Posts Tagged ‘Trend Following’

Trend followers alert: gold breakout!

Sunday, June 20th, 2010

For those of you who are into a trading technique called “trend following” (or “momentum trading”), you will want to know that gold prices had broken out of its trading range last Friday at around US$1256. For those who are unacquainted to trading, trend following traders are always on the lookout for prices that “break out” of a trading range in search for a trend to ride on.

The tricky issue for Australian traders is that though gold prices had hit a record high in US dollar terms, it is still below the record high in Australian dollar terms (in the first quarter of 2009).

Our? friends from Market Club has more detailed explanation on the charts here.

Meanwhile, for those who are into stock-picking, it is time to compile a list of stocks that you want to buy. We will talk more about it in the coming articles.

Are you a range trader or trend follower?

Thursday, April 1st, 2010

Remember, back in Explosive gold price movement ahead. But up or down?, we showed you that gold prices had been bound within a range from February 2009 to the day when the article was written (September 2009). As we showed you in the price charts, the range got progressively narrower and narrower as the months go by. That gave rise to a price formation called the ?pennant.? As we wrote in that article,

A pennant is like a spring coiled up, ready to jump [either up or down] at any moment.

Not long after we wrote that article, gold prices broke out of the range and made a record high of US$1,226.37 on 2 December 2009. Today, gold prices are range bound again.

How to buy and invest in physical gold and silver bullionIn 2005, we remembered the headline from the Australian Financial Review (AFR) screaming “gold fever” as gold prices hit US$500 for the first time in many years. As the crowd piled into gold, driving it to a then record high of over US$730 before a major correction threw it down to a low of around US$540. Then gold was range bound for about a year before making another dash to above US$1000 before the Panic of 2008 crashed it to around the US$700 level. Then it recovered, made another dash to US$1000 before being range bound again. The rest of the story you know.

Do you see a pattern? Basically, the story goes like this: range-bound, break out, dash up, correction, range-bound… rinse and repeat. You can visually see this pattern nicely in the Why gold will not make new highs or lows this year video made by our friends in Market Club (which we have an affiliate relationship with). If this pattern repeats itself, we may see gold prices becoming range bound for the rest of this year before making a record high next year.

For those who are into trading, this is a good opportunity to engage into “range trading.” The principle behind this type of trading is very simple- sell when prices reach the upper range and buy when it reaches the lower range.

For traders who engage in “trend following,” they follow a different approach. They wait for break-outs of the range and buy/sell accordingly. For example, if gold breaks out of the trading range upwards, they buy.

Is it possible to be a range trader and a trend follower at the same time? One old trader told us “No, unless you are extremely smart.” Why? When you see gold prices reach its upper range, a range trader will sell (or short sell). A trend follower, on the other hand, will buy.

What if you are trying to be both? Do you buy or sell?

Is trend following trading risky?

Tuesday, January 30th, 2007

In a nutshell, Trend Following is a trading strategy that buys (or technically speaking, go ?long?) when prices are in an uptrend and short sell (or technically speaking, go ?short?) when prices are in a downtrend. Unlike other trading and investing strategies, trend following only look at one thing for its buy or sell decisions: price. Also, trend following does not try to anticipate price movements or foresee long-term fundamental outlook?it merely reacts to price behaviour.

Does trend following works? Michael Covel, in his book, Trend Following?How Great Traders Make Millions in Up or Down Markets made a thorough case for this trading strategy. We suggest you read his book if you are interested in the idea of trend following.

However, there are some in the finance industry who claim that trend following is very ?risky.? The underlying reason for such a claim is based in the fact that trend following exhibits very volatile returns. Is there any flaw behind such a claim?

First, how is volatility measured? Standard deviation is most often used for measuring volatility. The calculation of standard deviation requires the statistical mean as one of its input. Here lies the weakness for the claim that trend following is ?risky??the underlying assumption behind standard deviation is that prices follow a normal distribution As we said before in How the folks in the finance industry got the idea of ?risk? wrong!, this assumption is generally not true in practice. Price often moves in trends, and the incidence of extreme movements (e.g. 1987 stock market crash) shows that normal distribution is an invalid assumption. Therefore, according to the assumption of normal distribution, meltdowns like 1929 and 1987 are so rare that they occur once every billions of years (we are not sure of whether it is billions or millions, but you get the idea). Thus, if you believe in trend following, you cannot believe in the idea that volatility that is defined by standard deviation is ?risk.?

One more thing: since most of the financial industry uses the faulty normal distribution example as the basis for measuring ?risk,? we cannot help but feel that perhaps much of the financial risks in the world are being wrongly appraised. If that is the case, the next fat-tail event will indeed draw many nasty surprises.