Every week, traders ask the same questions. Which is better: MACD or Bollinger Bands? Which is more profitable: ADX or Williams %R? The search for the best entry indicator never stops. And the answer is always the same.
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.
No Predictions
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.
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.
This distinction matters more than most traders realize. Every indicator on the list above was designed with a prediction embedded in its logic. Bollinger Bands assume mean reversion. RSI assumes overbought and oversold conditions carry predictive weight. MACD assumes crossovers signal future direction. Each one asks the trader to act on what the market might do next. Trend following asks only what the market is doing right now, and whether it is doing it with enough force to stay in the trade. That is a fundamentally different question, and it requires a fundamentally different tool.
- More on indicator issues.
- Here are examples of useless Technical Analysis.
- Breakouts.
Entry and Exit Straight Talk
The entry obsession runs deep. It is reinforced by a trading industry that profits from selling new systems, new indicators, and new signals. But the questions worth asking are never about which indicator is better. They are about what happens after you get in.
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 to 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.
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; 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.
That last answer contains the complete reframe. Most traders walk into the market asking where to enter. A trend follower walks in asking how much to trade given today’s volatility, and what their current equity position can support. The entry is a consequence of that calculation, not its starting point. Position sizing based on volatility is what the TurtleTrader rules were built around. It is what separates a system that survives from one that blows up on a single bad trade. More on risk management here.
How High Will It Go?
The entry fixation shows up in another form too: the profit target. Traders who obsess over entries tend to also obsess over exits, setting fixed targets that cap what a trade can return. The 30% rule is a perfect example of how this destroys performance over time.
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.
The broker’s 30% rule and the novice asking for a price target are different expressions of the same error: replacing the market’s verdict with a personal one. The trend follower has no opinion about how far a move should go. The exit rules are mechanical, triggered by price action, not by a predetermined number. That is the only way to stay in a trade that goes from 5 to 100. More on the Tom Basso approach to systematic trend following.
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.
Support and resistance analysis asks the market to honor levels that are meaningful only to the person who drew them. Trend following asks nothing of the market. It simply waits for price to move in a defined direction with enough force to justify a position, sizes that position according to current volatility, and follows the move until the rules say to stop. There is no negotiation with the chart and no expectation that any particular level will hold. The market does what it does. The system responds. That is the complete picture.
For the full context of how the original TurtleTraders approached entries within a complete system, see the TurtleTrader story.
Frequently Asked Questions
Which technical indicator is best for trend following entries?
None of them in isolation. Technical indicators account for roughly 10% of the overall success of a trend following system. The remaining 90% comes from money management, position sizing based on volatility, and the discipline to hold winning trades. No single indicator, whether MACD, RSI, Bollinger Bands, or any other, functions as a trading system by itself.
Do trend followers buy low and sell high?
No. Good traders buy higher and sell lower all along, focusing on how much money they are making or losing overall. As a trend moves up, a trend follower buys more as the price increases. Trying to buy the lowest price is an attempt to predict a bottom, which runs directly against the reactive philosophy of trend following.
What is the key concern in trend following if not entry price?
Market volatility and current equity. The key question is how big you should be trading based on today’s volatility, not where the market is. On a crash day or the day after, volatility is much larger, so position size must be smaller. The entry level is far less important than the size of the position relative to current risk conditions.
Why is support and resistance a waste of time in trend following?
Because your entry price has only personal significance. The market has no knowledge of where you got in and no obligation to respect levels you consider significant. Whether a market penetrates support or resistance has nothing to do with your entry price. Trend following ignores these concepts entirely and acts on price movement alone.
What should the objective of a trend following trade be?
As Tom Basso describes it, the objective is for the position to go to the moon. The exit plan is defined in advance, but the profit target is not. The trend follower stays in the trade for as long as the trend remains valid according to the system’s rules, taking whatever the market gives rather than capping the return at an arbitrary level.
Trend Following Systems
Want to learn more and start trading trend following systems? Start here.
