Market: Any/stocks.
System concept: Trend-following systems, especially those that are long only and those that lack good filters, are vulnerable to market corrections and long-lived drawdowns. Previous Trading System Labs have shown how such systems can benefit from the addition of filters to protect against corrections (or down-trending/range-bound conditions) and prevent trading against the direction of the prevailing trend.
So what usually happens before a drawdown starts to rain on a trend-following system’s parade? A market that has been trending very strongly suddenly pauses and enters a consolidation, or corrects the most recent bull move, before resuming the trend. Common wisdom attributes these reactions to profit taking on the part of traders who established positions at lower price levels. Some traders have always considered these moments to be a good opportunity to enter the market in the direction of the primary trend.
Having also stressed that trading a minimally correlated supporting system is usually a viable alternative to over-optimizing a primary system, the following technique (suggested by a Wealth-Lab community member) can be a useful addition to the trend trader’s repertoire. The idea behind this pullback system can be summed up as follows: big move, pullback, and rebound.
Here’s how it unfolds: The big move (greater than a certain percentage) starts a few days (bars) ago, then pulls back by a certain percentage for another few days, after which this brief period of reduced volatility is interrupted by price rebounding and approaching the previous high. The underlying concept is that periods of higher volatility (like big moves) beget periods of low volatility (like the reaction and possible rebound), and vice versa.
Trades are exited via a channel-based trailing stop that adapts to the current price, and which is placed far enough away from the market to allow price to fluctuate and lock down profits by riding the trend.
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