Trend Investing: Tools To Determine The Trend

I make it no secret that I am a trend investor. I do not buy positions to hold them forever. Instead, I buy positions when the price is in positive territory based on a specific metric and sell those positions when the price is negative based on the same metric.

How do you determine what the trend is? What kind you do to find out if the trend is up or down? Once you have determined the trend direction, how do your determine if it's time to buy or sell?

There are many forms of trend investing which are acceptable. Although the tools might be different, they all work in a similar fashion with similar effects. The biggest variable is your chosen time cycle. Longer cycles mean less trading, shorter cycles mean more trading.

Common Trend Metrics

There are several common trend metrics that are used to determine if the price trend is up or down. Moving averages, simple price breakouts, and time-series lookback momentum are all popular. A trader can get much more technical, but the benefits start to become a lot less clear. As a general rule, simple metrics tend to perform better over the long term.

Moving Averages

Moving averages are a simple tool that can be found on many brokerage charts and Yahoo! Finance. A moving average is simply a calculated average of the price over a specified number of past trading days. Using the closing price of each day is most common.

While there are many forms of moving averages, simple moving averages (SMA) and exponential moving averages (EMA) are the two most common measures. A simple moving average is a straightforward calculation. For example, you use a 5-day simple moving average of XYZ. On Day 1 the closing price was $8, on Day 2 it was $9, on Day 3 it was $8.50, on Day 4 it was $9.25, and on Day 5 it was $10. Your simple moving average would be ($8+$9+$8.50+$9.25+$10) / 5 = $8.95.

Exponential moving averages use a mathematical formula to apply more weight to recent days. This causes the EMA to be higher than the SMA if the price is moving up and lower than the SMA if the price was moving down. In our 5-day example, the EMA would probably land around $9.25. This makes the exponential moving average somewhat more responsive than the simple moving average.

Most traders using a moving average strategy would put in stop losses on each position at the SMA or EMA number so the system automatically sells the position for them if the price drops below the SMA or EMA. They would update the stop loss price at the end of each trading day or week.

Here’s a chart of XIC.TO with a 200-day Simple Moving Average (shown in purple):

Source: TheRichMoose.com, Yahoo! Finance

As you can see, you would have purchased a position in XIC.TO on September 20, 2017 when the price crossed $24.40 per unit. Your current stop-loss price on that position would be $24.73.

Here’s the same chart of XIC.TO with a 200-day Exponential Moving Average (shown in red):

Source: TheRichMoose.com, Yahoo! Finance

You would have purchased a position in XIC.TO on September 14, 2017 when the price crossed $24.07 per unit. Your current stop loss would be $24.82.

Moving average strategies can cause a lot of buying and selling action when the price hovers around the moving average line. For this reason, when a position is initially entered a trader will drop the stop loss price to 5-10% below their purchase price to try avoid these frequent whip-saw trades.

Simple Price Breakouts

Breakouts can be very complex, especially combined with other tools. For this purpose though, we’ll use a simple price breakout. It can also be called a “box breakout”. A simple price breakout would be the price making a new high, or a new low, based on a specified look back period.

For example, let’s say you are tracking an ETF where the highest price in the last 6 months is $20 and the lowest price is $15. Using a breakout strategy, you would buy the ETF if the price exceeded $20. You would sell the ETF, or even short sell the ETF, if the price falls below $15.

Most traders using a breakout strategy would put in stop losses at their sell points. They would update those stop loss prices at the end of each trading day or week.

Here’s a chart example of breakout prices using XIC.TO using a 6 month lookback:

Source: TheRichMoose.com, Yahoo! Finance

The breakout prices are shown by the black lines. If you are not already in the position, you would enter a new position if the price exceeds $26.16 (the highest price in the last 6 months). If you have a position on, your stop loss price would be set at $23.69 (the lowest price in the last 6 months). You might also short sell a position if the price falls below that number to try profit from a further price drop.

Since the difference between the high price and low price can be quite large depending on your lookback period, many traders will set their initial stop loss price at 5-10% below their purchase price to avoid a large drawdown on that position.

Just as with the moving average, the lookback period is carried forward from day to day or week to week.

Time-series Lookback Momentum

The last strategy we’ll look at might be the most simple form of momentum investing. It forms the basis for the Dual Momentum strategy that I share on this blog and was popularized by Gary Antonacci.

In this metric, you buy a position if the current price is higher than a prior price specified in your lookback period. You sell—or take a short position—if the price is lower. You would only look at the price once a week, once a month, or once every two months. Generally a stop loss is not used.

This strategy differs from a breakout strategy—aka box strategy—because time-series lookback ignores the price movements that occurred in between the current price and the lookback price.

Here’s a chart example using XIC.TO with a 6 month lookback:

Source: TheRichMoose.com, Yahoo! Finance

Since the price 6 months ago was exactly $24.02, you would buy a position if the price was higher than $24.02 and you would sell your position if the price was below $24.02. What happened in between is completely ignored.

Using the Trend to Make Trades

Getting into (or out of) a position is the easiest part of trend investing. The key to remember is the highest potential return/lowest drawdown occurs at the first signal. After that, the return potential of that trade will drop.

Getting into a position sometime after the signal is not catastrophic—it can still be very profitable if the trend goes for a long time. Using a less-frequent system will reduce whip-saw trades as the trend solidifies.

You will enter a position when the signal first occurs based on your system parameters. Those system parameters might have you check your signals daily, weekly, bi-weekly, monthly, etc.

If you trade only once a week on Fridays, you will enter a position if the price is higher than the trend tool signal on Friday. If you trade once a month, as in Dual Momentum, you will buy only if the price is determined to be in an uptrend when you log into your account that month.

It might not be worthwhile moving into a position if the trend signal has been positive for some time. For example, using the 6-month breakout system, you would have entered a trade in Canadian stocks (XIC.TO) on October 11, 2017 at a price of $25.02 (the previous 6-month high on April 25, 2017). It might now be worth entering anymore—three months after the signal—now that the price is 3.6% higher and the sell signal (last 6-month low) is $23.69.

The Effects of Time Cycles

The frequency of trading will largely depend on the time cycle you choose for your trend investing strategy.

If you choose very long time cycles, such as 10 months (200-day moving average) or more, you will not be trading very often. Many positions will be turned over just once or twice a year—possibly less. Longer time cycles also reduce whip-saw costs. Don't go too long though, even 18 months is probably too long for measuring time cycles in this format.

If you choose medium time cycles, such as 6 months or 3 months (150-day or 100-day moving average), you will trade more often. You can expect most positions to be traded several times a year. This can somewhat increase your whip-saw costs while reducing your drawdowns on a position.

Short time cycles, such as 1 month, 1 week, 1 day, or less, will result in frequent trading. This is day trader territory. Most positions will be traded daily or even many times throughout the day. Not only will your commission costs start to eat into any profits, you will be whip-sawed frequently. You may also be considered a trading business by the CRA and be taxed at higher tax rates. I will not be referring to short time cycles when speaking about trend investing in this blog as I find these systems to be foolish.

The length of time cycle chose will determine the responsiveness of your trading system. The shorter the time frame (to a limit), the lower your drawdowns will be. This is because the spread between entry prices and exit prices will be tighter. Long time cycles mean you will buy at higher prices and sell at lower prices, assuming you don’t short sell. Surprisingly, this doesn’t really matter; longer time cycles are often just as profitable as medium time cycles because of the reduced whip-saw effect.

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6 Replies to “Trend Investing: Tools To Determine The Trend”

  1. Hey Darren,

    Something about some of these systems just seems inherently wrong. For example, you first present the moving averages system, but it seems to me like this will drastically be reducing returns. By only buying when the price passes the average, you’re limiting the equity you could have built while building up to this average. If we assume that in the long wrong, returns will average say, 7%, then it seems to me you would want to buy when you can analyze the situation and see that the current price is below a historic 7% return.

    This comes up again in the second system. You suggest buying when the price hits the highest price it’s been in the last 6 months, and selling when it hits the lowest price it’s been in the past six months. By suggesting that, are you not saying, “Buy high, sell low?”

    Would love to hear how you interpret this!

    1. Mr. Rich Moose says:

      It’s definitely somewhat counterintuitive at first glance. You buy new highs and you sell new lows, where’s the value in that right?
      The only way to “get it” is by doing backtests. Moving averages are the easiest. Just go onto Yahoo Finance and open an interactive chart on any big index or stock. Then open the 5 year timeline and use the indicators tool to plot a 200-day/40 week simple or exponential moving average. You will instantly see that if you trade end of week prices, you will actually buy lowish and sell highish with a few whipsaw trades in between each bigger movement. The big thing is that you miss a large portion of every major crash.
      Box breakouts and lookback momentum work the same way, but you will need to manually backtest using downloaded excel sheets. It’s a lot more time consuming and not as visual as plotting a SMA/EMA on a chart.
      In my testing, breakouts and lookbacks trigger fewer trades when used in a disciplined strategy.

  2. Definitely counterintuitive, but once I thought about it a bit more it made sense. If I consider what I’ve done so far, which is bought and held (only for a short period of time so far 🙂 ), then essentially I bought somewhat close to the moving average, and I will, some day far down the line, sell relatively closely to the moving average. By buying when it crosses this line upwards, you are aiming for it to go up the next few days, thus bringing up the moving average, and the point when you are going to sell. When you sell, the next few days will hopefully be lower, bringing down the moving average and therefore lowering the price that you will be buying at.

    What happens if you have an order to buy at $30, it hits thirty and then drops to $29.50? Now you own stock that is below the moving average, and you should not be owning…

    1. Mr. Rich Moose says:

      Yes exactly. The research on time series momentum has found trends to be quite persistent in the 3-12 months period. So, if a price has moved up in the past 3 months, it’s likely to continue moving up for some time.
      Short term movements tend to mean-revert. This basically means that a month with a big up move tends to be followed by a flat or down month. Long cycles mean-revert as well (big market cycles like 5-10 years tend to revert to a value based metric like a CAP/E or P/B number).
      When I buy a new position, I always put in a stop so that I risk no more than 2% of my total portfolio value on each trade. For example, let’s say my portfolio value is $500,000 and I divide that into 10 positions. A new position would be $50,000. Given my max risk (2%), I would not let the price fall past a total loss of $10,000 on that position. Since I buy 2:1 leverage, I set the stop price at 10% below my purchase price. I ignore the little wiggles higher and lower than my purchase price as it’s just noise.
      If you keep the mindset of never risking more than 1-2% on each trade, you quickly realize that small losses don’t matter. Just diversify across a few positions, set a price, and sleep without worry. Once the price gets well above your purchase price, you know the trade will be profitable and you will lock in a nice gain at some point down the road.

  3. My understanding from reading this blog of your Dual Momentum Strategy indicates that there are only a few different holdings that complete for being held once every month. Once a candidate is chosen through look back analysis the Rich Moose enters that position with his entire portfolio plus margin. How does this dovetail with your comment above about only entering a position with 10% of your portfolio at a time? Are you running Dual Momentum in parallel with another strategy? Something is missing.
    Also, when entering a position you say that you place a 10% drawdown stop loss order in place. Have you done some research into the optimum area to place a stop loss? Another way of asking is: would a 5% stop loss be activated by short term volatility yet the 10% stop loss you use is far enough away from the entry point to avoid any short term volatility activation therefore allowing the RM to hold the position long enough to (hopefully) realize the medium/long term momentum gain?

    1. Mr. Rich Moose says:

      Hi Mark, while I like the strategy in general and use something similar in my registered accounts, I don’t run Dual Momentum as I share it monthly in the Portfolio updates. I find Dual Momentum is not very well suited to using higher amounts of leverage when adjusting for risk. It would probably be fine with 1.25:1 or even 1.5:1. Because you only look at the portfolio once a month and don’t use stops with Dual Momentum…
      This is the strategy I use in my non-registered account: http://therichmoose.com/post20170728/
      I was initially skeptical of breakouts, but after doing some back-testing I have moved over to breakouts instead of moving averages for buy signals to simplify the strategy and reduce trading. I use broad ETFs and run a dual system (6-month breakout and 1-year breakout for most long positions).
      I just pick 10% initial stop as an example of $100,000 position ($50,000 equity leveraged up) on a $500,000 portfolio. I won’t risk more than 2% of the total portfolio equity on any one trade ever. If I take a bigger position (as I would with EAFE or U.S. stocks), my initial stop would be tighter.

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