Trend Following Using Two Techniques
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Hi, in today’s video we discuss the role of market direction and the impact it has on your trading success.
Good trading is not just about making money all the time, It is rather about making a lot of money when the time is right, and focusing on preserving that money when the time is not right. For example, I constantly share my equity curve for all to see, and to date this captures the last 8 years. You can see how I have managed to grow the account at a consistent pace in good market periods and then contained the damage in not so good market periods.
Whilst the equity curve looks to be on a solid trajectory over the longer period, if we segment some of the curve, we can see periods of lack luster performance too. Having traded the markets for decades now, my expectations are aligned to these poorer performing periods, the trick is however to stop them from turning into significant drawdowns, which are more prone to occur in bad markets.
When traders follow the same processes, rules, and trading mechanisms in bad markets just as they do in good markets, they are very susceptible to higher drawdowns, sometimes giving away all the profits and more. A perfect example of this is Cathie Woods Ark Innovation fund, we can see on this monthly chart how price accelerated from April 2020, peaked in 2021, and then crashed to a lower point than when it started. This downward move was in alignment to a broader world market decline in 2022. It still baffles me how such a high-profile fund had zero risk management whatsoever.
To confound their ignorance of market direction even further, Cathies fund decided to sell the company Nvidia just as it started to be one of the best performing stocks at the start of 2023.
Just to recap on how inept these decisions were, the fund held everything throughout the market decline and started to sell its best performers as the market began to move back up, words fail me…
Let’s move away from that buy and hold type approach to a more active position management style. There are several ways in which we can avoid such major drawdowns whilst being more aligned to the overall market, this could be through singular position management in way of a stop loss or a specific indicator, for the purpose of this video however, we look at overall market direction and portfolio performance to decide on how we apply our strategy.
It's not difficult to understand that when the overall market is declining, more of our long positions will fail, just as a strong upward market will result in more of our trades becoming profitable. Therefore, the key to good trading is to have a process that is adaptable and conducive to the overall market.
Let’s get to the obvious question - how do we determine and trade different market directions?
Markets generally follow cycles, there are bull markets that last for perhaps one to three or more years, then there is a correction/consolidation that lasts for maybe 6 to 18 months, and then the cycle often repeats. Occasionally there are periods of decline or bear markets that take the market down violently, as it happened in the dot com period, the great financial crisis, and more recently during the pandemic.
There are several ways to determine the market direction. One can follow the Dow theory which we discussed in one of our previous videos. The theory when applied to the index, is arguably the most accurate way to conclude the direction of the market, however this approach alone can be lagging and perhaps not the most efficient approach for a trader.
In essence, the theory says that the market is in an uptrend if it makes higher highs and higher lows. For example in this chart showing the S&P500 index, the bull run started in 2020, the uptrend was only confirmed when the market surpassed its previous swing high after making a higher low.
Similarly, downtrends or bear markets are characterized by lower highs and lower lows, as can be seen in the recent downtrend in the S&P 500 during 2022.
The problem is however that the high and low analysis is done in retrospect.
Though Dow theory is the easiest way to determine the market direction, traders take several other routes to find the state of the markets. Some of them are quite complicated, relying on too much data, whilst some of them give too many false signals leading to high portfolio churn. The Dow Theory however is a solid starting point.
In one of our recent videos we showed how the 10 and 20 Exponential Moving Average Crossover has become the foundation of our strategy. When used in conjunction with the S&P 500 index it has proven to be highly predictive of market trend, and for us, the optimal tool to adapt our trading strategy. In fact, had we completed the analysis prior to the 2022 market decline we would have eliminated losses almost entirely. Rather than discuss the detail in this video I highly recommend you taking a look.
Another way to determine the market direction is to look at your own recent trading statistics. If your recent win rate has declined significantly in the last batch of trades, perhaps it’s because the entire market is choppy and not conducive to your approach. If however your trade success rate has improved significantly, then it is an indication that the market is perhaps healthier.
The adaptive approach to position management, based on trading performance is something I apply through the use of the Kelly Criterion method, in which my position sizes will change in accordance to my trade statistics, which again is more often than not a direct correlation of the broader market direction. Again, it is another video I suggest watching.
The 10 & 20 EMA strategy and the Kelly Criterion position management approach can not only be objectively predictive of the market direction, but also reactive in terms of adapting your strategy accordingly. Ultimately, we only apply the approach in alignment to market direction in combination with the appropriate position size, by doing so we improve win rate probability and overall equity profile.
I preach the importance of discipline regarding the rules within a strategy, and this becomes even more important when the market becomes hostile. Losses can pile up quickly without objective rules, whether that is the setup, position size or market direction.
Many traders become emotional and start trading irresponsibly or revenge trade to recover lost money, the management of such a situation lies within your mindset, however the route cause to the problem is to not allow those losses to build up, often a result of not trading in the direction of the overall market direction and with too much position size.
When your trading stats or market direction analysis suggests a non-conducive environment, you must adapt your strategy accordingly. That’s how you become a more mature and profitable trader.
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