Unfortunately for many long Oil, yesterday’s move did bring Crude Oil futures down below their , 50, 60, 70, 80, and 100 day moving average of prices (most models use a 50-100 day moving average as an exit point to confirm a trend has ended). Using an 80 day moving average for an example, this trend following model would be exiting its long trade this morning because of the close below that level.
As we outlined in our original post, the spike higher in Oil prices following the MENA unrest was a classic trend following breakout. We had hoped to give regular monthly updates on this example, showing how a theoretical trend following model would move let profits runs while its exit level slowly moved higher; but were cut short on those plans thanks to the large drop yesterday.
But nonetheless, this may better illustrate how trend following works (or doesn’t) than if Crude had kept going up for many months. Consider the following comments from an Attain client following yesterday’s sell off in commodities:
These are times when I scratch my head and realize how little I understand how managed futures really work. Clearly, [trend followers] puffed up like balloons in April only to basically give it (mostly) all back in May. Why do trendfollowers round trip like this? I thought they used trailing stops…but they just seem awfully wide to me. Maybe I just don’t understand that a long-term model … is riding a very long-term trend and must, therefore, have wide stops to stay invested.
The toughest part about managed futures is…to change how… [you] think about things. I think you are supposed to book profits and sit on losses. That is the stock and bond world mentality. Managed futures is just the opposite.
This example trend following trade shows what drives a lot of people crazy (and out of) managed futures. The model correctly got into the long Crude Oil trend, and was holding long with Crude up at $113 (which would represent gains of about $14,000 per contract), then gave it all back in the course of three days as Crude Oil futures sold off all the way back down below $100. The end result was a roughly breakeven trade.
How can a manager give up so much profits in such a short time? Why was the stop so wide, why did the managers not get out sooner, and so on are the questions clients have…. While the managers are usually looking at the chart and trade saying it worked exactly as it was supposed to – we got in with the trend, rode it for a while, and then got out when the trend ended, what’s the problem?
The reason the exit point is “so wide” is to give the trade room to run. It is pure mathematics – if you use tight stops, you will get hit on those levels more often, which will result in a higher frequency of winning trades, likely. But, the amount you win on those winners will be much smaller, and you will greatly reduce the chances of hitting a homerun, outlier type trade (because things typically do not go straight up, they go two steps forward, one step back). If you use wide stops, you will not get hit as often and leave the trade room to run, but you will have times when you give back a lot of open trade profit.
If you like the possible outlier returns (2008) of managed futures, and look to see those repeated in the future, you have to accept this ‘let profits run’ investment profile. While most of us think of just the upside when we hear the words ‘let profits run’, the reality is when these profits are ‘running’, they are going up and down. Yesterday saw the profits ‘run’ in Crude Oil, all the way down to their exit point. Letting profits run means giving the trade a wide berth to do what it will. If it goes on to be one of the outlier trades managed futures are known for, great. If not, so be it, the trade only lost a small percentage of equity.
The managers are looking at it as a fact of life, that the trend ended and they got out – while clients are looking at it as a missed opportunity. The managers consider where the trade gets out (breakeven and above is great), while the client usually considers how high the account got before the trade was exited.
We’re not likely to solve this disconnect in this space, but hopefully shed some light on why stops can seem so ‘wide’ at times. They are like that because that is what you are investing in-a chance at outliers.