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Trend TradingTrend Trading & Trading Support and Resistance,I wrote this article as a follow up to the trading system where I compared waiting for a market correction with entering immediately after a new high or low. Trend following, or trend trading as it is sometimes called, is one of the oldest technical trading strategies out there and despite it's fall in popularity in recent years, it is still one of the most effective technical trading strategies there is. However, despite trend trading strategies still being relatively effective on many markets, taking advantage of the trend has become more and more difficult in recent years and as a result mechanical trading systems that seek to utilise the effects of the long-term underlying trend do tend to need to be a little more sophisticated than they once were. The oldest mechanical trend following systems are probably the Donchian Channel breakouts and the Simple Moving Average crossover systems of old. These old fashioned trend trading strategies simply aimed to take advantage of the trend by buying on a new high and waiting for the market to go even higher still, or sell on a new low and wait for the price to fall even further before closing the short position by buying it back again. Old fashioned trend trading strategies like these are probably still the best way to trade large liquid markets that are moved by macro-economic fundamentals. When economic fundamentals, governments, and their central banks are driving the market there tends to be strong clean trends to trade, and old fashion Donchian Channel trading systems and the likes tend to do very well on these markets. Unfortunately though, most markets nowadays are not actually driven by market fundamentals and global economic policies. First world governments rarely interfere in stock and commodities markets and financial institutions and high worth individuals now have access to so much capital to be used for purely speculative purposes that their speculation is what is driving most markets; only the likes of the Forex market (at least the major currency pairs anyway), the Bond market and things like interest rate markets are large enough to have a reasonable degree of resistance to the whims of speculators. Markets that are being driven by economic fundamentals behave very differently to markets that are being driven by speculation; the single biggest difference is that markets don't trend to produce clean trends (except when they are forming a speculative bubble) when they are driven by speculation. The trend can (and usually does) still exist when the market is begin driven by speculation, but things like support and resistance plays a much larger role as speculators aim to buy on short-term dips and sell quickly and take their profits on short-term peaks. This constant buying and profit taking means that any longer-term underlying trend will tend to be 'choppy' and to be successful any trend trading strategy must take this 'choppiness' caused by speculators aiming to buy low and sell high into account. So while any long-term underlying directional bias (the trend) may not be clean enough to be tradable with old fashioned trend trading strategies and systems due to the effects of speculators speculating, the directional bias usually still exists and it is still unwise to go against it. As the reader will no doubt have gathered, I believe that the best way to trade a speculative driven market is to buy on a dip and sell on a high during an uptrend; or go short on a high and close the short on a dip during a down trend. It sounds easy enough, but the difficult part of building a trend trading system to do this is distinguishing between a genuine dip or peak and a change in the trend. It is also very difficult to tell when a dip or peak is likely to end, but for the purposes of this article I just want to focus on distinguishing between a genuine dip or peak and a change in the long-term underling directional bias/trend. Any trend can end at anytime and it is usually impossible to pick a market’s turning point, however, there are events where a trend reversal is (statistically speaking) less likely. One of these events where a reversal is statistically less likely is after a new significant high is made in the case of an uptrend or after a new significant low is made in the case of a downtrend. For example, suppose the underlying directional bias is up and during this uptrend we decided that we wanted to buy on a dip of, say, a ten day closing price low. Does the new ten day closing price low signal a change of trend and that the market is going to keep going lower and lower, or is it simply a dip in an uptrend and a good opportunity to go long? Unfortunately, we can never know the answer to this question for sure, but I would argue that if this ten day closing price low occurred not to long after a new significant high was reached then it is more likely to be a dip and a good buying opportunity rather than the start of a new downtrend. To test this theory, I am going to perform four tests on a number of different markets. The details of these tests are as follows - Experiment 1: Buying new highs & selling new lows (pure trend trading),When a new 120 closing price high is made, that is, when the price closes higher than it has ever closed in the previous 120 days, I will automatically enter a long position and hold the long position for 40 days. Likewise, when a new 120 day closing price low is made I will go short and hold the short position for 40 days. This strategy is ‘pure’ trend trading as all it does is enter in the direction of the long-term underlying trend and wait for a pre-determined amount of time, no attempt is made to enter or exit at a favourable price, the system simply enters a position in the direction of the long-term trend as soon as the trend is detected. Experiment 2: Buying dips & selling highs (but only in the direction of the long term underlying trend),When the market makes a new 10 day closing price low I will go long if the trend is up and hold the long position for 40 days – to decide the direction of the long-term underlying trend I will measure when the market last made a 120 day closing price high and when it last made a 120 day closing price low; if the 120 day closing price high was made more recently than the 120 day closing price low I will say that the trend is up and take the long trade. When the market makes a new 10 day closing price high I will go short if the long-term underlying trend is down. Again, I will say the trend is down if the last 120 day closing price low was made more recently than the last 120 closing price high. This system could be described as trading support and resistance (buying dips and selling highs) in the direction of the trend, rather than trend trading. Experiment 3: Buying dips & selling highs (but only if the circumstances are favourable),When the market makes a new 10 day closing price low I will go long, but only if the market has made a new 120 day closing price high in the previous 20 days; the long position will be held for 40 days. When the market makes a new 10 day closing price high I will go short, but only if the market has made a 120 closing price low in the previous 20 days; again, the short position will be held for 40 days. This system could be described as trading support and resistance (buying dips and selling highs) with special attention being given to the trend. Due to the importance given to the trend in this system, I would say that this system is almost trend trading. The trend has a huge role as no trade can be taken if it’s not supported by a recent trend signal, but it is still trading the support and resistance as the dips and peaks are what it is entering on rather than the trend. Others however may disagree with this category and say that this system is essentially a trend trading strategy. Experiment 4: Buying dips & selling highs (purely trading using support and resistance),When the market makes a new 10 day closing price low I will go long and hold the position for 40 days. When the market makes a new 10 day closing price high I will go short and hold the position for 40 days. There is not a single element of trend trading in this system as the trend is not even taken into account, this is purely trading support and resistance. The Results,I am going to test these four different trading strategies on 6 different markets, two commodities (gold and silver), two of the major currency pairs (the EURUSD and the GBPUSD) and two major stock indices (the FTSE 100 and the S&P 500. The results of are as follows - Experiment 1: Pure trend trading -
Experiment 2: Trading support & resistance, but only in the direction of the trend -
Experiment 3: Trading support & resistance, with special attention given to the direction of the trend -
Experiment 4: Purely trading support & resistance -
In my article on different types of markets, I wrote that there were three different types of markets, fundamentals-driven markets, speculator-driven markets and aggregated derivative markets. Fundamentals-driven markets I wrote, were things like major currency pairs and interest rate markets, and that these markets were best traded with trend following systems as they tended to produce the cleanest trends. Speculative driven markets I wrote, were things like commodities and these types of markets were much harder to trade using trend trading strategies alone. And lastly, aggregated derivative markets, I wrote, are simply: The results of these tests help to confirm a lot of this. The two major currency pairs that I tested performed best with a purely trend trading strategy, but they also performed pretty well with support and resistance when special attention was given to the trend. The stock market indexes also performed very badly when traded with the trend alone. And trading using support and resistance alone only produced a positive expectancy on the stock market indexes (albeit, it was not a very big expectancy). The real story however, was that commodities and stock indexes both performed very well using a support and resistance trading strategy but ONLY when the market's long-term underlying trend (i.e. it’s long term directional bias) was taken into account. And that paying special attention to this bias, i.e. measuring how long ago it made a new high or low and only trading if it was made recently improved things. For those that are interested in mechanical trading, I have made a commodities trading system for trading gold and silver using this information. |
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