Saturday, January 25, 2014

The house of cards

There has been a sharp drop on the major indices this week. The reasons as to why are not important to trend followers - they simply observe what is happening to the price and act accordingly based on their chosen rules and parameters.

It has to be said that we are still relatively close to all-time or multi-year highs on many of the world's major indices, and it remains to be seen whether this will turn out to be a pullback within the context of an uptrend, or the start of a new downtrend. Again, this would depend on your preferred timeframe.

This weeks market drop has caused much reaction on social media and the blogosphere. The 'broken clock' brigade, who I referred to here a few months back, have come out in force saying they have now been proven right. They are conveniently fogetting the 50 or 60 prior attempts over the last year or so to call the top in the market - even the one I referred to in that old post was proven to be short-lived, and on many longer-term systems that price drop did not register as a trend change.

I've shown here two charts of the Dow (click to enlarge) - one is the standard daily chart and system set up, the other a longer-term system I've been working on. As you can see, because they work on different timeframes and parameters, they now have different signals in place.

What this week WILL show up is where traders have been over-exposed in terms of risk (if they've been running too much portfolio heat), even if you have been trading in the direction of the prevailing trend. Those who had too high a level of risk will have either suffered a major loss of open profits, or a big drawdown to their equity. A lot of stocks that were trending up nicely have either pulled back quite sharply, or even reversed and triggered stops. All those hard earned gains quickly gone, like the proverbial house of cards. That is the nature of the markets. That is why good risk control is so important, and why you need the psychological skills to deal with these market conditions.

This type of movement in the markets is one of the reason why I recommend not including open profits when calculating your equity for position sizing, especially when utilising a trend following method.

Those who have been in the business of top picking over the last year or so, will have already incurred plenty of losses trying to predict what will happen, so their short position sizes will be considerably smaller than if they had followed the trend until they got the appropriate entry signal.

The current market environment is when trend followers go through the process of giving back a chunk of accumulated profits before their trailing stops are hit. This is not an easy process to go through, but is the compromise you make for keeping your positions open until a trend exhausts itself. The other alternative is that people try to be smart and exit at what they believe to be the extreme of the movement. That leads to the potential for cutting for winning positions short ,which will destroy the postive expectancy of your system.

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