The motto of every trader should be: avoid big losses.

Two causes of big losses: big position, no stop.

Defining big loss, big position, right stop in a quantitative uniform way across market moods, instruments, one’s own moods is what takes me from ‘logically-I-get-it’ to ‘actually-I-make-it’.

Hite’s 1% rule and the ATR are nice ways to quantify these.

Regarding the extreme fat tails, they happen either because (a) market has to adjust to a real fact, a company made huge profits (b) a bluff feeds on itself (c) bluff has been called and market has to reset and overcorrect

Mandelbrot does note that there are events that drive prices in a predictable direction, just that one cannot predict WHEN. Hence, a company announces increased earnings and on that day, stock tanks.

This is why, Buffett model of time-agnostic buying value at a discount, when you can patiently wait UNTIL it appreciates, assuming the company does not go bankrupt in the meantime, is also a solid framework for moneymaking on stock investments, though the analysis, patience and ability to weed out bad ideas is hard. TF on the other hand is a simple framework but to grasp and implement it in its detail is so hard, on a trade by trade basis. Until trades are sized so small that one can be indifferent to the outcome of a given trade, TF is hard to implement.

Thanks for your comments – and you make a very valid point. I think the main point I was trying to illustrate that “cutting losses short and letting winners run” (which is one of the main concepts of trend following) in a fat tails distribution should yield positive returns – because fat tails mean that there will be “relatively speaking” many extreme movements (ie. long trends).

Agree that there is a bit more to trend following than that (otherwise you really only need random entries with tight stop-losses…). The main “extra” is that the actual entry provides a positive edge compared to a random entry and as you point out this implies auto-correlation

your blog is very interesting.

Concerning TF and fat tail, we often hear that TF profits from fat tails, but can we conclude that it is “The” reason why it works? What about a distribution with fat tails but where the daily returns are strongly negatively autocorrelated? What about a distribution without fat tail where the daily returns are positively autocorrelated? I was never able to demonstrate that fat tails is “The” reason. Would be enough to find a theoretical distribution without fat tail that is profitable with TF to demonstrate that fat tails is not the reason. Read a research once where the impact on TF of the different moments and other features of the distribution were analysed. I think, the conclusion was that fat tails had a negative impact. More important was the path of the daily returns (“directional volatility”). Have to find where I have this research.

However there is also a behavioral aspect to investing/trading which generates these fat-tails (maybe similar to the reflexivity concept described by Soros) which proves that the gaussian does not apply to the price distribution.

One way of looking at this is if you picked stocks randomly, most of them wouldd randomly “err” on the positive or negative side but more stocks than “predicted” by the normal distribution would exhibit extreme movements. And this is shown by Trend Followers performance with more losing trades than winning ones (albeit winning trade gains far exceed losing trade losses).

I hope this clarifies my point… I was not trying to say that stock movement is completely random – it is definitely linked to the fundamentals (in the long term); but the change in the fundamentals is random from an investor point of view (even though it might result from excellent management from the Company directors).

This post was mostly inspired from various readings (mostly these books) as well as Trend Following by Michael Covel (and there are a few more posts coming regarding this!)

the overall market is a reflection of the economy and a particular stock price is a reflection of the health of that company. if we agree on this then the stock price is not a random walk down the street. if a company is enjoying 30% growth year over year, the stock price should rise year over year to reflect that growth. so in good times you should see a lot of trending stocks.