Thursday, May 08, 2014

Trend following in a nutshell

It's late 1999. Seemingly everyone is making money in the markets riding the dot.com bubble. Tech stocks are moving up $20 - $30 per day. New IPO's jump up 100% on their first day of trading. Trading is easy. Money is rolling in. Life is good.

Six months later, the markets have peaked and are starting to trend downwards. Those same people are now are not heeding what the market is telling them. "It's a pullback" they say. Some buy more stock in the anticipation price will rebound. Some just hold on. Many don't have an exit plan. But the trend has changed - price is giving you a very clear signal.

One year later, the bubble is a distant memory. The Nasdaq is only at 30% of its value at its peak. The paper profits have disappeared. Many of the same people have ridden those stocks all the way up, and all the way down again.

A one off? No. Go take a look at the run up in the Japanese Nikkei in the late 1980's, and compare it to the price levels you see today. Imagine if you used a buy and hold approach back then.

On stocks, you may want to look at charts like Worldcom. Or the most infamous of them all - Enron. In a lot of cases, price trends will start to develop long before any underlying fundamentals or reasons become public knowledge. In some cases, like the tech bubble, profitable trends can develop without ANY fundamentals!

Extreme? Maybe. But trend followers know that these kind of moves can and do happen, in indices, individual stocks, forex - anything.

When a trend follower puts on a trade, they are looking at one of three scenarios:
  • small loss (governed by proper initial stop placement with only a small element of your equity placed at risk);
  • small profit (trade which started to trend but then failed), or;
  • big profit (trade which took off and developed a meaningful trend).
Yes there can be instances when things like price gapping through stop levels can occur (all the more reason for good risk control), but in the main those are the three main possibilities.

What may seem initially to be a big move, may in the fullness of time become to be seen as a small opening part of a huge trend. All you can do is identify direction in which price is going and tag along for the ride. Who knows how far it will take you?

Best of all, it does not require any knowledge about the underlying fundamentals. It does not mean following the advice of brokers or analysts, who in the case of Enron were still issuing buy notes most of the way down. It means you do not have to follow Cramer and people like him on Bloomberg or CNBC.

All it takes is the ability to act on what price action is telling you, to follow the direction in which price is heading, and (most importantly) when the party is over, have the ability to cash in your chips and move on. And at some point in the future, it can also present you with the opportunity to ride those previous big winners back down again.

Simple? Yes. Some might say too simple. But it focuses your approach on the one metric that everyone can understand and follow - price.

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