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| Track signals for profits |
| Devangshu Datta / New Delhi Sep 02, 2010, 00:42 IST |
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One of the simplest trend-following trading methods has been around since the 1980s. It uses basic signals. The trader seeks a 50-day breakout — high or low. The trade is in the direction of breakout (long for high, short for low). The position is added to, as the breakout is confirmed.
Initially, stop-losses are set. Stop levels depend on individual pain limits, but it will be within the prior trading range. That is, if there's been a high breakout from say, 95 to 100, the stop-loss would be at 95 or lower.
The trader uses exit signals to book profits. The exit rule will be something like a 20-day high/low move in the opposite direction to the trade. That is, if the trader is long on a high breakout, he will set his exit at a 20-day low. Vice-versa, he'll set the exit signal at a 20-day high if he's short on a low breakout. Until the exit signal appears, the trader keeps the position open.
Some traders use 60-day signals, others use 40 days and adjust exit signals accordingly. This system seems stone-aged in an era of complex program-trading. But it works. It typically generates many small losses, whenever breakouts fail. But it does generate large gains every so often when the signal starts a sustained trend.
There are several key factors this system accommodates. One is that a 50-day breakout suggests a new intermediate or long-term trend coming up and keeps the trader out of short-term whipsaws (where brokerages eat profits). Second, pyramiding an already-winning position is a good tactic. Third, there are strict stop-losses and strict exit signals. Taken together, these minimise losses and attempt to lock in profits and maximise gains.
Sophisticated traders use signals smoothed by moving average systems or crossover moving average systems. These cut down on poor signals (they also eliminate some winning ones). Some high-level “quaint” systems use spectrum analysis (Fourier Transforms) to isolate major cycles in a given price trend. Then the time frames are set to exploit those cycles.
Ideally, any such system uses futures instruments (stock futures, index futures, commodities, forex) to exploit inherent leverage. The trader will have some rollover manoeuvring to ensure low slippage when a near-term contract needs to be swapped at settlement.
The moving average methods seem to work pretty well with Indian data. A 50 DMA (daily moving average) has picked up all the major Nifty moves since 2008. The moving average signal went negative (suggesting a sell of the Nifty futures) on August 31. A 50-day low breakout hasn't occurred. However, the number to beat would be Nifty 5,210 (June 30). Prior history suggests going short with a stop at around 5,425.
The author is a technical analyst
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