Why the Trend is My Friend

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  • on June 28th, 2010

In prior posts, I’ve debated fundamentals vs. technicals. Inside of technical analysis, trend following vs. mean reversion is another subject of debate.  I do employ mean reversion techniques to my entries and exits to improve pricing, but am firmly in the trend following camp when it comes to selection.  This starts with my belief that markets move in the direction of change, and the delay by investors to act on this new information is the best edge I can find.

But there is another reason that is neglected in most of the debates.  By acting with the trend, we often get a 2nd chance to make that exit we missed the first time.  Trend fighters can certainly profit, but must be right on the timing of both their buys and sales.  That’s a tall task…I’ve been trading for nearly 20 years and still find difficulty distinguishing between a) a winner that should be left alone and b) one in which a profit should be taken.  When you own a stock making higher highs and higher lows, in most cases even a major selloff is followed by some type of retest of the highs.

This is not the case with a downtrending stock, as each move is a lower low and lower high…these bounces can be captured, but you really need to nail it on the first pitch.  I’m surprised only Brian Shannon repeats this, but in an uptrend the sum of the rallies must be greater than the sum of the declines, and vice versa for a downtrend.

Witness gold.  It ripped higher to finish the week of June 18, nearly lifting to levels that required adjusting my position.  (In short, my strategy with ETFs is to own them using bull call spreads, adjusting the long strike if and when it goes in my favor.  This gives me a built-in initial stop, and lets me keep my full upside).  Anyway, my thought coming into June 21 was to lift my long call in $GLD to the 124 strike from 121…a reduction in exposure but still there if it runs hard.  It looked a little higher overnight that Sunday, but by the opening it was flat and then got crushed for 2 days.  Dammit!

Here we are a few days later, and the retest of the highs arrives.  I have no idea what gold will do from here, but was given a 2nd chance to adjust my position.  Contrast that to a counter trade like buying BGU.  I was intrigued by the failure of the market to accept lower prices on Friday morning, and thought the annual Russell rebalance was putting a temporary lid on large cap stocks in favor of small.  Rather than give me multiple chances to exit profitably, it gave me repeated chances to buy at better prices…the exact opposite of what I want my position to do.  I was lucky to move on without losing, but only because I happened to make a solid exit.

When asked why I don’t buy “cheap” stocks, that is why.  I’m not talking about value investing, in which a smart fundamentalist digs in and is willing to wait for value to be recognized.  I mean buying because a stock is down from where it was, a strategy completely lacking in edge.  Not only would I need to buy it perfectly, but also need a perfect sell in order to beat the losing holders to the punch.  And I’m far from perfect on my best day.

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

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