Tuesday, August 23, 2011

Using trend following to 'time' your fundamental beliefs

Pure trend following means that price action is the sole criteria when deciding whether to go long or short. The argument for this is that, in a lot of cases, price leads fundamentals, not the other way round - indeed, in some of the Market Wizards interviews, some great examples were given of these types of trades. This is the way I personally trade. I fully appreciate, however, that lots of traders prefer to trade when the technical analysis side of a trade ties in with the prevailing known fundamentals. This would apply not only to individual equities, but also to the general market indices, as well as commodities such as oil or gold.

Trend following can help those who like to trade on their fundamental analysis by telling them when the time is right to follow their fundamental beliefs. In a strongly trending market, blindly following your fundamental beliefs, if the trend is against you, can result in a significant loss of capital.

You may decide that there is a particular company for which you are extremely positive or negative about their future prospects - simnply charging in and either going long or short without regard to current price action can result in a large loss. Why is this? Well, consideration must given to the state of the general market, for a start.

Those who have read Nicolas Darvas' book How I made $2 Million in the Stock Market will know that he made his money after identifying suitable companies based on their future prospects, but he also waited until both the price action of that company's stock AS WELL as the general maket conditions were right using his 'Darvas box' method to time his entry and minimise his risk to catch the big price increases he desired. He also then managed to hold onto his gains as he exited when his technical analysis told him to do so.

Although Darvas devised his own method for determining entries, exits as well as pyramid points, he was basically following an upward trend in those stocks, at a time when the general market was also going up. This is also where a pure trend following strategy scores, in that it helps you time your entries, as well as your exits - remember, we are not trying to pick tops or bottoms in any market, but simply waiting for a potential trend to appear, to play only when the odds are in our favour, and then get out when that trend has run its course. If that coincides with your own fundamental beliefs on whether that particular equity or market is going to rise or fall, then you have a green light to go trading.

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