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This article was written on March 20, 1999. The title was a little bit too cute. "Why do trends exist? " may be a better title.
The most basic idea in technical analysis is "trend following". Simply because it is so basic does not mean that we should over-look it. We always love to investigate why and how.
First question, of course, is why trends exist. Next one is why we have to follow the trend. And why there are 3 types of trends: slow non-resonant, fast non-resonant and resonant.
In analyzing and predicting future events, people tend to focus on a few highly probable outcomes that are more obvious and ignore the low probability scenarios. In some cases, as various possible outcomes become less and less likely to occur, certain previously neglected, less probable scenario (the dark horse) suddenly pops onto the frontline. The market has to discount this surprise discontinuously. (Resonant Trend) Discontinuous adjustments are usually violent and sudden. Some technicians study patterns because they try to distinguish the initial parts of these discontinuous and violent adjustments from random swings.
If no surprise occurs and the fundamentals (supply and demand) point to a clear-cut conclusion, the price will move gradually. At certain point, trend following traders start to take profit and anti-trend speculators (those who love to attempt to pick the tops or the bottoms) take their shots, and hence, a retracement happens. (Slow Non-resonant Trend) If fundamentals are very clear and unambiguous, retracements may not occur. (Fast Non-resonant Trend)
If you understand the nature of these 3 types of trends, then it should be simple. If the direction of a trend is upward (uptrend), then you should buy at the beginning phrase of the uptrend and get out (sell) at the closing phrase of the uptrend. If the direction of a trend is downward (downtrend), then you should sell at the beginning phrase of the downtrend and get out (buy) at the closing phrase of the downtrend.
As we have seen, trends exist mainly because of either underlying fundamental changes (supply and demand imbalance, for slow non-resonant & fast non-resonant trends) or sudden fundamental shocks (neglected scenarios suddenly become fact, for resonant trends). As a result, trends tend to persist for a period of time. Therefore, we have to follow the trend, not fight against the trend. If the trend is up, buy it, not sell it. Sounds simple? Well, in fact, it is very difficult! The most difficult question in trading is "How to define the entry points and the exit points of our trades? "
There are 2 types of trend following methods that by definition, will catch ALL the trends: 1. Moving averages cross over system; 2. Breakout rule.
1. Moving averages cross over system (MA) faces a big problem: whipsaws. The problem with MA is that it gives buying or selling signals even when the market consolidates and forms a range. If there is a range, then there is no trend. "No trend, no trade" is our motto. MA contradicts our motto. You can lose a lot of money in range trading before you catch a trend. Exception: During a major inflationary or deflationary era, when huge moves are often, and when consolidations are rarer, MA can indeed be a very profitable method.
2. Breakout rule is the most popular trend following method. Breakout rule works great in theory: it only gives signals when the price is outside the trading range. However, there are 2 factors against breakout rule: 1. false breakouts; 2. slippage.
(1) False breakouts occur when technical traders (or technical funds) who use breakout rule interfere with the price. Normally, without vast amount of money buying or selling based on breakout rule, price is simply the reflection of the vote in market place. People make their buying or selling decisions on their outlook of the commodity. Every trader is voting. Market price is the final vote of all these buying and selling, the interaction of supply and demand. (I always respect market price under this normal condition. )
Nevertheless, when the technical funds who use breakout rule to trade step into the picture, helped by the locals, they are likely to cause the anticipation of a breakout and hence a false breakout. The Heisenberg principle in physics provides an analogy for this process. If something is closely observed, the odds are it is going to be altered in the process. The more a price pattern is observed by speculators, the more prone you are to have false signals, and false breakouts. At this situation, price no longer reflects the real vote, and the real interaction of buyers and sellers in the market place -- the price may simply be the result of that a breakout system is kicking in.
(2) Slippage is the difference between a theoretical execution price on a trade and the actual fill price. Since there is a large amount of money managed by technical funds who use breakout rule, the fill price (entry point) during a breakout is likely to be horrendous because all these money kicks in at the same time. Slippage is likely to turn some breakout trading systems from money makers (on paper) into money losers (in reality).
Combine (1) & (2), technical breakout approach faces an up-hill battle. The problem is that once you have defined a breakout and taken a position (with bad fill price, i.e. slippage), every breakout guy has taken a position as well. Since there is no one left to buy, the market swings around in the other direction and takes your protective stops out. (i.e. false breakouts)
My experience is that false breakouts way outnumber true breakouts in the market nowadays. If you make $5,000 in catching a trend by following the breakout rule but lose an average $800 in 8 false breakouts, you will end up losing $1,400. This is where the theory meets the reality. Certainly, if we enter a major inflationary or deflationary period, breakout rule will be a very profitable method because the money made by catching a major move (usually very large in high inflationary or deflationary era) will overwhelm the total losses caused by false breakouts. In 1970's, when there was a high inflation rate, traders who used breakout rule were rewarded handsomely.
All of the above are for general information only, not for trading purpose.
If you have comments or suggestions, email me at firstname.lastname@example.org
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