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One of the axioms of trend trading is that the trader must take every trending signal the given system throws up. It is impossible to tell which trend will be strong and which trend will fizzle out. Trend trading systems may often see a sequence where several moves fail, before one move really takes off. If your system is not yielding good results, you can change the system parameters. But you cannot arbitrarily decide which signals to take and which ones to ignore.
I tend to trade with the trend while holding strict stop losses and being prepared to reverse and take a position in the opposite direction. However, this has its own serious dangers.
First, if the stop loss is too close to the market price, it is possible to be stopped out early while the trend is alive. Second, if the movement changes from trending to range-trading, rather than to reverse-trending, you can easily end up with a series of losing trades in both directions.
For example, let’s say you decide to take an up trending signal in a stock at 135. You decide to set a stop loss at 132 — three units below your entry price and you go long. You also decide to move the stop loss up every time the stock rises five points. If the stock drops to 130 — five units below the entry price, you will go short instead, with a stop loss at 133 — or three points above entry.
The stock rises to 145 – so far, so good. Then it retracts to 141, triggering the stop loss. The stock drops to 139, triggering your short signal. Then it jumps to 147, and then to 150. You go long at 145 (after exiting the short at 143). Now, it drops again to 142, triggering a reverse sell signal. You go short. The stock goes back to 148 and then it drops to 141. It keeps triggering signals, which lose money. This is no longer a trending pattern and your stops are too close to the price to decode changes in pattern. One way to reduce losses in this sort of situation is to use a double or triple confirmation condition built into the system. For example, suppose the first signal is a 20-session high or low. Then the confirmation may be a moving average based buy signal – for example, you will take the trade only if the five-day moving average (DMA) rises above 10-DMA. A third confirmation would be to to check if the move aligns with market breadth. That is, if the market advance-decline ratio is positive, you take long trades and ignore short trades and vice-versa, if the advance-declines ratio is negative.
However, even with such filters, a period of range-trading can cause high losses. Checking potential drawdowns is necessary to avoid taking on a system which could ruin you before it starts making profits.
The author is a technical and equity analyst
