I love things to be quite simple and straightforward. If I can understand a concept or strategy, and if I can explain that strategy to a teenager in a few hours time, I'm okay using it. I can trust it.
To me, investing is a lot like life: complexity doesn't make things better and you're likely to f*ck it up and be worse off than when you started.
Trading—in the context of trend investing—often has very negative connotations of being either completely kooky or overly complex. The terms technical traders use don't help: cup and handle, head and shoulders, resistance points, wedges, triple tops, triple bottoms, dead cat bounce, and so on.
Naturally these traders are poor advocates for the concept of trend investing, or trend trading. Nothing turns off an investor interested in these strategies more than seeing a chart like the one below. It's confusing and simply ridiculous.
The truth is these overly technical traders tend not to do so well investing. They often trade short cycles, look for too many indicators, and get jumpy looking for reasons and indicators to explain each move. Many technical traders incur high trading costs and have a low overall success rate.
A study put out by Fidelity out of the U.S. showed that the account holders who performed the best were dead, or forgot about their accounts. While certainly not conclusive, this can imply active investing is a fool's sport.
Well, I am ready to be a fool because I believe the majority of these poor returns were the result of bad reactive trading. Selling stocks after a market crash and pouring money into GICs. Buying stocks when things are already way too hot. And trading based on "tips" or financial news.
The real problem in the majority of these cases was the lack of a plan, or lack of investing discipline.
Simple Trading Is Risk-Averse Trading
Trading does not have to be complicated. The basic premise of trading is following a set of rules that guide you on when you should enter a position and when you must exit a position. The exit is the most important part!
Trading done right it is likely to limit losses on downturns. This helps reduce portfolio volatility. It also opens up the possibility of beating the market over the long haul because the market downturns don't take as much wind out of your sails.
If a stock or market is trending up, it's very likely to keep climbing in the medium term. Likewise, if a stock or market is moving lower, the path of least resistance is that it goes still lower. This attribute of trend (or momentum) is very well researched.
This reality counters what most traders believe as demonstrated by their actions—particularly with nervous fundamental investors. Many investors will sell their position as a stock is climbing, mainly because they want to take the gain and are afraid of seeing a rising stock fall. Often they'll actually see the stock they sold continue to move higher and higher.
Likewise, many investors "double down" on a position that's in a loss. They don't want to sell at a loss, believe the stock will go back up, and buy additional shares to bring down their cost average. They might also believe their personal analysis of the stock values it higher than the current price. Unfortunately, more often than not the stock will continue to slide lower and lower.
When this is pervasive, it isn't just a case of bad luck or a wrong call: it's human nature. We're adverse to loss and it costs us big time. We also tend to lack self-discipline when not having broad rules to govern our behaviour.
Using Moving Averages
There are only a few rules which I use and I shared them in my intro to trading post. It all boils down to two simple factors: trade based on moving averages (or breakouts) and always look to limit risk.
On pretty much every brokerage website, or even Yahoo!Finance, you can run Simple Moving Averages (SMA) and Exponential Moving Averages (EMA). I like to use both, and I prefer using medium to long term averages. Moving averages help smooth out prices so you can get a clearer picture of what's happening.
I also find it useful to run two separate ranges to help scale into a position. For example, I might enter a position with say 10% of my portfolio value when the price crosses the 100-day SMA to probe the trend. Then, if the price crosses the 200-day SMA, I'll top it up with another 10% to make the position a full 20% of my portfolio.
I typically do not buy unless the price has fallen below all the moving averages, showing a clear correction and re-entry point. Using moving averages to identify bounces can ensure better grasp of the price trend.
For example, a price might just touch a moving average line triggering a sell signal. If it immediately moves up the next trading day, it may be worthwhile to re-enter the position quickly at a small cost. It's an unfortunate cost of trading, but hopefully the price of re-entry is little more than the commissions.
On the sell side, I will absolutely sell if my initial position (or probe) falls after purchase between 5-10%. I know the trend is not in my favour, so I want to limit my loss. I'll also sell once the price falls below the long-term moving average I'm using.
Example using XIC.TO, the iShares TSX Capped Composite Index ETF:
I've run a 100-day SMA, 100-day EMA, and 200-day SMA over the past three years. Let's review my potential actions:
- Enter a 10% position in November 2014 at a price of ~$23.50 when it crossed the 100-day EMA;
- Sell the position a few weeks later at ~$23.85 when price fell below the 100-day SMA (profit 1.5% in less than a month);
- Enter a 10% position in the beginning of January 2015 at ~$23.25 when price crossed above the 100-day EMA;
- Add another 10% to have a full position at the end of January 2015 at ~$23.50 when the price crossed over the 200-day SMA;
- Sell in March 2015 at ~$23.60 when the price fell below the 200-day SMA (profit 1.5% on first 10% and 0.4% on balance);
- Enter a 10% position in March 2016 at ~$20.70 when price crosses 100-day EMA;
- Add another 10% to the position in April 2016 at ~$21.40 when price crosses over 200-day SMA;
- Sell in May 2017 at ~$24.70 when price fell below 100-day SMA (profit 19.2% on first position and 15.3% on balance)
Some of the trades didn't make a whole lot of money, but every trade was profitable and that matters. While the overall ETF price was basically flat over the past 3 years, this simple strategy made more than 15% and provided the opportunity to earn even more during the out periods. Also, you would never have seen a drawdown of more than 5%.
Some would scoff at making these 8 trades over the 3 years—preferring the simplicity of buy-and-hold. That's fine, but recognize it's a completely different type of investing.
Trading means paying more attention to your portfolio, setting up stop loss orders, watching several potentials for entry points, and completely blocking emotions or stupid temptations. It's not for everyone. In fact, I would say it's not ideal for most people who have better things to do than track ETFs and stocks.
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