Tuesday, February 07, 2012

Act accordingly on a proper change of trend

"Every truth passes through three stages before it is recognized: In the first it is ridiculed; in the second it is opposed; in the third it is regarded as self-evident.”

I came across this quotation today which sums up very well the stages that the majority of investors and traders go through, particularly with regard to a change in trend.

This can be seen very clearly where investors are discussing a stock in which they have invested heavily. The fundamental story may be compelling, but if the stock continues to fall in price after they have bought in, then they are losing money - fact.

In the past I have exited positions in a stock (for a profit) only to be ridiculed by investors holding onto a position, however the charts gave me a clear exit signal. In the months following my exit, those that have held on end up having to resign themselves to sitting in a loss for a while - the easy 'ten bagger' they were banking on is in a clear downtrend and, rather than cut their losses, they are now sitting on huge paper losses (which incidentally I consider to be a very real loss).

After a while, they then resign themselves to the fact that there is no future prospects for the stock, so they either a) leave the position open but try and forget about it or b) sell up. Even then, they normally try to see the positive side of this by saying the capital losses incurred can be offset against profits made elsewhere, thereby reducing any tax liability. Quite often they exit the position right around the time when the trend reverses back to the direction they originally wanted.

Just on this issue (which is slightly off at a tangent) I'm not sure what others think, but if I was trading shares in the traditional sense then I'd be more than happy to pay any tax on profits - like a trend follower suffering losing trades (which are restricted as exits are made strictly in accordance with exit signals), tax should be considered a cost of doing business. Particularly in the current economic climate, paying tax means you are making profits - what's so bad about that? Of course, I trade using spread bets (available to UK residents) which are tax exempt :)

Anyway, to get back to the main topic here, to me it seems that a lot of investors suffer a period of self denial when a stock goes against them - "I am right, the market is wrong - I will be proved right" - that kind of thing. There is an emotional attachment which is poison - the market doesn't care whether you are long or short a particular stock - it responds to ALL participants. It should be remembered that the market, and the price fluctuations are the sum of ALL market participants, and you have no idea of anybody else's trading timeframes, the reason they have put their positions on etc., so if the price goes against you, then you are on the wrong side of the trade.

As a trend follower, you simply follow price, so you are automatically taking every market participant's opinion into account. If a price is trending up, you should be long, and if its trending down, you should be short. Simple.

I went long on a particular UK stock yesterday, only to be 'advised' on a bulletin board that "I can tell you this one is still down nearly 50% with little hope of recovery whatever charts you are reading". Well, if I am wrong (which I frequently am) then a 1R loss is simply a cost of doing business, and I will move on to the next candidate. Why did I buy this stock? Because it is breaking out to new highs, signalling a potential new uptrend and satisifed the criteria for my stock selections. What else can a trend follower do? So I've been ridiculed for taking the trade - time will tell if price moves in my favour or not.

Counter trend traders, and those who like to call market tops and bottoms, also go through this three stage process. Some of these traders I have read about seem to do well for a while calling market turns, gaining a following, and then, as so often happens, make some pronouncement about a big market turn - only for the trade to go against them, and their followers, who like a herd of sheep have blindly followed into the same trade. Even worse, the trader with the following does not even use stops, and preaches patience before the trade will come good. Well, as this particular trader I'm thinking of trades ETF's and indices, he is massively underwater, and no doubt some of his followers have blown their accounts.

Trend following is considered a boring, not very glamorous way of participating in the markets. I don't trade for excitement, I trade to make money. The whole purpose of trading such a system is that it gives you very clear guidelines of when to get in a trade, and more importantly, when to get out of a trade - if it means taking a loss, so be it. Move on. However, a trend follower, if they have set up a proper system including approporiate risk management parameters, will avoid these massive blow ups, as well avoiding the issue of holding onto massive losses in the hope that they will turn round - someday. The first loss is your best loss. Of course, we cannot avoid a drawdown from a series of losing traders, but that is part of the process of finding the big winners. Every losing trade brings me closer to a winning trade.

A trend follower will therefore avoid having to go through those three stages mentioned at the beginning of this post. The truth is in the price, and we act accordingly upon what price is saying. We control our losses and do not restrict our profits. So we never get in at the absolute bottom or top of the previous price move - so what? Price is the only thing a trend follower needs to worry about.

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