Saturday, March 30, 2019

Questioning some popularly-held beliefs

Stripping back our beliefs and subsequently our rules to their absolute basics, as trend followers, ideally we would want to be able to:
  • generate an entry signal as early as possible into a new trend;
  • exit a non-performing trade, if the new trend has failed, as soon as possible; and
  • allow our position to run as far as possible on our chosen timeframe until that trend is invalidated.
Around those basic concepts people can follow pure price data or utilise technical analysis to 'formulate' their entry and exit rules.

As I've said before, I can be a bit of a trading heretic, and like to challenge some of the more popularly-held beliefs about how to trade successfully.

Below are a couple of those beliefs which I believe are worth further scrutiny - the use of multiple timeframe analysis and trend 'filters'.

Generally, trend followers look to enter on price breakouts, and therefore enter long only on new price highs, or go short on new price lows.

It is one thing to wait for a potential new trend to appear before 'hopping on'. It is quite another to join a trend where price has already moved a reasonable distance in the direction you are looking to trade.

Yes, it is correct to say that you can never predict when a trend will end, but it is my belief that it is more difficult to join an existing, well developed trend, than to join and participate in a potential new trend.

Jesse Livermore commented on this very topic:

“It has always been my experience that I never benefited much from a move if I did not get in at somewhere near the beginning of that move. And the reason is that I missed the backlog of profit which is very necessary to provide the courage and patience to sit through a move until the end comes – and to stay through any minor reactions or rallies which were bound to occur from time to time before the movement had completed its course.”

When using some form of multiple timeframe analysis, typically you would use the longer-term timeframe to assist you in determining the 'bigger picture' view of the market and then 'drill down' to the shorter-term timeframe to identify your entries and exits.

So as an example, you may use weekly charts to get the longer-term perspective, before using the daily charts to time your entries and exits.

In theory this makes a lot of sense, but I don't know of many trend followers who utilise such an approach.

The problem is that, for the trend on the weekly timeframe to look good and indicate a potential new uptrend, price would generally have had to already been rising on the short-term (daily) timeframe for a while beforehand.

As a result, there is the chance that the best of that particular uptrend on the daily timeframe had already run its course.

It is also likely that any volatility measurement will have increased as the trend progressed - particularly if it is an aggressive price move. This would need to be considered with regard to risk, stop placement and position sizing. I talked about this important aspect here.

In my mind, it is far better (and simpler) to focus on what price is doing on that timeframe and in accordance with your own parameters. This was particularly applicable and beneficial to my own method and performance.

My inspiration for how to look at a trend was Ed Seykota - you can see his definition here, which in itself is thought provoking.

Let's now turn our attention to the use of trend filters.

These are typically used to 'allow' trades to be taken in a certain direction when price is compared to a long-term measurement, such as the 200 day moving average.

If price is above the moving average, then only long positions can be taken. If price is below, then only short positions can be considered.

And if you are a long-only trader, then when the markets you are looking to trade fall below the moving average, then theoretically you would remain in cash until price moves back above the moving average.

Again, this theoretically makes sense, but is something that would have been detrimental to my own performance.

As an example, I was able to do very well when I started getting lots of long signals in late March/early April 2009. I didn't know at the time that the long-term general market downtrend had bottomed out. All I was reacting to was the volume of new long setups and signals I was being presented with.

Had I been using a filter such as a 200 day moving average, I would have missed out on those profitable uptrends - I would have been stuck on the sidelines waiting for the 'filter' to give me the green light.

Now I know this may be anathema to some - for example, those traders who state that "bad things happen below the 200 day moving average".

Of course they can - but bad things can also happen when price is above the 200 day moving average, and good things can happen below the 200 day moving average as well.

Similarly, and more recently, I simply reacted to lots of short set ups and signals I got last Autumn, regardless of where price was in relation to any filter.

Now, I know that plenty of people use either or both of these theories within their own work, and if using it in your own trading works for you, then great. You've gotta do what works for you.

But it is not the only way - there have been plenty of successful traders who do not use multiple timeframe analysis or trend filters, such as these below:

The Turtles used two basic systems: 'S1' used 20 day entries and 10 day exits, and the longer-term 'S2', which used 55 day entries and 20 day exits. They got in as early as possible to a potential new trend (as determined by their parameters).
And in both of these cases they simply went long on new highs or short on new lows, in accordance with their rules, regardless of whether it was aligned with any perceived longer-term trend or filter.

Jesse Livermore himself used no such multiple timeframe analysis. He didn't even use charts - he simply kept his own records of price on his specially printed notepads, and from there calculated his 'pivotal points' which he used to help identify when to enter or exit. These were all simply calculated using daily prices.

Nicolas Darvas traded on a 'long-only' basis, but also stuck to the one timeframe - he used his own 'box' theory, again based solely around prices received via his daily telegrams, to try and identify boxes of consolidation and subsequent breakouts to the upside.

These people, along with others who use similar methods, are just acting upon signals given to them via their basic rules.

Simple, but very effective...

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