Wednesday, August 20, 2014

Being on the wrong side of the market

The last couple of weeks have seen a bounce in the indices following the drop in late July/early August, and there's been plenty of traders out there who have been quick to profit from that. That's fine - buying on pullbacks works until it doesn't, in the same way as shorting rallies works until it doesn't, and buying breakouts works until it doesn't.

In the meantime, over the last two weeks, and indeed the last couple of months, my trades have lost money.

So, what on earth was I looking at which others weren't?

Well, I follow price trends, and my timeframe and system parameters are relatively short-term. This is great when a new trend starts to develop, as you can get in early in the direction of the new move. On the negative side, you can get caught out when markets go into wide ranges, periods of higher than usual volatility, or simply a non-trending state. Currently we are in this kind of phase, and over the last couple of weeks, those that bought on the market pullback have fared much better - no question about that.

Now, as I follow trends, the next question is how do I define a trend, and that is answered in full here, but the critical part is this:

"Traders often look at a series of highs and lows attained over a period of time to determine the trend. A series of higher highs and higher lows signify an uptrend, while a downtrend is identified by a pattern of lower highs and lower lows."

So, as objectively as I can see, of the major indices I track, only the Nasdaq is in a confirmed uptrend, as it has made fresh highs. On the other indices, what do we have:

FTSE: After making highs in May, this has since shown a pattern of lower highs and lower lows, which has not yet been invalidated. I've shown here the broader FTSE All-Share, but both the FTSE 100 and FTSE 250 are exhibiting similar types of charts:


DAX: still quite a way off its highs just over 10,000 made in June and early July. There is a pattern of lower highs and lower lows on this chart since those summer highs were made. You can see how the nature of the price action has changed from making higher highs and higher lows to now making lower highs and lower lows:


As mentioned, the picture is slightly different in the US, as the Nasdaq is continuing to make new highs. However, both the Dow and S&P are below their most recent highs, with a lower low in place.

Russell 2000 - this is of far more relevance, as it is a broader based index. Here we have peaks at the beginning of both March (not shown) and July which pretty much match up, and a pattern of lower highs and lower lows since the top made in July. However, it looks like the current move up, which now pretty much matches up with a late July lower high, may invalidate this pattern by the time you read this.


Note that above you will see no mention of oversold indicators or oscillators - this is what pure price action, on my chosen timeframe, is showing. Therefore the state of the markets was my cue to be very cautious, and even ended up with me putting on some short trades. The price channels that I use and normally show on my charts attempt to 'frame' this type of price action. In the past I have talked about what I call the 'staircase' effect where the price channels can highlight more easily a series of higher highs and higher lows, or lower highs and lower lows.

This cautiousness I would also say is different to those who repeatedly called for a market top in 2013, when new highs (particularly in the US) were being made on a regular basis. People were simply saying then that the markets were simply too high - there was no structure in the price action to substantiate that a possible top had been made.

There have been plenty of famous traders (Jesse Livermore being one) who used the price action in the indices as a starting point to help determine what their bias should be. William O'Neill states that 4 out of 5 stocks tend to follow the same direction as the indices. By the same token, there are trend followers (including some who I follow on social media) who concentrate solely on the trends in individual stocks rather than let the trend in the general market determine what their bias or exposure is. Neither way is wrong. By the same token, you are never going to get it right all the time.

To be clear, if I was trading using say the weekly timeframe, or with longer-term system parameters, then I would still be happily trading the long side. Similarly, if the patterns of lower highs and lower lows I am looking at are invalidated, then all bets are off, and I will happily jump back in on the long side. A few losing trades now will be small beer when viewed as part of the next 1,000 or 10,000 trades.

So, on this occasion, I suffered some losses. That's fine - I can cope with that. As a historical comparison, because of my relatively short-term system parameters, I was able to get into new long positions a lot earlier than most trend following methods in March/April 2009, so I was to profit in that instance. Some you win, some you lose. Either way, I am much happier ploughing my own furrow, based on what my charts are telling me, on my timeframe, with my own parameters. Que sera sera...

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