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| Art of trend following |
| Devangshu Datta / New Delhi Jul 28, 2010, 00:08 IST |
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One of the most successful trading methods is trend following. It was popularised by commodity traders in the 1980s and continues to do well. Trend followers are technicians in being totally focused on price-volume.
But rather than seeking to anticipate reversals, trend followers stick to trend-confirming tools like moving averages. They wait for breakouts, set trailing stop-losses and hold the trade, until stopped out. Some use “permanent reversal” systems — they never exit, only reverse trade direction. They set no profit targets — only stop losses.
Trend followers stick to highly liquid futures — the underlying could be anything. The more sophisticated work out correlations between different portfolio elements to ensure diversification. The central theme is to control loss on every given position. One of the better-known systems – “turtle trading” – had a potential maximum loss of 24 per cent of total capital.
The trader accepts many small losses on range-trading whipsaws to try and capture big trends. Some of the more successful methods have low-win ratios — over 50 per cent of trades lose. But the few winners are big.
Obviously, if win:loss ratio is low, the average positive return must far exceed average negative return.
Also, the system must trade relatively infrequently across long time-frames. Otherwise, brokerages hurt and circuit filters (normal in commodities) restrict maximum returns.
Most popular systems seek signals like 20-day highs or lows, or a penetration of a 55-day moving average. Breakouts in these time-frames imply reasonably long-term trends. Great discipline is required to calculate and rigidly maintain stops.
Someone I know has traded the BankNifty since January 2008 using a trend-following system with a 35-day exponential moving average (EMA) as the trigger for entry-exit. He enters (long or short) on 1 per cent penetration above/below the 35 EMA. So far, it's been very successful. Though I can't discuss details of stops, etc, anybody can map BankNifty versus 35 EMA to assess viability.
The last 35-EMA buy signal was early July. The BankNifty hit a new high on 22 July. Buying flies in the face of fundamental opinion. Interest rates are rising, bank margins may be hit, etc. It can be justified if you believe real interest rates are negative, due to under-reported inflation. Or, perhaps, rising GDP growth will lead to more loan offtake and fewer defaults.
A trend-following system such as this stays long on BankNifty without worrying about fundamentals. Other long-term technical signals are positive. A short-term correction has come and gone with the index dropping to 9,900 before it jumped above five-figures again. Just ensure you set good stop-losses and adhere to them, if you decide to trade this way.
The author is a technical and equity analyst
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