Tuesday, December 28, 2010

Make sure you define your own interpretation of a trend

Trend following is a relatively simple concept - if a price is trending up, you go long, if its going down, you go short. The trick is to clearly determine the parameters that define a trend, and to use the appropriate timeframe.

Someone who swing trades over the course of 1-2 days may see a downtrend to exploit (when using hourly or 15 minute charts, for example), whereas someone (like me) who trades strictly off daily charts may interpret the exact same movement as a minor pullback occurring in an uptrend. Then again, I could see an uptrend and someone who trades a off weekly or monthly charts would interpret that as a minor bounce in a downtrend.

Following on from this, the stop/exits will all be different depending on the time frame - generally speaking, the longer the timeframe the system seeks to exploit, the wider the stops. These obviously have a knock-on effect regarding money management and your overall risk control.

In my own system, I view anything on less than a daily timeframe to be 'noise', and not worthy of further consideration.  People who use differing entry or exit criteria (whether they use x day highs/lows, different moving average lengths etc) also view trends over shorter or longer periods in the same manner.

Basically the longer the timeframe, the later traders enter and exit a position - the shorter the timeframe, you would enter and exit quicker, but at the expense of possibly being whipsawed out of a larger trend, on a longer timeframe. As an example, my system was giving me long signals in mid March 2009, after the markets bottomed out, whereas as someone using a longer term system may have only started taking long signals a month or two later. There is no right or wring method - you must go with what you're comfortable with, and define your system rules accordingly.

The Turtle Traders in the late 1980's had two trend following systems avaiable to use (S1 and S2), which looked for shorter or longer term trends. There were filters included in the system to avoid taking all the shorter term system signals. However, it was a condition to take ALL signals from the longer-term system. It was also a system rule for each trader to determine the 'mix' of trade signals to follow from the two systems. Some used only one system, others used a set mixture from both systems.

This is something I will be considering in my own trading in 2011 and beyond.

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