How a trend following system actually works?

When trying to trade using a trend following approach, the most critical part is to know what is your time horizon over which you are analysing the market. Are you observing the market on a minutely, hourly, daily, weekly or monthly basis? This is the first question you need to answer.

The second immediate question you need to answer is what is your lookback period? The lookback period is the number of periods (based on your time horizon) you are considering judging whether you are in a bull, bear or range market. For example, you could design a trend following system that assess the market every day based on a 30 days lookback period (ie 30 price observations).

Over a 30 periods-lookback period with a daily observation, the trend is bullish even if on a short-term basis, the market corrected swiftly (close to 30%). That means that a trend following system based on these parameters should not cut nor short this market. Even though the market violated the moving average, there were no confirmation at the close of the day.

Because the market dumped 30%, the tempting choice would be to go to maximum flexibility. It would mean reducing time horizon (ex: to minutely) and look back period (5–10 periods) to adapt more quickly to changing market conditions. If you follow this strategy, you will increase exponentially your trading frequency (turnover). As trading has a cost, especially in crypto you need to pay to your exchange (ex: 4bps for Binance Futures or 7.5bps for Bitmex) and the induced slippage, maximum flexibility is a bad financial choice. On the other end of the spectrum, waiting “too long” to adjust to a change in trend is not the optimal strategy even though you would reduce trading cost down to a minimum.

This is visible on the chart below, just 2 days after the trough. So sometimes, the right trend following system will avoid any unnecessary trades and keep you in a perfectly valid trend. Had you been with a lower time scale and slightly shorter lookback, you might have just cut your exposure or even short too early. In this case, this would have cost dearly.

What that means, in the end, is that depending on the market structure, your choice will be fitted for some cases and not fitted for others. You will never get it right 100% of the time. Markets are too uncertain for a fixed system. This is where having a staggered approach with trend following systems that look at various timescales and various trigger parameters is essential to reduce uncertainty and adverse market conditions. That is the reason why at NapBots, we recommend that you do not bet on 1 only strategy but that you allocate in a diversified way.

What we have developed at NapBots is a market regime indicator (“extreme market” regime) that will flash a big red signal when overbought or oversold conditions are met. These cases happen after a long bull or bear markets when emotions are driving investors. In these cases, the market is ready for a sharp reversal in the opposite direction of the trend.

However, the crypto markets have historically demonstrated a tendency to keep on going in their original direction even when they enter these extreme market regimes. And they can travel extremely far before turning back. So, the strategy of going against the trend is not the right one. You may go broke doing so. What is interesting in these circumstances is to adapt a move from a medium / long term trend following approach to a much shorter one. This will keep you in the original trend if it lasts but will adapt your positions more quickly (not instantly) when winds change.

At NapBots, we are providing such “extreme market” indicator as well as providing trend following strategies with different timing horizon and lookback periods. Do not just look at their trading frequency (hourly, daily or weekly) to determine how reactive they are. But go into their individual description to learn more about which lookback they are considering.

We believe that combining both an extreme market indicator and adequate strategies and enhance the performance of your allocation. Please refer to our indicative table to help you decide which strategies are more relevant (not always more performing though) to a specific market regime. We have designed these market regimes so that they do not change too often as the idea is to be on autopilot.