Friday, August 14, 2020

Trading A Trending Market


I had an interesting conversation with a frustrated trader recently.  He lamented that it is impossible, as an active trader, to trade a market that "goes up every day".  Out of this frustration, he had broken rules, placed trades outside his "playbook", and lost money.

It's a great example of how a negative trading psychology can create poor trading, but also follows from poor market understanding.

With a big shoutout to the Index Indicators site, above we see a chart of the SPX 500 (black line) over the past three months.  The green line represents the percentage of stocks in the index that close above their three-day moving averages.

Now here's the important principle:  In any market, there is always a trend component and a cyclic component.  In other words, we can best describe any time series as a linear, directional function plus a dominant cycle.  It is the ways in which the linear (trend) component combines with the cyclical component that creates the charts we see.

In a market with a strong trend, the linear component will dominate and corrections (from the overlying cycles) will be short-lived.  In a range market, the cyclical component will dominate and there will be only a small directional aspect to movement.  If we can estimate cycle frequency by locating trends and ranges within longer time-frame cycles (cycle amplitude is in part a function of volatility), then we can use cycle extremes to more actively trade directional movement.  

The chart above illustrates this concept.  We have had good buying opportunities when the percentage of stocks trading above their three-day moving averages has dipped below 50.  In an uptrend, such pull backs occur at successively higher price lows.  By waiting for the cycle trough, we can participate in the trend with good risk/reward.

So, for instance, buying those 11 occasions in the past three months when fewer than 50% of SPX stocks were above their respective short-term moving averages led to a a 91% win rate with an average holding time of a little more than two days.  Such an active trading strategy did not capture all the gains of buy-and-hold, but the active trader participated in half of those gains while keeping the maximum downside to under half a percent.

The important point here is that many trading psychology problems come from fighting trends.  If we perceive a trend, a promising strategy for active traders is to buy dips at successively higher lows (or sell bounces at successively lower highs).  Trending markets are impossible to trade only if you have no tools for identifying the cycles within trends.