Wednesday, August 26, 2009

The philosophy of a trend follower

There are many ways of trading in the equities and commodities markets. These consist of utilising fundamental analysis, technical analysis or a combination of the two. A good trading method should be robust, which to me means that you can use the same method when trading stocks, the GBP/USD, soybeans, gold, or anything else, without having to tweak the parameters.

Trend following (which is the method I use) allows you to do this insofar as price is the one and only indicator I follow. I profess to know very little about technical methods such as Elliot Wave, fibonacci, etc and even less about fundamental analysis.

Larry Hite was quoted in his Market Wizards interview that 'we don't trade markets, we trade money'.  He also advises to avoid optimization, stating that 'it's incredible how rich you can get by not being perfect'. Near the end of the interview, he concludes 'I knew that if you traded across the board, controlled your risk, and went with the trend, it just had to work'.

Most trend following is carried out on commodities, FX, futures etc. I have simply taken this and decided to use it on individual equities. By carrying out the same trend analysis of the general indices, this determines whether I should be actively looking for any buying or selling opportunties. It also tells me when to hold off entering any positions (It is important for me to remember that cash is also a position, particularly in a trendless market).

When a buying signal is given, I will then look for individual equities giving signals in the direction of the market trend. I then spread my trading capital across those equities. Why? Some issues will outperform the general market, some will underperform. By diversifying across the board, and by strictly controlling my overall risk, I attempt to maximise the returns available.

To conclude, I have a couple of sayings that have helped me to trade with the trend:

1. One man's retracement or pullback is another man's trend reversal;
2. Support and resistance levels are there to be broken.

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