TREND RECOGNITION

TRENDS

Interestingly, and perhaps revolutionarily, the most successful traders in the world—although not as well known as Soros or Buffet—have long term (over ten years) rates of capital appreciation of almost twice as much as these luminaries. Such rates, of up to 60% a year, would never be predicted if markets were completely random; indeed, the chances of such rates of return have been compared to the spontaneous production of aircraft in windswept junkyards: there is simply no way the rates of return of Soros and Buffet are random, let alone those who double their long-term returns. Among those who do are Ed Sekoya, formerly of MIT and the first to write computer programs to trade stocks, and John Henry, the manager of a hedge fund (and owner of the World Championship Boston Red Sox). Successful trend followers are distinct from other market players in their refusal to predict prices. Rather, they identify trends, using mathematical and chart-based techniques. Once a trend is identified, the trend follower bets that the trend will continue. Since he or she doesn’t know when the trend will stop, the trend follower uses a stop loss order below the market (if long or having bought stock, commodities, or other instruments) or above the market if short (if having sold borrowed stock, commodities, or other instruments). The stop is kept outside normal volatility fluctuations which, if exceeded, might indicate a change of trend. By cutting losses quickly, but staying in trends until they end, trend followers do not try to outsmart, but rather stay in trending markets. Some report that while their intellectual analysis persuades them of a change of trend, they defer to their objective mathematical measures that a trend is still in progress. In retrospect, certain simple but effective systems—such as buying stocks that have doubled in price from their 52 week lows to reach all time new highs when they have relative strength of 80 or over (relative strength, which measures a stock’s price performance relative to the market as a whole, can be found in Investor’s Business Daily, and at Barchart.com in the Sectors section)—and selling them when their relative strength reaches 75 or lower—can be recognized as trend-following systems. Another example is the system of Stan Weinstein, originally a commodities trader. Weinstein exhaustively studied charts and read works of technical analysis looking for systems. His system, explained in How to Profit in Bull and Bear Markets, is a trend following one that buys stocks that move through their 30 week moving average to the upside, and sells stocks that move down this average to the downside. He then does not try to predict, but rather uses stops to get out of successful positions. Many of Livermore’s precepts, such as “trailing along” stocks that have normal reactions can also be recognized, in retrospect, as trend following methods and systems. The most successful trend followers follow several trends at once, both uptrends and downtrends, in markets around the world. Some trends can last for decades. For example from the early 1980s to 2001 stocks trended strongly higher while commodities decreased in value; in the two decades before that, however, commodities rose in price while stocks stagnated or decreased in value.

In summary, the most effective means of making money in the markets appear to be by trend following, a system which works best when mathematically automated to recognize and ride trends within normal levels of volatility.