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Trend following lessons 22.04.17
Simple but not easy
Happy Easter and Vaisakhi!
There’s not been any significant change this week. We continue to see asset/sector leadership coming from commodity producers/miners (oil, uranium, steel, gold, agriculture). Meanwhile, bonds and home builders are the weakest areas.
So instead of a market review, I’ll focus on something different: trading process & lessons.
The goal of trend following is to limit losses and capture potentially unlimited gains. This strategy can be illustrated very simply like this:
In a new uptrend, you first wait for a base to form and then buy the breakout. You don’t buy far above from any clear level of support - that’s FOMO. And you don’t sell early because you’re afraid prices will reverse suddenly – that’ll severely limit your upside potential.
Similarly in a new downtrend, you sell when price breaks a clear level of support. You don’t be stubborn and then panic sell far below the breakdown level – that’ll result in a big drawdown. And you don’t attempt to buy just because prices dropped a lot - that’s catching a falling knife.
I’ll add that people looking exclusively at valuations and/or sentiment will tend to be the ones selling & buying too early. Trends can often continue for years past the point that the fundamentals told you to sell.
The above chart seems so simple, but you’ll have to battle your emotions every step along the way. As one of my mentors says, “trend following is simple but not easy.”
Increase your time horizon
There’s a sweet spot to the amount of trading you do.
You don’t want to buy & hold forever or else you’ll miss out on trend changes. But you also don’t want to be too short-term and over-trade either as that’ll result in a lot of whipsaw losses (ie. being confused by noise).
Let me illustrate this with a recent example.
Below are monthly charts for SLX (steel producers) and XAU (gold miners).
I posted these several times on this blog because they have been so clean. In late Sept, not only did XAU hit major 8yr support but sentiment towards gold was also deeply in the gutter. I got so excited by this sector that I wrote 7 blog posts dedicated to gold in Oct-Nov. The first of these posts showed 4 monthly charts in the PM space all on multi-year support (link).
However, for the first 4 months after XAU first hit that big support, the gold sector chopped sideways. Here’s the daily chart which doesn’t look as pretty:
If one had focused on the XAU monthly chart, bought on support, the position would be up over 40%. But because I focused more short-term, my return was not as good. I had closed my GDX position in early Dec before getting long again in early Feb.
This is a lesson that repeats over a lot: When you find a clean monthly chart, be patient and give it time to work.
Of course, there’s some caveats to this:
It’s hard to trade off monthly charts, as you can suffer big intra-month drawdowns.
There’s opportunity cost of your trade not working for 4 months when there’s other trending markets out there.
It’s OK to miss the initial part of a bull market. Big trends can last a long time. It’s better to pay some “insurance” and get confirmation of a new trend instead of potentially catching a falling knife.
As you can see, there’s is no absolute flawless way to trade. Every trading strategy will have its pros/cons and periods of underperformance. But by patiently sticking with the big trends, it pays off in the long-run. Keeping a trading journal is also important as you can look back at why you bought/sold instead of beating yourself up.
That’s all for this week! If you found this post useful, please give it a like and share. Thanks for reading.
Important Disclaimer: This blog is for educational purposes only. I am not a financial advisor and nothing I post is investment advice. The securities I discuss are considered highly risky so do your own due diligence.