Building a Rules-Based Monthly Trend-Following System

A discretionary approach to trading, based on intuition and subjective judgment, is a recipe for disaster. The successful position trader operates with a well-defined, rules-based trading system. This system is a complete set of rules that governs every aspect of the trading process, from what to trade to when to enter and exit. This article will provide a practical framework for building your own monthly trend-following system.

Step 1: Define Your Tradable Universe

The first step is to define the universe of instruments that you will trade. This should be a diversified list of markets and asset classes that are suitable for long-term trend following. A typical universe might include:

• Stock Indices: S&P 500, NASDAQ 100, Russell 2000, MSCI EAFE, etc.
• Fixed Income: US Treasury Bonds (long-term, intermediate-term, short-term).
• Commodities: Gold, Silver, Crude Oil, Natural Gas, Copper, etc.
• Currencies: Major currency pairs (EUR/USD, USD/JPY, GBP/USD, etc.).

It is important to choose markets that are liquid and have a long history of trending behavior.

Step 2: Define the Trend Filter

The next step is to define the primary trend filter. This is the rule that will determine whether you are in a bullish or bearish regime for a given market. A simple and effective trend filter is the 200-month simple moving average (SMA).

• Bullish Regime: The price is above the 200-month SMA.
• Bearish Regime: The price is below the 200-month SMA.

Only long positions will be considered in a bullish regime, and only short positions will be considered in a bearish regime.

Step 3: Define the Entry Rule

The entry rule specifies the precise conditions under which you will enter a trade. A simple breakout entry rule can be very effective.

• Long Entry: Buy on a breakout to a new 12-month high.
• Short Entry: Sell on a breakout to a new 12-month low.

This rule ensures that you are always entering in the direction of the prevailing momentum.

Step 4: Define the Exit Rule

The exit rule specifies the conditions under which you will exit a trade. A trailing stop-loss based on the Average True Range (ATR) is a robust and adaptive exit strategy.

• Long Exit: Sell when the price closes below a 3x 14-month ATR trailing stop.
• Short Exit: Buy when the price closes above a 3x 14-month ATR trailing stop.

This rule allows you to ride the trend for as long as it lasts while still protecting your profits from a major reversal.

Step 5: Define the Risk Management Rule

The risk management rule specifies how you will size your positions. A fixed fractional position sizing model is a simple and effective approach.

• Risk per Trade: Risk no more than 1.5% of your total equity on any single trade.
• Position Size Calculation:

Position Size = (Total Equity * 0.015) / (Entry Price - Initial Stop-Loss Price)

Position Size = (Total Equity * 0.015) / (Entry Price - Initial Stop-Loss Price)

Data Table: A Complete Rules-Based System

Step 6: Backtest and Validate

Once you have defined your trading system, the next step is to backtest it over a long period of historical data. This will allow you to assess the system's historical performance and to understand its statistical properties, such as its win rate, average win, average loss, and maximum drawdown.

It is important to be aware of the potential for curve-fitting and to use out-of-sample data to validate the system's performance.

Conclusion

Building a rules-based trading system is a important step in becoming a successful position trader. A well-defined system provides a framework for making objective, disciplined trading decisions, free from the emotional biases that can be so detrimental to performance. The system outlined in this article is a simple but effective starting point. You can and should adapt and refine it to suit your own risk tolerance and trading style.