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118TECHNIQUES USINGTWO TRENDLINES ig
 
 
FIGURE 5-10 Trading system using two moving averages.
 
Close out long whenprices move between
        
Slow movingaverage\ Fast moving
average
Buy when pricesmove above bothmoving averages
  
Sell when pricesfall below bothaverages
 
Donchian’s 5- and 20-Day Moving Average System
The combined use of two moving averages has been popular among professional advisors.Of these, the most well-known is Donchian’s 5- and 20-Day Moving Average, a methodclaiming one of the longest recorded operational results, beginning January 1, 1961. Thereis no explanation for the selection of these two values, but in 1961 when moving averageswere considered state-of-the-art, they were a reasonable choice. The selections can be jus-tified because of their close relationship to the number of trading days in a week and amonth; even now, similar calendar periods might add some desirable features to a system.
Donchian’s idea is to use a volatility-penetration criterion relative to the 20-day mov-ing average, but with some added complication. The current penetration must not onlycross the 20-day moving average but also exceed any previous 1-day penetration of a clos-ing price by at least one volatility measure.
The 5-day moving average serves as a liquidation criterion (along with others) and isalso modified by prior penetration and volatility. These features tend to make Donchian’svolatility measurement self-adjusting. Even if selected poorly, the new penetration mustexceed prior breakouts; without thorough testing, it may be difficult to determine whichrule has more significance. To maintain a human element, Donchian requires execution ofcertain orders to be delayed a day if the signals occurred on specific weekdays or before aholiday, The combination of different factors is generally the result of refinement overyears of actual operation, but neither complexity nor sophistication_guarantees_ success,only the results will tell.
More Than Two Moving Averages
If two moving averages improve trading, it should follow that three or more are even bet-ter—but it doesn’t, With the use of two moving averages, there is a main trend identifierand a timing device; the addition of one or more averages or indicators must fulfill a dis-tinct purpose. When multiple moving averages must agree on the same. signal, there is less
* Richard D. Donchian, “Donchian’s 5- and 20-Day Moving Averages,” Commodities Magazine (December 1974).“120 TREND SYSTEMS
 
chance of getting a trading signal and less time holding the trade. The results of movingaverage systems using two and three moving averages are covered in Chapter 21.
COMPREHENSIVE STUDIES
Because computerized testing programs have made it easy for anyone to test any numberof trends in combination, there have been very few comprehensive studies publishedwithin the past 10 years. Nevertheless, there is a great deal to learn from putting the resultsof various systems and markets side by side. Earlier in this chapter there is an informativecomparison of six major trending systems; others studies have been included in Chapter21 (“Testing”), Among them are systems similar to the single and double moving averagemethods just discussed, as well as the selection of a third trend for entry timing. An impor-tant objective of the testing process is the longevity of the parameters selected; this dis-cussion can also be found in Chapter 21.
SELECTING THE RIGHT MOVING AVERAGE
Up to now, the selection of the right moving average, the one that will work in the future,has only been discussed in general terms. The best moving average speed for a hedger maynot be the same as for a speculator. For example, a hedger may be marketing cattle eachmonth and may néed to choose a time at which to preprice his or her product. A 3-daymoving average might generate five sell signals in 1 month, each the result of a 2-day pricemove—an ineffective tool for the hedger. The hedger needs an average of one sell signalper month to be a useful timing tool; the speculator has no such concerns.
For the speculator, the right moving average speed is the one that produces the bestperformance profile. This profile could be simply maximum profits, or it could be a morecomplex combination of profits, equity variation, and use of margin. In Chapter 21, thecomputer is used to find the combination of speed, stop-loss, and other rules that best sat-isfies a preset criterion; a computer, however, is not always necessary.
Computer testing of a trend system or other trading strategies sometimes leads to solu-tions that are highly fitted. The computer may find that a 3-day moving average was moreprofitable with lower risk than a 20-day trend, which was only slightly worse in perfor-mance. Our logic tells us that the results of the 3-day system will be more‘difficult to attainin real trading, because execution costs in fast markets with many trades may be higher thanexpected. A slower selection is more conservative and more likely to return the expectedresults. However, the trader must be the judge of whether the selection is reasonable.
A grain trader knows that the seasonal price pattern forms a complete cycle each year.At best we can expect one long upward move followed by a shorter, faster decline. -Not alltrend speeds can capture the profits in this pattern. For example, if the uptrend lasts for sixmonths, a 6-month moving average won't see any of it; therefore, you will need a movingaverage not much longer than % of the length of the trend and perhaps shorter. If mass test-ing of moving averages using an optimizer results in a best moving average period of 6months, that choice must be understood as a failure of the system to find any shorterperiod that worked. ue
Selecting the Trend Speed
Observation of a price chart will show the trends of the market. The trends that two traderssee will often be different. Some traders immediately focus on long-term price trends;
* Perry J. Kaufman, “Moving Averages,” in Trading Tactics: A Livestock Futures Anthology, Todd Lofton (ed.)(Chicago Mercantile Exchange, Chicago, 1986).SELECTING THE RIGHT MOVING AVERAGE 121
 
others see much shorter movements. To find your own best moving average speed withoutthe use of a computer, look at a price chart and mark the beginning and end of each pricemove that you would like to capture. These trends may occur every few days, or only threeor four times each year. In this exercise, the major trends were selected from the chart forAugust 1985 pork bellies (Figure 5-11).
Use the fact that a moving average of 2-day speed will be neutral over a period of ndays in which the price returns to the same level. (Remember that a 1-year moving averageis used to remove the annual seasonal effects.) If the daily price changes are nearly equal,one leg of this move (the trends identified in Figure 5-5) will occur in /2 days. To be cau-tious, select moving average intervals slightly longer than two times the worst retracementwithin the trend to prevent being stopped-out of the trend.
When calculating profits generated by a moving average, part of the trend movementis lost at the beginning and end of the trade. This part is equivalent to the price changeover % of the moving average period, because it requires that much time for the movingaverage to break even, or become neutral with respect to the price move.
Keeping these two points in mind, the best trend speed can be selected from present-ing the largest moves and largest reversals, as shown in Table 5-6.
The longest period needed to offset the largest reversal is 3.1 weeks (each week is 5days), and it takes a 16-day moving average to neutralize the largest move. A 16-day mov-ing average usually requires 8 days to break even. Allowing 2 weeks (10 days) of pricemovement to reach the break-even point, the following profitability remains:
 
Trade Move/Week Profitable Weeks Total Profit
 
I 1.30 8 10.42 1.25 6 753 1.40 3 424 1.70 5 8.5Total 30.6
 
_ Naturally, there will be periods of uncertain direction and small losing trades withthis or any price series; however, capturing these four price trends will go a long waytoward profitability.
MOVING AVERAGE SEQUENCES: SIGNAL PROGRESSION
Consider the case in which you have selected a 20-day moving average to trade. Youenter the day with a long bond position and you get a sell signal. However, you don’tknow because you are not looking, but the 19-day and 21-day moving averages did notget sell signals. This means that the day that was dropped off the calculation 20 days agocaused a slight shift not seen by the other neighboring trends. 1s this important? Yes.
A moving average is simply a consensus of direction. It is an approximation of valuesintended to put you on the right side of the market more often than not. It is most fallibleat the time prices are changing direction or going sideways. Any information that clears upthe problem is helpful. For any moving average system, we would like to see a steady pro-gression of trend change from the short term to the long term. This is seen in the followingillustration:
Example E1. Moving Average Period in Days
1234567891011 12 13 14 15 16 17 18 19 20 21 22 23 24 25Trend uuuuuuuuu uuuuuuuuuudddddd122 TREND SYSTEMS
 
 
FIGURE 5-11 Selected trénds and reversals.
Tp pe
+44
 
Unfortunately, not everything is as uniform as this example. The shorter-term trendscan be very erratic, and they often appear in small groups of uptrends and downtrends(see Example E2). This is easily explainable because adding and subtracting 1 day, whenonly 2, 3, or 4 days are used in the moving average calculation, can quickly.change thedirection of the trend. As you get to longer intervals, such as 20, 30, and 50 days, this is notthe case, and in reality, it doesn’t happen often. Yet, when it does, it is clearly an odd casenot to be trusted.
 
TABLE 5-6 Selecting Trends and Reversals _
 
 
Total Needed toRange Move Duration Move per OffsetTrade (cents) (cents) (weeks) - Week (weeks)*|. Sustained move up 60-73 13 JO 13 3.1Largest reversal down 66-62 4 vy 402. Sustained move down 76-66 10 8 1.25 24Largest reversal up 73-76 3 ' 3.03. Sustained move up 66-73 7 5 14 29Largest reversal down 73-69 4 ' 4.04. Sustained move down 73-61 2 7 7 12Largest reversal up 63-67 40 2 2.0
 
*The number of weeks of profitable movement needed to recover the loss due to the largest reversal.LIVING WITH A TREND-FOLLOWING PHILOSOPHY 123
 
Example E2. Moving Average Period in Days
123456789 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25Trend uudduduuu uuuuuuuuuudddddd
There are also cases in which the longer trend begins to reassert itself and the resultsappear the same as in Example E1, however, the trend change occurs from the longer termdown (from right to left instead of left to right). The case we must watch for satisfies nei-ther of these, but occurs in erratic pattern, such as in Example E3. Here we see a dominantlong-term uptrend with the very short end turning down. Because of another downtum afew days ago, which then disappeared, this most recent downturn also caused a shadowturn in the 20-day range. Is it a leading indicator or a false signal? All indications are thatsmooth changes in a trend are a more reliable indicator. Another case is given in the sec-ond line of Example £3. Here, the smooth trend change from up to down is occurring fromleft to right; however, as it gets to 13, days, it also jumps ahead to 19 and 20 days, leavingthe 14th through 18th days still in an uptrend. Again, we favor the orderly approach andwould wait for all trends to change below the one we are using.
Example £3. Unreliable Turns in Trend<Moving Average Period in Days>
123456789 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25Trend dddduuuuu uuuuywuouusidduuus48AdTrend ddddddddddddduuuusud:duuuedu5 4
An example of this process is shown in Figure 5-12. Moving average calculation peri-ods of 5 to 50 days are shown in increments of 5 days for a total of 44 consecutive days.This illustration points out how the long-term uptrend (X) is breached by shorter-term,less consistent trends. Perhaps the best trend is the one with the majority of Xs or Os onthe same line.
LIVING WITH A TREND-FOLLOWING PHILOSOPHY
The advantages and disadvantages of trend systems are similar to most other types of trad-ing strategies. The first question that a trader. should ask is, “What can I expect from a trendapproach?” The calculation period of trend will change the profitability, size of individualprofits and losses, and reliability. This is covered thoroughly in Chapter 22. Fast trendsenter trades on the first strong move following a price reversal; slower averages take moretime to identify a trend change. No matter what its speed or how well-timed, a trend signalcan never occur at the right point; consequently, watching prices vary with respect to thetrendline will be frustrating. The moving average system will rarely enter or close out aposition at just the right place; it can only extract profits from the middle of a trend andhold losses to a minimum. The risks and magnitude of reward are intcinsic to the speed ofthe moving average although the risk/reward-ratio may be similar for many moving aver-ages. The success of such a system can only be judged by its actual performance; thus, theweekly or monthly accumulated results should be studied rather than simply observing therelationship of the trendline to prices. -
The slower the trend, the further it will lag behind a sustained price move. Professionaltraders lean toward the faster trends and portfolio managers toward the slower. Whentrading only one market, individual trade risks can be kept small using faster trends. Theportfolio trader can offset the long-term adverse move in one market with an equally longfavorable trend in another. The advantage of diversification and long-term trends is thateach market will move in the direction of the trend a majority of days, even though thatTREND SYSTEMS
124
FIGURE 5-12 ~ Sequences of moving averages.
 
Moving Average Period
15 20-250 (30 35 40 5 50
10
Day
 
 
7xx KK KKK KKK KKK KKOOOOOXKXKK XK KOO XK KKK KK KK KK KKK KKK
x xX KKK KKK KKK KK OOCOOOOKXKKXOOOOKOXXXX KKK KKK XXX KKK KKK KKK KKK OOOOOOXXX KK O00000XXKXXK XK KKK KXKKK KK KK KK KX OX KOO 00000X000000 000K XxX KK KKK RK XKX KK KXKKKKKKOXODODDIDDIVDOXODDD00000 XX KK K K KKK KK KKxX XXX XXX KOXKOXODDDDODDDDDDDO00OXX XX XXX XX XXX XXXxXxXKKKKKOODDDOOODDOVOOOXOXKO00 XK K KK KKK KK KK KK KKxxx XK XXX OO0O00000000xXxXxXxXxKxKOOXXXX XXX XK XXX XK XXXOXXXXXXOODD00000000XXXX XK OOX XK KK XX KKK O'O XK XX
XxOOXXXKOXOO0O0O0OXO0000KXKxXKXKxXxKXOOO0OXKKKXXxXKOOO0O0XXXLIVING WITHA TREND-FOLLOWING PHILOSOPHY 125
 
may mean only 6 out of 10. A portfolio of 10 markets, each with a 60% probability of amove in the trend direction, should result in 6 of them moving in a profitable direction. Itis more likely that all of them will be profitable on the same day than it is that all will belosers.
Slower trends are more likely to endure than faster ones. These slower trends oftenprofit from fundamental market changes, such as seasonality, production cycles, and infla-tion, They stick to a trend while it develops. The faster trends are attempting to catch shiftsin market psychology, short-term cycles caused by trading patterns and current events, andwide swings in high-priced, uncertain markets. The patterns that make fast trading prof-itable also change quickly. A 3-day moving average may be highly profitable for one month,then produce consistently losing trades.
“Take Your Profits and Let Your Losses Run”
Many traders are guilty of profit-taking using trend systems. Cutting losses short is anintrinsic quality of a trend-based system as is its lag. It is inevitable that a trader will wantto close out a trade that has a $1,000 profit and a stop-loss at a level that captures only$300. However, this places an arbitrary limit on potential profits while letting lossesremain at their natural size. A trend-following system compensates for many small losseswhen prices sustain a large trending move. Don’t cut it short.
Using Other Reasons to Exit a Trend Trade
Avery long-term trend will often find the direction of the underlying economic fundamen-tals. For example, a 1-year Treasury bond trend would have been long for about five yearsduring the late-1980s. Once you understand that the position you are holding is based on asustained economic situation, you can exit the position when that situation changes, Look-ing at the T-bond example, prices continued to rise (interest rates fall) to offset slow eco-nomic growth and high unemployment. Once the Central Bank (the “Fed”) raises rates, it isa good indication that the uptrend is nearly over. Because the very slow trend lags farbehind the actual market price, it may be another year before prices cross the trendline andsignal a change of position. This is also likely to occur after a large part of your profits havebeen given back to the market. Exiting the trade when the fundamentals change would bea safe way of capturing more profits and being exposed to less market risk—provided thefundamentals are the ones that were driving the market and your profits. 
Momentum and Oscillators
price levels. Among technicians, momentum establishes the speed of price move-
ment and the rate of ascent or descent. Analysts use momentum interchangeablywith slope, a straight-line angle of inclination of price movement as measured from a hor-izontal line representing time. Momentum is also thought of as force or impact; it is oftenconsidered,’as in Newton’s Law, that once started prices tend to remain in motion in asomewhat straight line.
Rate-of-change indicators, such as momentum and oscillators, are used as leading indi-cators of price change. They can identify when the current trend is no longer maintainingits same level of strength. This gives the trader an opportunity to begin liquidating theopen-trend trades before prices actually reverse. As the time period for the momentumcalculation shortens, this technique of leading a trend changes to become more aggressiveand is interpreted as a countertrend method. Use of a rate-of change indicator anticipateschange even sooner. :
Before beginning a discussion of various momentum calculations, a brief comment onterminology will be helpful to understand how various techniques are grouped together.We begin with a single price, which has no movement. When we talk about bonds at 110or gold at $400 per ounce, we are relating a price level and not implying that prices aregoing up or down. Next, we describe the speed at which prices are rising or falling. It is notenough to say that the S&P rose 3 points; rather, you must specify the time interval overwhich this happened “The S&P rose 3 points in one hour.” When you say that you droveyour car at 60, you really imply that you were going 60 miles per hour, or 60 kilometers perhour. This description of speed, or distance covered over time, is the same informationthat is given by a single momentum value. -
The last measure is one of change in speed, which is either acceleration or decelera-tion. The price of the Deutschemark may have risen by .0150 dollars per mark in the pastweck, indicating an average speed of .0150/5, or a rise of .0030 dollars/mark per day; how-ever, it started rising slowly and increasing its speed over the week. Perhaps the mark rose-0010 on Monday, .0020 on Tuesday, .0030 on Wednesday, .0040 on Thursday, and .0050on Friday, increasing in speed (or accelerating) by .0010 each day. The term rate of change(ROC) will also