I’ve been spending some time testing new system ideas and have been getting encouraging results. I thought it would be worth sharing some of my findings so far. Trend trading mainly falls into two categories:
1. Trend following
2. Contra trend
Trend following systems tend to wait for a strong trend to establish itself then hop on the back of it. A bit like the turtles in the film Finding Nemo surfing on the deep ocean current. It makes sense to go with the flow, as that is where the crowd is going right?
Contra trend trading takes the opposite view – believing that the crowd is often wrong and what you need to do is spot extremes when the crowd is too bullish or too bearish then take a position in the opposite direction. To use the example of our Finding Nemo turtle dudes, the deep ocean water current isn’t fixed; it can often switch direction.
The trend trading question: go with the flow or against the current?
The thing is that both approaches can be right depending on market conditions. Sometimes trend following systems do well, while other times, spotting short-term contrarian moves is the best option.
Different systems tend to work better on different time frames. I think the main mistake that many system vendors make is trying to make a system fit every time frame.
Referring to end of day trading here, you tend to get more reversals and pullbacks over the short term (a few days) and intermediate term (weeks), but with longer term trading (months) you tend to get more follow through.
Here’s a very simple moving average cross over system with thanks to Market Sci (http://marketsci.wordpress.com/2008/09/21/moving-average-crossovers-debunked/)
On a chart, load the S&P 500 with daily bars.
Load a simple 50 period moving average.
Load a simple 200 period moving average.
Buy if the 50 MA crosses over the 200 MA.
Build up interest on cash deposit when not long.
Since 1960, this strategy would have returned 8.3% a year compared to 6.4% a year buying and holding the S&P 500.
Not spectacular, but pretty simple and reasonably effective.
In the short term though and with shorter term moving averages (10/20) for example, markets tend to become more contra trend. However the picture is complicated because short term indicators produce the best returns, but are more subject to change.
For example buying at a 10 day low has been a great contra trend strategy over the last 10 years, but before that, the exact opposite worked well (buying at a 10 day high).
There’s some fascinating stuff over at the Market Sci blog on this. Well worth a read of this post: (http://marketsci.wordpress.com/2009/01/18/the-moving-average-spectrum-%E2%80%93-part-ii/). Geek alert though (I sadly put myself in this category). So I’ll try to summarise what’s being said:
Short-term indicators tend to be more predictive than longer term ones, especially over a period of days. However they are also more unstable which means you need to keep a close eye on them.
The moving average strategy produces reasonable if unspectacular returns.
A good approach with end of day trading might be to use a long term indicator like the 50 MA crossing the 200 MA for your market bias and then to nip in and out of the market based on short term indicators such as the 2 period RSI.
I wrote a system based on the 2 period RSI back in the January edition of What Really Profits. If you are already a member, get in touch.
As a quick summary here’s the rules:
You need the daily chart with the following two indicators displayed:
1. 50 period moving average.
2. RSI set to 2 periods.
Go long if price is above the MA(50) and RSI(2) is less than 5.
Exit when RSI(2) is above 70 or an 8% stop loss is hit.
To work out the 8% stop loss simply take your entry point and times this by 0.92.
Go short if price is below the MA(50) and RSI(2) is greater than 95.
Cover when RSI(2) is less than 30 or an 8% stop loss is hit. To work out the 8% stop loss simply take your entry point and times this by 1.08.
Add this to the 50/200 crossover system and you could have something very useful there.