The rules of the game haven't changed

I started getting involved in trading back in 2003, and didn't get into trend following until 2006. As a result, I missed the huge trends (both up and down) from the dot.com bubble around the millennium.

While thinking idly back to those times, which are now getting on for 20 years ago (yikes!), I began pondering about how things have changed in the intervening period.

Back then, Facebook and Twitter didn't exist. The dot.com bubble sprang from something new to the masses called the internet. Mobile phones were nowhere near as common as they are today.

How on earth did we survive?

And that got me thinking, from a trading and historical viewpoint.

Combining technicals and fundamentals for investing

Recently I had the opportunity to review an investor’s portfolio. This was valued in excess of £1m. The allocation of the funds was entrusted to a well known brokerage. I was asked for my opinion on the performance and allocation of the fund.

Do we even need charts?

In his book How I Made $2 Million in the Stock Market, Nicolas Darvas talked about how he created his own 'box' method of trading, based on simply recording the daily high, low and closing prices of stocks he was trading or interested in. This information was provided by telegram from his broker to wherever he was performing his dance act across the globe.

In How to Trade in Stocks, which he wrote shortly before his death in 1940, Jesse Livermore reproduced his own tabulated records which simply recorded price in the relevant columns denoting various price reaction points, whether the stock was in an upward or downward trend etc. From here he was able to identify the 'pivotal points' for each stock, which then helped him to commence his trading operations.

2015 - any parallels to 1987?

As a trend follower, I'm not in the business of making predictions - I follow where price goes. Elaine Garzarelli I am not. Also, predictions can easily blow up in your face if you are proven wrong. On this post, however, I am simply observing and pointing out a few comparisons between what is happening now and what occurred twenty eight years ago.

So what happened in 1987? 

• The crash followed a recent move down from all-time highs made a couple of months earlier;
• There was an international situation which contributed to the price move - in this case, it was the spat between James Baker and the Germans;
• Price accelerated to the downside throughout the week, culminating in a big drop on the Friday on heavy volume.

A time to pause and reflect

The markets have shown plenty of indecision and volatility this week. While a lot of the indices are still close to multi-year or all-time highs, there is clearly a battle going on between buyers and sellers. Despite this, I have only been stopped out of one position this week (for a +2.57R profit), and now I am left with two current holdings, which are also both in profit, so my exposure to this volatility is light.

What is noticeable again is that very few stocks have made it onto my watchlist in the last couple of weeks or so. And of those that did, hardly any have actually triggered an entry, and they tended to quickly fail. That in itself is a warning sign that market conditions are not favourable toward my own approach.

Fundamentals, Investing and Trend Following

The vast majority of investors and longer-term traders use some form of fundamental analysis when selecting stocks to invest in. This is all well and good, but what triggers a buy or sell in their investments?

The usual story is that, once they believe that a particular company has good prospects and the fundamentals look promising, they will start to buy, with the intention of holding their positions until such point that the fundamental story changes. The trick is to realise when there is a danger of overstaying their welcome, and to exit their positions before losing the bulk of their profits. This is where a trend following system, geared towards longer term trading and investing, can be invaluable.

Although longer term investing can be profitable even when there are adverse general market conditions, it should be remembered that, in a sharp downtrend in the markets, even the strongest and best stocks fundamentally will suffer, as was seen in late 2008. Of course, when a downtrend like that starts, it is not known whether the affected stocks will rebound at least back to its former highs, or will even continue further downwards.

In the past, I have suffered abuse from the 'fundamentalists' on a bulletin board when my own trading system signalled the end of an uptrend in a particular stock, and therefore I exited my position with a nice profit. However, those who solely used their fundamental analysis accused me of de-ramping the stock (as if I could influence the markets!!!) and rubbished my own analysis. The stock in question was just below 50p at the time, having peaked at 60p a couple of weeks prior.

The investors I left behind continued to champion this particular stock, and some of the posters on the bulletin board in question 'loaded up' their position to almost absurd levels, so confident were they that soon they would be holding significant profits.

As of last week, that particular stock was at the 15p level, with a lot of investors now holding massive losses after 'buying on a pullback' which was actually a new trend - downwards. Some of those still holding shares are even blaming the directors for the lack of  recent positive news flow from the company for their losses!

Now, this may be an extreme example, but you only have to think about stocks such as Enron to know that people who were once sitting on huge profits in some of their investments managed to ride the share price all the way down, losing all of their hard earned profits. Enron fell from around $100 to 50c, with the true fundamental picture becoming apparent late in the day. You can also think of those who made (and lost) fortunes in the dot com bubble when prices collapsed there too. In these cases, it was not only individual investors, but hedge fund managers who also commited the same crime of not exiting their positions when the trend reversed - greed took over and they decided to load up even more.

Those of you who have read about Nicolas Darvas will know that he used a basic system marrying fundamental and technical analysis back in the early 1960's and did very well.

No system is perfect, and my intention is not to poke fun at those who have lost money by holding on too long - far from it. Everyone invests or trades to make money, however there is always someone on the other side of a winning trade, who loses money. Sometimes it is me, sometimes it is those who follow the company 'story'. Either way, if you are able to combine the two in your longer term holdings, I would be amazed if your overall returns did not improve.

Using trend following to 'time' your fundamental beliefs

Pure trend following means that price action is the sole criteria when deciding whether to go long or short. The argument for this is that, in a lot of cases, price leads fundamentals, not the other way round - indeed, in some of the Market Wizards interviews, some great examples were given of these types of trades. This is the way I personally trade. I fully appreciate, however, that lots of traders prefer to trade when the technical analysis side of a trade ties in with the prevailing known fundamentals. This would apply not only to individual equities, but also to the general market indices, as well as commodities such as oil or gold.

Trend following can help those who like to trade on their fundamental analysis by telling them when the time is right to follow their fundamental beliefs. In a strongly trending market, blindly following your fundamental beliefs, if the trend is against you, can result in a significant loss of capital.

You may decide that there is a particular company for which you are extremely positive or negative about their future prospects - simnply charging in and either going long or short without regard to current price action can result in a large loss. Why is this? Well, consideration must given to the state of the general market, for a start.

Those who have read Nicolas Darvas' book How I made $2 Million in the Stock Market will know that he made his money after identifying suitable companies based on their future prospects, but he also waited until both the price action of that company's stock AS WELL as the general maket conditions were right using his 'Darvas box' method to time his entry and minimise his risk to catch the big price increases he desired. He also then managed to hold onto his gains as he exited when his technical analysis told him to do so.

Although Darvas devised his own method for determining entries, exits as well as pyramid points, he was basically following an upward trend in those stocks, at a time when the general market was also going up. This is also where a pure trend following strategy scores, in that it helps you time your entries, as well as your exits - remember, we are not trying to pick tops or bottoms in any market, but simply waiting for a potential trend to appear, to play only when the odds are in our favour, and then get out when that trend has run its course. If that coincides with your own fundamental beliefs on whether that particular equity or market is going to rise or fall, then you have a green light to go trading.