Sunday, December 29, 2013

A trend followers perspective

I've been catching up on some reading over the holiday period, and it seems there are plenty of people out there who are still trying to time the top of the current uptrend. These people are referring to the market being overbought, that a pullback is healthy, we are in a bubble or a parabolic move etc.



To anyone who uses a trend following system, these reasons are clearly nonsense. We have a different mindset to the majority of other market participants.

The points discussed below are designed to show the difference in a trend followers approach to the market compared to other traders, as well as some of the things to be aware of when trend following. In other words, if traders who want to be trend followers are not looking at the markets in this manner, they have not developed the mindset (yet) of a trend follower.

There are thousands of ways to profit from the markets - these are just the thoughts geared towards one such way of trading.

I always like to boil trading down to it's basic essentials. I try to look at any market in an unemotional, simple and objective manner. In this sense, trading should be simple, but by no means is it easy. The apparent simplicity of a trend following approach discourages a lot of people. Those people think it is too simple to work in today's markets. They believe you need something complex.

To a trend follower, the indices are showing an uptrend. That's all they need to know. Any decent trend following system will have given a long signal a while back, and those traders will be riding that trend until their system gives them an exit signal. That is all they are concerned with.

"Pure price systems are close enough to the North Pole that any departure tends to bring you farther south" - William Eckhardt

Sometimes my son will come into my office and take a look at my charts. I will ask him - which way is the line going? He will either say up or down. He sure as hell won't be talking about overbought conditions, bearish divergences or the like. If a 5 year old can see it for what it is, then a trend follower could do a lot worse than look at the chart in the same way. There is no need or reliance for lots of squiggly lines, oscillators or other indicators. Price and its trends are everything.

""Larry, if you want to know where a market is going, all you have to do is this." He threw his charts on the floor and jumped up on his desk. He said "Look at it, it will tell you!"" - what Jack Boyd told Larry Hite, from Hite's interview in Market Wizards

A trend follower and their system has no concept of what is overbought or oversold. All they see is the price structure and its direction. If its up, then you should be long. If its down, then you should be short. End of.

Trend followers make a great deal of money from parabolic (I prefer the term strongly trending) moves. Think gold in 1980, the Nasdaq and the dot.com bubble from 1999/2000 etc. There are plenty of examples. Sure, they never get out at the top, and if the end of the trend is abrupt and there is a sharp reversal, then a chunk of those open profits can disappear in a flash. But I would far deal with that, than try and be smart and bank a small profit when a new trend starts to develop, and then watch a huge move develop over the following weeks or even months without me. (For what its worth, it was the same in 2008, but in the opposite direction).

"When a market is making a historic high, it is telling you something. No matter how many people tell you why the market shouldn't be that high, or why nothing has changed, the mere fact that the price is at a new high tells you something has changed." - Larry Hite, again from Market Wizards

All the while, remember that all big profits from a well developed trend start out as small profits. In the same way, all big losses from going against a well developed trend start out as small losses. It should be clear to any one wanting to follow price trends that you cut losses short and let profits run.

So what if you are one of those who has sold out their long positions? In the words of Old Partridge from Reminiscences of a Stock Operator, you have now lost your position. How will you feel if the market continues up, leaving your exit price far behind?

Cutting profits short is an easy way for a supposed trend follower to destroy the positive expectancy that his system would have. Trend followers need to have a big winner every once in a while, as it is those trades that cover a bunch of small losses and leave some profit left over.

Trend followers do not try to be smart, outwit or argue with the market. They do not predict. Trend followers do not have a crystal ball. They let price tell them when the existing trend will have finished. That could be next week, it could be in three months time, could be in twelve months time...

Trend following is a reactionary way of trading. They wait to see what price is telling them, then act accordingly. Price shows them the way - as Jesse Livermore would call it "the line of least resistance".

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