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 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):
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):
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:
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:
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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