * 500,000 = 1000
18.8 * 50 = 940
1000 / 940 = 1.06
Trade one contract
Now imagine that you get a buy signal in the gasoline futures, with a contract size of 42,000 and an ATR of 0.4. Using the same formula would tell you to take fewer than 0.6 contracts. If you keep rounding up, you'll end up with much higher risk than you set out to.
Do professionals really trade that small?
In my experience, the single largest reasons why non-professional traders fail is that they take on far too high a risk. Professional trading is about grinding out returns, not making a quick killing. We're not gamblers. If you can compound at 10-15 percent over a decade, you'll be a star. Some years are better, some are worse. But trying to compound at 100-150 percent is gambling and likely to work briefly at best before blowing up.
Remember that in the example of the 0.2 percent daily impact above, that's per position. We might have 30 to 50 of them open.
Can't we just raise the leverage?
I would strongly advise you against this seemingly simple solution.
The futures contracts as such would, of course, allow you to take this course of action. You could take 10 times higher leverage than in the previous example but you wouldn't be very likely to survive long, financially speaking.
Consider these two simulations below. They're based on a professional grade trend following trading model, realistically simulated and executed on a set of 80 markets covering all asset classes. This first simulation uses a risk of just 10 basis points. This is a realistic return pattern and reflects what we've seen the industry do in reality. With this small position size, the strategy would have compounded at a respectable 15 percent a year. This is well over what traditional investment strategies would have made, and that's after the past few difficult years.
Monthly simulated returns - Diversified trend following strategy with 10bp risk
Source: Original research - Simulated in RightEdge
Now compare what would happen if we simply cranked up the risk ten-fold, to a full percent daily risk per position.
Monthly simulated returns - Diversified trend following strategy with 100bp risk
Source: Original research - Simulated in RightEdge
Looks great, right? Starting off with 500 percent return in the first year and 200 percent in the next. And how about those 2,000 percent in 2008?
Well, it would be nice if reality was as kind as a simulation. What the second simulation doesn't show is that you would have wiped out your whole account the first year. That's right, you would have lost it all the first year, so the rest is really moot. But let's say you started in 2001, instead. Then you would have wiped out in 2002. Full account losses also occurred during 2004, 2005, 2006, 2009 and 2013. In theory, the accounts recovered. If it wasn't for the fact that you had to post margin to stay in the game.
So can small accounts participate?
Sure they can. They just have to do things a little differently. This article looked just at the problem. In further articles, I'll explore how strategies can be adapted for CFDs, ETFs and even single stocks.
Andreas F. Clenow is a hedge fund manager and principal at ACIES Asset Management. He is also the author of the best-selling book Following the Trend (Wiley 2012).