This post explains the philosophy of trend following, why an options trend following system makes sense, and how to get started trading.
The philosophy of trend following trading:
Trend following is a way of trading that attempts to capture large market trends. Trend following systems can take place on any timeframe or holding period, but are usually applied on a daily or longer timeframe. Trend following systems frequently have a low percentage of winning trades (in many cases less than 50%) and the losses are overcome by occasional large winning trades. Basically, in a trend following system you have numerous small losses and big winners that pay for the small losses. In the image of the EUR/USD there are gray ovals that indicate entries and exits on a Donchian channel based trend following system. The image shows two losing trades, as indicated by the red dashed lines, following by a winning trade.
Trend following is a popular way of trading for money managers because the results are quantifiable, you can backtest the trading system, and trend following systems are easy to scale up as more money is added to the system. The risk taken in a trend following system is usually defined by some percentage of account equity and is frequently a small amount, say 1% of account equity. The small risk size per trade allows numerous markets to be traded, all markets can have an equal amount of risk, and you can take many losses without much account damage.
Systematic trend following is usually based on price and does not account for fundamental information. Fundamental information is assumed to be “priced in” to the various markets. Trend following systems trade many markets using the exact same system. The markets traded include currencies, commodities, stocks, and bonds.
One of the things I noticed through trading trend following systems is that returns tend to be clustered together and the winning periods are usually followed by periods with low returns or drawdowns. In trading (and investing) people usually like to see stable returns that are consistent over arbitrary periods of time. In trend following, returns are not stable, but over time they are very consistent. Two simple ways to smooth the returns of a trend following system are to increase the number of uncorrelated markets being traded and/or to trade another system.
Trend following with options credit spreads:
Trend following with options is a way to smooth the returns of a trend following system because, while it is trend following in nature, it does not require large trendd to be profitable. If we think about a typical trend following system that uses price breakouts to identify trade entry and exit points, price must advance beyond the point of breakout in order for the trade to make money. Unfortunately, most breakouts fail (less than 50% winning percentage, remember) and the trades lose money. By selling options in the direction of the trend, we’re attempting to be less right about the trend itself because money can be made in one of three ways: the trend continues, price chops around the entry price and never really advances so our short options decay, or the breakout fails but it takes a while to fail and the the short option decays.
The idea behind trend following with options is that it is much easier to be a little bit right about the general trend direction than it is to be right about a breakout. In most cases, price does not breakout in one direction and then reverse to breakout in the opposite direction. When we sell credit spreads in a trend following system, we can usually be successful as long as price does not totally reverse direction shortly after a trade is entered.
Because our options trading is trend following in nature, we’re not attempting to sell delta neutral spreads like iron condors or butterfly’s. Additionally, we’re not trying to exploit volatility through calendar spreads. What we’re interested in doing is incorporating options selling and trend following principles into a system that can be implemented on a variety of uncorrelated markets on a regular basis.
One of the the reasons we’re interested in selling options or using credit spreads for trend following is that over time short options decay and even if the trade isn’t totally right on direction, it still has the potential to make money or lose less than a long option.
How to use credit spreads for trend following:
The first step in using credit spreads for trend following is to clearly identify the system you intend to trade. I put together a sample system, Theta Trend, that is a great starting point. You can download Theta Trend for free on the Start Here page. I would recommend finding some indicator that you can use to identify the trend, choose the markets you want to trade, and then look for the credit spreads or naked options you want to sell. I like to sell credit spreads with a short option delta of roughly 25-35 and I like to sell credit spreads approximately 60 days from expiration.
Choosing markets is an important part of putting together an options trend following system because in trend following we want to trade markets that are uncorrelated. Essentially, we want markets that move in different ways and are not related to each other. For example, I like to trade the Euro (FXE), Gold (GLD), Bonds (TLT), Stocks (IWM, QQQ, or SPY), and Oil (USO). The reason I trade unrelated markets is that it creates positions that move differently and if I have a losing month in one market, I will hopefully have a winning month in another.
Please note that trading numerous equity markets does not create the same level of diversification as trading different asset classes. If you have positions on in the Russell 2000, Nasdaq 100, and the S&P, you essentially have one big stock position rather than three different trades. A trend following system would recommend trading a Russell 2000 position, an Oil position, and a Bond position rather than only equities. That being said, I’m not telling you what markets to trade, but I am suggesting that the US Stock Markets are highly correlated.