In “Reader Question: More On Sell Stops,” reader Jon responded by saying the following:
If you buy only when the index cuts above the trend line and sell when it cuts below it you will, by definition, realize profits equal to the increase in the trend line between these two moments in time!
While that is correct if in fact the trend lines are sloping up, they sometimes continue to head south before heading higher, especially after a large correction. Reader Richard shared these thoughts:
Regarding today’s blog on Sell Stops, there is another reason to not base a Sell Signal on a major trend line. In my experience, when a price curve pierces a major trend line from below, thereby generating a Buy Signal, the trend line almost always still will be sloping downward, and, because the trend line is a relatively long-term moving average, the trend line will continue to slope downward for some time before turning upward.
If an equity’s price would turn downward during the meantime, and if the equity’s price would cross the trend line from above, thereby generating a Sell Signal, the trend line probably will be lower than it was when the Buy signal was generated, thereby resulting in a loss for that trade cycle. Therefore, relying on a major trend line as a Sell Signal would work only when Buy/Sell cycles would be of relatively long durations (which of course cannot be determined in advance).
The market meltdown of 2008, and the subsequent recovery in 2009, is a good example to demonstrate what Richard is talking about. The chart below shows a snapshot in time of the Domestic Trend Tracking Index (TTI) and its buy signal effective 6/3/09:
The trend line (red) was still in correction mode when the price line (green) crossed above it and generated a new Buy. It took about another 4 months before the trend line reversed direction and recovered enough to follow the price line higher.
My experience shows that you need to have at least a 6 months period from a buy to a potential Sell if you are relying on the upward sloping trend line to bail you out.
I have found it much easier and effective to use the upside crossing of the trend line as a Buy point only, while downside protection should be accomplished via your trailing sell stop points.