Tuesday, February 25, 2014

React, don't predict - and when late means early

It is important to remember that trend following is a reactionary method. Trend followers never predict what's going to happen in an instrument or stock. We wait for a signal to be given and then follow it.

It is also important never to be too rigid in your appraisal of what is happening, and this is where a systematic approach can help. Only a few weeks ago, short signals were given on the major indices. However, it was almost impossible to find any decent setups that matched our criteria. Therefore, standing on the sidelines was the most prudent thing to do to see if a) if the trend to the downside started to develop, and b) whether any decent shorting opportunities presented themselves.

Well, as we now know, the markets created one of those 'V' shaped reversals and promptly moved back up. I've shown the Nasdaq chart below detailing this.

So whereas at the beginning of the month I was starting to look for short trades, now with new highs made in the markets, I am back looking at potential long positions.

It is in these phases where trend followers tend to struggle - non-trending, volatile markets are the worst combination to deal with. So far this year they have reminded me of Spring 2011.  Also, there is no guarantee whether the markets will start to trend now a new breakout to the long side has been given, or whether the fresh long signals will also quickly fail. No-one knows (despite what others may say). This is why strong risk control is important, to keep as much of our equity intact.

A meaningful trend in the general market will last longer than a day, or a couple of weeks. There will be plenty of time to get into positions which match your criteria.

Trend following as a concept is the polar opposite to those who try to 'buy low and sell high'. By the very nature of the system, there must have been some strength in a stock or instrument to go long, or some price weakness prior to going short. As a consequence, a lot of people will say that trend followers enter new positions relatively late. Price must have already moved up for us to open a long trade, probably about the same time as a swing trader will be getting out of the same stock because it is giving an overbought signal.

However, where trend following scores is that, when a meaningful trend develops over days, weeks or even months, then it will look as though the trend follower would have got in extremely early in that price move, and will have been able to hold their position until an exit signal is finally given.

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