Two Types Of Whip-Saw Signals

Reader VR posted these comments:

I understand there are two ways you can get whip-sawed. One is the big bang event in which the trend line crosses from buy-to-sell-to-buy.

The other and more frequent one within the buy cycle is if your fund drops more than a certain percentage points stopping you out and then going back up through the old high prompting you to get back into the market.

Can you give us an insight into any analysis you may have done to tell us whether it is beneficial to follow only the larger cycles or to follow the more frequent cycles within the ‘buy’ zone?

In other words, is it better to just follow the trend line?

The short and incomplete answer would be: It depends on market behavior.

If you have a slow and steady uptrend, with the Trend Tracking Indexes (TTIs) remaining fairly close to their trend lines, then you could use the trend line as your exit point. Actually, that’s what I have done throughout the late 80, 90s and into the year 2000.

Things changed when the tech bubble burst and the markets not only crashed but also whip-sawed several times during the first nine months of 2000. Take a look at a chart of the domestic TTI for that period:

The large red arrows on the left show the highs and lows the domestic TTI made during the blow-off period. It is obvious that, if you had followed the piercing of the trend line as a signal to sell, you would have given back most of your accumulated profits since the Buy of 11/17/1999.

That is the inherent problem. Whether you use the TTIs as I do, or simple 200-day moving averages for individual funds/ETFs, the issue remains the same.

A strong bullish period will drive the price line (green) way above trend line (red). If this happens within a short period of time (6 months or less), the trend line lags too much to lock in any profits in the event of a trend reversal. While you may avoid an above the trend line whip-saw here and there, you also risk giving back most of your gains.

That creates an emotional problem for investors as well when seeing accumulated profits evaporate by waiting for the trend line piercing to generate the sell. I have seen, during violent moves such as the above chart shows, unrealized gains of 40% evaporate down to 3%. While you personally maybe be able to handle that, if you manage money for others, that is simply not acceptable.

The bottom line is that I have found the use of a trailing sell stop, when above the trend line, a far better choice in controlling risk (locking in profits and limiting losses), especially in the volatile environment we are living in.

About Ulli Niemann

Ulli Niemann is the publisher of "The ETF Bully" and is a Registered Investment Advisor. Learn more
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