Saturday, February 27, 2016

I'm just following orders...

Every approach to trading has its own strengths and weaknesses, and often these show themselves when the inherent market direction or conditions (trending or non-trending, stable or volatile) change.

In its purest form, trend following is a reactionary process. You go long when price has started to show strength and made new highs, and go short on weaknesses, and made new lows. Therefore, when markets get choppy, you can suffer small loss after small loss. However, you can also cotton onto new trends far earlier than a lot of other market participants do...

I have talked here about the weakness trend following has when dealing with a 'V' shaped reversal. When these types of moves start out you accept them as a counter-trend move or retracement within the context of a longer-term, more dominant trend. However, as these become more pronounced, then they can become more difficult to deal with. 

Open profits may end up being significantly diminished. Trailing stops may have been triggered. The thing is, you never know with any degree of certainty (despite what some people may say!) if you have been stopped at the extreme of the counter-trend move, or whether this is the start of a new trend, in the opposite direction to which you were trading.

Over the last couple of weeks I've been able to get back into the markets and start opening some trades. The funny thing is that these have all been long positions, even though the direction so far in 2016 in the major market averages has clearly been down, with a partial rebound more recently.

The setups met my requirements, fell within my risk parameters, and then gave an entry signal. So what was I supposed to do?

As a trader who follows clearly defined entry and exit criteria, your job is not to question the signals when they present themselves. So I'm just following orders...

Peter Brandt summed it up excellently in a tweet this week:

Now, your chosen timeframe and parameters will also determine in which direction you will be trading. People who elect to trade longer-term trends may well be still holding short positions, with their own methods trying to 'embrace' the current counter-trend moves. Those who trade towards the shorter-term end of the trend following spectrum (such as myself) have started seeing a number of long setups cropping up which appeal.

So, by using shorter-term parameters, you can get into a potential new trend a lot earlier, BUT you are obviously more prone to being whipsawed out. A good example of this was in the Spring of 2009. Lots of long signals on my own parameters started appearing in late March/early April, and consequently I was able to profit from those. 

At the same time, those traders who follow much longer-term trends may have been trading the same stocks in the opposite direction, trying to embrace what started out as a counter-trend move, and therefore had to sit through a significant erosion of profits before their trailing stops were triggered.

That period worked in my favour. Other periods, less so, as the longer-term trends were able to re-establish themselves.

Some people may read that and think that, by going long, there is an element of trying to pick the bottom in the recent price action. Not so. I am simply following my own tried and trusted rules and criteria which tell me when to get in, and also when to get out. And as they are based on classical trend following principles, price must have already demonstrated an element of strength for me to consider taking the trade.

People often use a trend 'filter' to help give them a green light when it is clear to trade in a particular direction. Indeed, I use such a filter myself. Longer-term traders and investors typically use the 200 day moving average as a filter. But for traders who trade shorter-term, is that the most applicable or relevant? Marty Schwartz used a 10 day moving average as his filter, given the very short-term nature of his trading.

Time will tell if any of these trades become profitable. Or indeed, if the recent move up in the indices is simply a counter-trend move or the makings of a new uptrend. Who knows?

As we can see, there are pros and cons to trading longer-term or shorter-term. And neither are wrong - but one may suit you better than the other.

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