Wednesday, February 22, 2012

A chart of two halves

I've attached an educational chart of the Nasdaq here to highlight the market states and how this affects trend followers.

 

In the first part of the chart, showing several months of 2011, you can see a general lack of direction, particularly from August onwards, coupled with the higher levels of volatility. Trying to trade this in a trend following fashion would have resulted in repeated exits due to the whipsawing nature of the market. This highlights a non-trending, volatile market - the worst combination for trend followers.

However you can see that since the beginning on 2012, it is almost as if someone has flipped a switch - a meaningful trend appeared, and the volatility has reduced right down. This therefore is a trending, stable market - ideal for trend followers as the volatility will make it highly unlikely for traders to be whipsawed out of a position.

The problem that trend followers have is that, with each signal, you never know whether a trend will take off. We do not try to predict - we simply act on the signals given. This in a nutshell explains how trend followers did very well in the 2008 - 2010 period, and not so well last year, and highlights the psychological barriers you need to overcome to be in a position to take the signals as and when they are presented to you.

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