Sunday, June 17, 2012

Why trend followers get the biggest gains in BOTH directions

Think back over the last 20 years or so, and of the stocks that increased the most in that time before falling back or levelling out. Who's on the list? Well, there are hundreds of multi-baggers, but to take just three (that everyone has heard of), there's Microsoft, Google and Apple.

Now think of those people who trade in the markets, who like to get a bargain. Generally, this means they like to buy something that's fallen in price, so that they feel like they are getting value for money. As a rule, they like to buy low, and sell high.

To get the huge winners like those three that I mentioned above, would someone who likes to buy on a dip have been able to get in on those stocks? Somehow I doubt it. The one thing those stocks did was continually make new high, after new high, after new high. They were trending to the upside.

Even if someone DID get in on one of those stocks on a pullback, I very much doubt they rode the trend for all it was worth - they probably got out when they got an 'overbought' oscillator reading, or a minor down day within the context of the uptrend. Worse still, they may have even have tried going short on the basis that 'it can't go up any further'.

The people who would have ridden those stocks up were either investors, or trend followers, who would have been getting repeated signals on the way, and may even have pyramided their positions (while still respecting their risk parameters) all the while the uptrend was intact.

What investors DON'T necessarily have is an exit plan, that enables them to ride such stocks on the way up, but enables them to get out with the bulk of their profits intact when the top is reached.

Now you may say that those three companies mentioned above had faultless fundamentals, but there are thousands of other stocks that had huge share price rises on nothing more than hype (think 1999 and dot.coms).

Sure, to have ridden these stocks all the way you would have needed a longer-term trend following system, but even a shorter-term system like I trade would have enabled you to get large chunks of those rises, would have got you out at an appropriate time when price told you to do so, AND would have even have told you when to short these burnt out shooting starts, like the dot.coms and thousands of others that have come and gone into the midsts of time. Again, if a stock is trending downwards, making new low, after new low, after new low, it is the trend followers who are able to stay the course all the way until the trend ends, or the stock reaches zero.

Want a case study? Go find a chart of Enron - trend followers would have made a fortune in both directions, while those who wanted to buy on pullbacks probably missed out on the way up, and when the trend reversed kept getting stopped out when they were entering long positions, thinking they had got a bargain. More recent examples include Research in Motion and First Solar to name just two.

I was speaking to someone last week who has always looked upon himself as an investor, and was looking for a way to marry up his fundamental beliefs with that of price action, that did not require lots of PC time. In this regard, a trend following system is an ideal candidate. The parameters of such a system can easily be tweaked to coincide with your preferred timeframe/holding period, but will still tell you when to get out of either a winning or losing position.
Don't believe me? Well, look at someone like David Harding at Winton Capital - his hedge fund has been long on gold for over 10 YEARS - he bought when it was still in the $200's. But he will know when the party is over and will exit the position at the appropriate time (and he may have done already - I do not know).

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