Sunday, November 18, 2012

Why I only buy on new highs and go short on new lows

Pure trend followers buy on strength and go short on weakness. In such a system you won't be opening positions on pullbacks or retracements that go against the main trend identified. Some traders will say that doing this would reduces the risk and maximises the rewards available.

I have never felt comfortable trading pullbacks. This goes back to when I very first started day-trading US stocks almost 10 years ago. The method I employed was based on breakouts, either in a long or short direction. In essence, that initial principle remains a core element in my trend following system to this day - only the timeframe has changed, along with paying respect to volatility and an additional trend filter to identify the set ups with the best potential.

Psychologically then, I would have a very hard time opening trades on pullbacks - what some people see as being a tradeable pullback, I see as a potential change in the direction of the trend.  How big a pullback would you allow for (and an erosion of profits with it)? Trading using hard and fast rules suits me and my personality.The other reason I shy away from those sort of entries is that, over a significant period of time, the system I use has done a great job of telling me when to get out of a stock, alerting to me a potential change of trend, as well as identify these differing trend signals in a relatively short period of time. This allows me to utilise my capital better - again, I would struggle with having my capital tied up in a non-performing stock for several months (or if I was a long-term investor, years).

Don't get me wrong, I know there are loads of traders out there who enter using pullbacks or retracements, entering on formation of bull and bear flags etc, and do extremely well. The point I'm making is that I would not feel comfortable trading in that manner myself - and if you are not 100% comfortable and confident in your method, you will struggle to faithfully stick to it.

Below I've shown a three charts with commentary that show this very well. These are not cherry picked - one of the examples I traded in both directions within a few months. You can find plenty of examples given the recent price action in the indices.

Again, trend following is not a holy grail - I frequently lose (more than half my trades are losers) but by using good risk control, I let the profitable trades run, and cut the others when I get an exit signal.

Given the robustness of the system, and the historical positive expectancy, I doubt if I will ever change the parameters or try to improve the performance metrics. I know that, in the long run, a trend following system is dependent on trends appearing in the markets I choose to trade. The proliferation of trend following strategies applied to futures, commodities, and indices have possibly contributed to poorer performance when trading those instruments compared to say 20-30 years ago. This is one reason why I very rarely (at best) trade those instruments using my system, and stick to trading stocks, which in my experience trend better.

Pain Therapeutics showed a nice breakout in early September and moved up nicely, consolidating and moving to new highs in mid-October before breaking down sharply. Some traders may have wondered how much leeway to allow the stock as it fell back (quite sharply) from those highs. A trend following strategy would have got you out, banking the profits generated, and also have given you a very profitable short signal. An investor who had bought this stock any time in the preceding few months would now be sitting on a loss.

A similar tale here in another US stock. A profitable long trade from September to mid-October, followed by a pronounced downtrend, which could have also been traded profitably. Coincidentally, I assume from the name, this is in the same sector as the first chart - remember that trend followers, as they focus purely on price, can trade instruments without even knowing what commodity or stock it is they are trading. All the information they need to know is contained in the chart.

This particular UK stock I did trade earlier this year, in both directions. Some traders may have interpreted the price action in April and early May to be a minor pullback or consolidation. As it happened, it was a great short set up per my system rules, which I followed, even though it was only a few months since I was in a long position! I did trade this stock again in August on the long side, however this did not work out and I was stopped out for a loss.

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