Sunday Musings: Trend Tracking Thoughts

One reader emailed an interesting comment regarding trend tracking and the adherence to strict trading rules. Here’s the relevant part of what he had to say:

I have written to you on the subject previously and thanks for the replies. You have devised a proprietary trend line as I understand it. You have a basic rule that is clean and clear to follow. The price drops below the trend line its in sell territory. Above its in buy mode.

Yet today you put a link to explain to avoid whipsaws you wait until the price drops 1% below the trend line. Rules are rules. Made to be followed or broken or interpreted as one sees fit. Statistical back testing can be fitted to achieve the results one wants or random or whatever.

My basic question is as follows: since your trend line is proprietary its only significance is what you have defined it as and established it to be. This most likely came from years of testing and perhaps trial and error after much research on trend following. Why then would you select (an arbitrary) a percentage to wait past the trend line or a “” couple days”” after falling below the trend line?

Are/have these additional rules also been determined through back testing empirical data or “”gut feeling”” from past experience. I understand you want to avoid whipsaws the bane of trend following. That said, it seems to me it breaks the first rule. Why not just adjust your trend line to incorporate this 1% differential into the trend line itself. Surely the rest of the industry is not using your proprietary trend line such as everyone watches the 200 moving average or 50 or 20 period or whatever.

Is this just yielding to your human nature to avoid a whipsaw to have comfort with yourself that you can justify you waited enough to be sure. Most all technicians have rules and preach to follow the rules. Most all of us humans break rules and that is where we get in trouble.

While it is understandable that you would want to systemize an investment approach to a point so that it can be used without questioning any step involved, or even thinking about it, that is simply not realistic. There will always be some subjectivity. Just look at the process itself an investor has to go through to make fund/ETF selections once a buy signal has been issued.

You may not have been a reader long enough to know that we applied the same process of letting the domestic TTI “clearly” cross to the upside during the last buy signal (June 09) to be sure a sudden market pullback would not create a whipsaw situation.

That is the only reason for using what you might call a trading band around the trend line. Remember, that trend line itself represents the dividing line between bullish and bearish territory.

However, after a bullish cycle, such as the last one, it only has a secondary function as an exit point. Our 7% trailing sell stop discipline will have you out of the market and on the sidelines long before the trend line is crossed to the downside. Those readers with a more aggressive risk profile can use the crossing of the trend line as their “last line of defense” before heading to all cash.

Other readers use the straight crossing of the trend line as their sign to move in and out of the market no matter the percentage. As an individual you can do that by using this tool anyway you see fit. When you handle OPM (Other People’s Money), you are dealing with a different set of circumstances. Clients understand that whipsaws are part of the equation, but they expect that efforts are made to avoid them whenever possible.

That does not violate any trading rules; it merely is a smart thing to do. Case in point is the event of last week, when the domestic TTI sank below its long-term trend line by -0.4%. Remember, there are followers of this method who use the downside crossing as a trigger for setting up a short position, which means you want to be as certain as possible that a bear market has in fact started.

By not following last week’s peek into negative territory, we avoided not only a whipsaw signal as the markets subsequently rallied, but also prevented setting up a short position.

Again, looking at the big picture, the reason for following trends in the first place is to step aside prior to a bear market devastating a portfolio. Second, there is no need to get caught up in details that do not detract from this goal.

We have successfully avoided the brunt of the bear markets in 2001 and 2008, and I do not expect those results to change in the future whenever the next bear rears its ugly head.

About Ulli Niemann

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