-••1-7 -1

Unfortunately, not everjlhing is as uniform as this example. The shorter-term trends can be very erratic, and they often appear in small groups of uptrends and downtrends (see Example E2). This is easily explainable because adding and subtracting 1 day, when only 2, 3, or 4 dajs are used in the moving average calculation, can quickly change the direction of the trend. As you get to longer intervals, such as 20, 30, and 50 dajs. this is not the case, and in realitj, it doesnt hsppen often. Yet, when it does, it is clearly an odd case not to be trusted

TABLE 5-6 Selecting Trends and Rewrsals

The number oIwmIj ot

Example E2 Moving Average Period in Days

1 3 4 5 6 7 8 & IC 11 IZ 13 14 15 16 17 18 19 20 21 22 23 Z4 25 Trent) uudduduut u uu uu uu uud dd d dd

There are also cases in which the longer trend begins to reassert itself and the results sppear the same as in Example El; however, the trend change occurs from the longer term down (from right to left instead of left to right) The case we must watch for satisfies neither of these, but occurs in erratic pattern, such as in Example E3. Here we see a dominant long-term uptrend with the very short end turning down. Because of another downturn a few dajs ago, which then disappeared, this most recent downturn also caused a shadow turn in the 20-day range. Is it a leading indicator or a false signal? All indications are that smooth changes in a frend are a more reliable indicator. Another case is given in the second line of Example E3. Here, the smooth Uend change from up to down is occurring from lefl to

right; however, as it gets to 13 dajs, it also jumps ahead to 19 and 20 dajs, leaving the 14th through 18th dajs atill in an upU-end. Again, we favor the orderly approadi and would wait for all trends to change below the one we are using.

Example E3 Unreliable Turns in Trend

=:Moving Average Period in Dajs:= 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 Trend dddduuuuu u uuu u u u dd u uu ud Trend dddddddddddddu u u udd u u u

An example of this process is shown in Figure 5-12. Moving average calculation periods of 5 to 50 dajs are shown in increments of 5 dajs for a total of 44 consecutive dajs. This illustration points out how the long-term uptrend (X) is breached by shorter-term, less consistent trends. Perhaps the best trend is the one with the majority of Xs or Os on the same line.

LIVING WITH ATREND-FOLLOWING PHILOSOPHY

The advantages and disadvantages of trend sjstems are similar to most other tjpes of trading sU-ategies. The first question that a trader should ask is, "What can I expect from a trend approadi?" The calculation period of trend will change the profitability, size of individual profits and losses, and reliability. This is covered thoroughly in Chapter 22. Fast trends enter trades on the first strong move following a price reversal; slower averages take more time to identifj a frend change. No matter what its speed or how well-timed, a frend signal can never occur at the night point; consequently, watching prices varj with respect to the frendline will be frusU-ating The moving average sjstem will rarely enter or close out a position at just the right place; it can only extract profits from the middle of a frend and hold losses to a minimum. The rides and magnitude of reward are infrinsic to the speed of the moving average although the risk/reward ratio may be similar for many moving averages. The success of such a sjstem can only be judged by its actual performance; thus, the weekly or monthly accumulated results should be studied rather than simply observing the relationship of the trendline to prices.

The slower the trend, the fiirther it will lag behind a sustained price move. Professional traders lean toward the faster trends and portfolio managers toward the slower. When frading only one market, individual frade risks can be kept small using faster trends. The portfolio frader can offset the longterai adverse move in one market with an equally long favorable frend in another. The advantage of diversification and long-term frends is that eadi market will move in the direction of the frend a majority of dajs, even though that

FIGURES-12 Sequences of moving averages.

may mean only 6 out of 10. A portfolio of 10 markets, eadi with a 60°o probability of a move in the trend direction, should result in 6 of them moving in a profitable direction, it is more likely tliat all of them will be profitable on the same day than it is that all win be losers.

Slower trends are more likely to endure than faster ones. These slower trends often profit from fundamental market changes, such as seasonality, production cycles, and inflation. They stick to a trend while it develops. The faster trends are attempting to catdi shifts in market psjchologj, shortterm cycles caused by frading pattems and current events, and wide swings in high-priced, uncertain markets. The pattems that make fast trading profitable also change quickly. A 3-day moving average may be highly profitable for one month, then produce consistently losing trades

"TakeYour Profits and Let Your Losses Run"

Many traders are guilty of profit-taking using trend sjstems. Cutting losses short is an infrinsic quality of a trend-based sjstem as is its lag. It is inevitable that a frader will want to close out a trade that has a $1,000 profit and a stop-loss at a level that captures only $300. However, this places an arbifrarj limit on potential profits while letting losses remain at their natural size. A frend-following sjstem compensates for many small losses when prices sustain a large trending move. Dont cut it short.

Using Other Reasons to Exit a Trend Trade

A very Icng-term trend will often find the direction of the underljmg economic fundamentals. For example, a 1-year Treasurj bond trend would have been long for about five years diuing the latel980s. Once you understand thai the position you are holding is based on a sustained economic situation, you can exit the position when that situation changes. Looking at the T-bond example, prices continued to rise (interest rates fall) to offset slow economic growth and high unemployment. Once the Central Bank (the "Fed") raises rates, it is a good indication that the upfrend is nearly over. Because the very slow trend lags far behind the actual market price, it may be another year before prices cross the trendline and sign a change of position. This is also likely to occur after a large part of your profits have been given back to the market. Exiting the frade when the fundamentals change would be a safe way of capturing more profits and being exposed to less market rid; provided the fundamentals are the ones that were driving the market and your profits.