A Counter Trend Indicator: Profit from Trend Followers’ Weakness

A good indicator is based on sound logic. It should try to quantify or visualize a concept that makes sense and is easily explainable. Mostly I use very simple indicators. The most basic of indicators can be very helpful if used rightly. The indicator I’m about to describe here is quite simple in concept but requires a few more steps than a moving average. If you’re familiar with the basics of trend following models, this indicator should make perfect sense to you.

The Plight of the Trend Followers

Most trend following positions end up losing money. This is not news to anyone who studied this field. The money is in the fat tails, the run-away success trades that make up for many small losing positions. Losing most of the time is simply the cost of doing business as a trend follower. But, what if you could exploit this phenomenon?

Think about how a classic trend following model works. Try to find weaknesses to exploit. Look for the points that cause pain to trend followers. That’s where you’ll find some opportunity.

Wait, what? Isn’t this site about trend following? Why are we talking about trend following kryptonite?

It’s very dangerous to lock yourself to one approach. If you start getting religious about trading methodology, you’ll get no where. Getting stuck in the trenches like Apple vs. Windows or technicals vs fundamentals is not only unprofessional, it’s outright dumb. Most approaches have valid elements and you can construct profitable trading strategies from many starting points, so why limit yourself to one approach?

There are still pure trend followers around, but they are becoming an endangered species. Sure, most of the returns in the 300 billion dollar CTA industry comes from trend following. It’s still the dominating strategy in this part of the hedge fund business. Most CTA funds however incorporate multiple systematic strategies, always looking for new alpha and models with low correlation to the existing portfolio.

So when do trend followers suffer? On sharp trend pullbacks of course. Whether that happens right after breakout or later in the trend, it’s these pullbacks that cause the problem. In particular when there’s a pullback far enough to trigger a stop loss and then turns back into the trending direction. This happens all the time and it’s highly frustrating.

But what if we could quantify and measure trend following pain? Perhaps we can find a way to enter trades just as many trend followers are forced out? Perhaps the exits of big CTA funds will cause the prices to be pressured further, making it likely for the price to rebound after?

Enter the Clenow Plunger

Most trend following models are very similar. The source code and rule set might appear different, but they all tend to buy and sell around the same time. Those of you who bought my book know how such a system might look. You did book my book right..? Oh come, just buy it!

Let’s start with the trading model presented in my book and make an indicator to measure pain level. Quick recap: The model had a trend filter using 50/100 day EMA, entered on 50 day extremes and took stops at 3 ATR units against the trend. And that’s the one sentence summary of my 300 page book. Sorry for the spoiler.

The stop logic is key here. What if we made an indicator that measures how many ATR units we are from the recent peak? Yep, that’s exactly what The Clenow Plunger does.

What kind of a name is The Clenow Plunger for an indicator? Back off, it’s my indicator and I’ll name it whatever I want!

Ok, here’s the basic logic of the Plunger. The input numbers can of course be changed as you please.

1. Check the trend filter, using a 50/100 EMA.
2. Check the last 20 day extreme price, in the direction of the trend.
3. Check current price.
4. Calculate the difference between current price and 20 day trend extreme.
5. Normalize this difference by dividing it by a 50 day ATR.

Now you’ve got an interesting indicator. When the reading is around 3, many medium term trend followers are exiting. If you do some simulations, you’ll also find that this is a pretty good entry point.

 

 

Trading the Clenow Plunger

The most obvious way to use the Plunger is for entries. No, I won’t give you complete trading rules. At least not in this post… This indicator can be used for entries into both counter trend and trend models, depending on how you want to handle your exit strategy.

Here’s how the indicator looks on a few different markets:

Note in these charts how the Plunger spikes up during pullbacks, just as it should. It measures the extend of the pullback on a normalized basis. In essence, it measured trend following pain levels. This can be traded in a few different ways of course. Having a good entry point is only part of making a complete trading model.

I might have mentioned before that I now publish a weekly futures analytical newsletter. Once or twice. Apart from covering a wide range of cross asset futures markets every week, I also do a special issue once a month. Next month, I’ll write about how to use this indicator to create a high performance trading model, complete with all the rules of course. If you’re not already on the mailing list, you can sign up for a free trial and receive this special issue.