Thursday, November 15, 2012

Trends vs value

Trend following is basically a timing mechanism that tells you when to go long or short on a particular market, as well as when to exit any existing positions. Some people do not like to trade unless they have an understanding of the reasons behind a move in a particular market, relying on some form of fundamental analysis for this. The danger with this is failing to heed the warning signals when an existing trend finishes and shows signs of reversing.

The basic tenet of fundamental analysis ( as I can see it) is that you hold your position until such time that the fundamental situation changes from that you were trading. The problem is that in a lot of cases price action precedes any significant changes in earnings or some other fundamental belief in a stock or instrument, or the underlying economic conditions.

In addition, a lot of fundamental investors and traders perceive that a fall in prices creates even better 'value' in a stock or instrument, as they are able to buy in at cheaper prices. They are therefore sucked into buying against the price trend. What could be perceived as good value now, may be even better value in a few weeks or even months. Wouldn't it be better to wait until the price trend has stopped falling and shows signs of reversing to the upside?

Trend following follows the opposite viewpoint. Depending on the parameters of a decent trend following system, any fall in prices can be seen either as a pullback within a current uptrend, a cessation of an existing uptrend, or the commencement of a new downtrend. Trend followers do not look for 'value'. They are happy to buy and sell higher, or go short and sell lower. Their systems try to find the 'line of least resistance' in the current drift in price, and act upon it.

As an example, some people may have thought that, at the beginning of October, Apple was good value at $600. It's even better value now at below $540. Who's to say that in a few weeks it will be below $500? All while this has been going on, trend followers listened to what the charts were telling them, and would have gone short several weeks ago (my system gave a short signal at about $650 as highlighted in this post), and therefore would have quietly have made some nice profits.

Of course, trend following does not work on every signal given - my own win rates can be seen on the blog sidebar, and often average out at around 50%. That is why we never go 'all in' on a trade. Prudent risk control allows us to trade a number of positions at the same time. If we are wrong, we cut our losses. If we are right, we let our profits run until the trend finishes. So if you are short Apple from $650, you would still be holding this position. Where will it end - now? $500? Maybe $400 or lower???

I am not bothered about whether any opinions and fundamental analysis I may have about play out - I am simply concerned with making money. I therefore concentrate on the one thing that can generate profits - price action.

The current price action in the indices shows that last night both the FTSE and DAX generated short signals, and therefore are now aligned with the major US indices. The bias in my holdings was already to the short side, and I will therefore be hoping to reap the rewards of this downtrend - although I trade individual equities, I now also have the general price drift in the indices confirmed as going in the same direction, which may well help drag the prices of those individual stocks down. If I am wrong, I will take my losses as a cost of doing business, and will move on. If I am right, then I will simply ride the trends until they end.

Given that we are now in the period of the year when traders and investors look towards some form of 'Santa Claus rally' the trend in the general indices are showing totally the opposite picture. Could be an interesting few weeks...

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