We are repeatedly asked: Which is better: MACD or Bollinger Bands? Which is more profitable: ADX or Williams %R?
And we repeatedly answer: None of them. Technical indicators are simply small components of an overall trading system, and not systems in and of themselves. They are like a couple of tools in a tool kit, not the kit itself. A technical indicator accounts for typically 10% of the overall trading success of a trend following system. Comments such as: I tried Indicator X and found it was worthless or I tried Indicator Y and found it useful, make no sense. These statements imply that an indicator is the actual trading system. Nothing could be farther from the truth.
Many popular financial web sites (i.e. CBS MarketWatch, etc.) and many trading books have popularized the idea of technical indicators as Holy Grails. Keep in mind, when you hear the hype about indicators, money management actually makes up the bulk of a winning trading system.
Trend following is not based on support and resistance lines or areas of congestion. Trend following is not based on Fibonacci numbers, the golden mean, nor is it related to the works of Gann or Elliott. The following predictive indicators are not used in trend following:
- No Bollinger bands
- No RSI
- No MACD
- No OBV
- No stochastics
- No ROC
- No Williams %R
- No P/E ratios
- No momentum
- No Advance/Decline lines, etc.
- More …
These indicators are all designed to predict what a market will do. You can discount all indicators designed to predict a market move. They are not, by themselves, a predictive trading system. Technical indicators are only useful as part of a complete reactive trading system.trend following uses a straightforward, reactive, technical indicator as part of an overall-trading plan. The only true method for trading is a long term trend following system that reacts to the market.
Don’t fixate on the technical indicator used in any trend following system. It’s important, but it is not the key. It’s the tool, but not the kit. Moreover, by itself, a technical indicator is meaningless.
Entry and Exit Straight Talk
Q. My understanding of trend following is that if you want to make money, buy low and sell high. Sounds simple. The trick is to identify entry and exit positions and there is a host of guys out there promising that their particular system will solve all your needs. Right?
A. Why do you feel entry and exit is the crucial issue in trading? What if you have an entry that wins 80% of the time but wins you very little money? And what if you only lose 20% of the time, but when you lose, your losses far exceed your wins the other 80% of the time? Additionally, you don’t buy low and sell high. Good traders buy higher and sell lower all along, focusing on how much money they are making or losing (not just winning percentages). Buying higher means that as a trend moves up you buy more as the price increases. For example, let’s say a trend begins at a price of 5 and goes up a 100. Would you only want to buy at a price of 5 or 6 or 7? Of course not. Depending on your system, you might buy at 20 or 30 or even higher. Not sure what we mean? Email and ask!.
Q. If the trend goes to 100, how do you know it in advance?
A. You don’t know. Let’s say looking back into the past we knew a market went from 5 to 100. The point is to ask yourself, when do you buy? At price levels of 5, 6 or 7? At 20 or 30? Buying more as the trend progresses is what we mean by buying higher highs. Trying to buy low is nonsense. You can’t ever know that it is going to go to 100, but you are fully prepared with a precise well thought out strategy so it doesn’t matter that you don’t know. Whether it’s from 5 to 6 or 5 to 100, you are ready to act.
Q. Are you promoting an alternative way of identifying the trend plus a money management system?
A. Realize that identifying a potential trend is maybe 10% of the overall success of a trend following trading system. The key is not where you enter and whether you have a profit or loss on a position. The key is how big must you be trading based on market volatility. That must be your concern. You’re not interested in the level of the market is; you’re concerned with the market’s volatility. For example, if it’s the day of a crash or the day after a crash, the volatility is a lot bigger. So you should be trading smaller. Lose the concept that where you enter is critical. What is relevant is your current position, your equity and where the market is now.
Editor’s Note: Of course, there is an entry/exit method involved in trend following. But, focus on where real trading success comes from: money management.
How High Will It Go?
The other day we were speaking with a successful broker and he revealed that one of his strategies was to ride a stock up for 30% gains and then exit. That was his strategy. Let it go up 30% and get out. Sounds reasonable. But as trend followers know, this type of strategy is prone to problems. The biggest problem being that it goes against the math of getting rich. He is not letting his profits run!
Tom Basso tells the story of the new trader who approaches an old trend follower and asks, “Where’s your objective on this trade?” The old trend follower replies that his objective is for the position to go to the moon. He says, “I have not had one get there yet, but maybe someday.”
When you trade as a trend follower, your objective is to stay in a position forever. You don’t want to think about exiting. Of course, you have a plan for exiting long before you enter the trade, but the idea is to follow the trend as far as it will go up.
Support, Resistance and Entry
Many people use the jargon terms support and resistance. You have probably heard brokers talk of their importance or TV’s continuous babble of predictions, meaningless advice and analysis. The words are used to describe perceived tops and bottoms in a market.
Unfortunately, support and resistance is a waste of time. Whether the market is going to penetrate support or resistance has nothing to do with your entry price. Your entry price has only personal significance. It has no objective significance in the market. The market is not going to go through a support point or go through a resistance point just because of what your entry price is. The concept is not a relevant factor. It’s hype.
Trend Following Products
Review trend following systems and training:
More info here.