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120 TREND SYSTEMS
‘SELECTING THE RIGHT MOVING AVERAGE 120
 
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 need 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, ifthe 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.
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).
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 forst 1985 pork bellies (Figure 5-11). |tee the bee that a aah average of n-day speed will be neutral over a period of 2days 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 n/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 moving
eak or become neutral with respect to the price move.we ping these re 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. h kiss
‘The longest period needed to offset the largest reversal is 3.1 weeks (eacl h wee sdays), and it takes a 16-day moving average to neutralize the largest move. A 1 ay, 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 Movel/Week Profitable Weeks Total Profit
1 130 8 10.42 1.25 6 753 140 3 424 1.70 5 8.5Total 30.6
—_—_—_—
i i irecti d small losing trades withNaturally, there will be periods of uncertain direction an °this or any price series; however, capturing these four price trends will go a long way
toward profitability.
MOVING AVERAGE SEQUENCES: SIGNAL PROGRESSION
i i to trade. YouConsider the case in which you have selected a 20-day moving average .enter 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? Nes.
‘A moving average is simply a consensus of direction, It is an approximation of tuesintended 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 Bro-gression of trend change from the short term to the long term. This is seen in the followingillustration: 7
Example El. Moving Average Period in Days .
1234567891011 1213 14 15 16 17 18 19 20 21 22 23 24 25
Trend uuuuuuuuu uuuuwuuuuuuddddadad 
122 TREND SYSTEMS
 
 
FIGURE 5-11 Selected trénds and reversals.
 
tSpanaal ee
cree. at
 
 
Unfortunately, not everything is as uniform as this example. The shorterterm 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 5-5 Selecting Trends and Reversals ~~
 
 
Total Needed toRonge Move Duration Move per OffsetTrade (cemts) (cents) (weeks) - Week (weeks)*1. Sustained move up 60-73 3 Jo 13 31Largest reversal down. 66-62 4 “1 492. Sustained move down 76-66 10 8 125 24Largest reversal up 73-76 3 1 3.03. Sustained move up 66-73 7 5 14 29Largest reversal down 3469 4 1 4.04. Sustained move down 73-61 12 7 17 42Largest 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
1234567891011 12 13 14 15 16 17 18 19 20 21 22 23 24 25Trend uudduduuu uuuuuuuusuudddadd
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 ne’ther of these, but occurs in erratic pattern, such as in Example £3. Here we see a dominantlong-term uptrend with the very short end turning down. Because of another downturn 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 E3. 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 E3. Unreliable Turns in Trend<Moving Average Period in Days>
 
1234567891011 1213 14 15 16 17 18.19 20 21 22 23 24 25Trend dddduuuuu uuuuuuuusdd duuudTrend ddddddddddddduuuuo4ud-duuud57d)
‘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 rend andhold losses to a minimum. The risks and magnitude of reward are intrinsic 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, theweeldy 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 that 
TREND SYSTEMS
 
FIGURE 5-12 ~ Sequences of moving averages.
 
‘Moving Averoge Period30
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8xxXxXOO0O0O0OXXXKXXXXXKOOOQOXXXXXXXOOO0OXO0000XOXXXxKOOX/|4xxXXXOOXXKXXXxXXXKOOXXXXXXOOO0O00000000OXXXKXKXKXOXx KK KK KKK KKK KKK KKOOXXKXKXKXODODOODODOOOOOXXXKXXKXXXX KKK KKK XK KKK KKK OOOXXOXO000000000000KxXxXxXxxKXX 8x KX KKK KKK KKKXKXKKODOOODDDDDDDDDDO0OXOXOXXKXKXKXKKXXKXXKKXKKKKKKKXKXKOOODDODDDOXON0D0D0DD0000KOXKXKXXXKXXXXXX KX KK XK KKXKODODDODDODOXODDD000XKOXKXXXXKKXXXX/YxXXKKKKXKXKXKKXKXKOOOOOCOXXXXXOO0OO0000XKXXXXKXKXXKXKXXKXXXX KX XX KKK XK KOKOOOOXXXXXOOODOOXXXXXX XXX XXX XXxXx KKKXXMKKXKKXKKKXKKOOXKXXXXKKXOOCOOXXKXXKXXKXKXKXKKXKXX
 
 
 
y
LIVING WITH A 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 beJosers.
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 proftable 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 Jevel 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 aTrend Trade
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 onasustained 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 isty over. Because the very slow trend lags far
a good indication that the uptrend is nearlbehind 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 be2 cafe way of capturing more profits and being exposed to less market risk—provided the
fundamentals are the ones that were driving the market and your profits.
Avery long-term 
128 MOMENTUM AND OSCILLATORS
ssFIGURE 6-2. Momentum sange.
 
 
Maximum 5-Day Upward Move
    
Maximum
10 aye ove 5
MaximumDistance =Limit Move x5
 
Manumum 5-Day Downward Move
 
The difference in the two approaches is limited by the percentage change in the underly-ing price over the 4-day period between f ~ 1 and £ ~ 5. It is not likely that the change willeven be noticeable on a chart of %M, and it is best to standardize the approach to takingpercentages using ¢— 1.
Price and Trend Difference
It is common for the term momentum to refer to the difference between today’s price anda corresponding moving average value. The properties of this new value remain the same.As the momentum becomes larger, prices are moving away from the moving average at afaster rate. When it gets smaller, the prices are converging with the moving average. Unlikethe first definition of momentum, a value that is positive but converging toward the mov-ing average may actually represent declining prices rather than prices that are advancing ata slower rate. The major similarity is that the peak of the price move is near the extremepoints of the momentum chart.
Figure 6-34 (upper panel) shows 10-period and 40-period moving averages plotted ona 15-minute German bund chart. Figure 6-36 (center panel) shows the difference betweenthe price and the 40-period moving average; the momentum value is fairly uniform, vary-ing by about .50 above and below zero. Because the moving average tends to catch up toPrices over time, the maximum variation of the momentum measured this way is not asextreme as when momentum is calculated .as the difference between two prices. Thismomentum calculation has also been called relative strength, because it is measured rela-tive to a moving average.
Moving Average Convergence/Divergence (MACD)
Momentum may also be seen as the difference between two moving averages, a techniquedeveloped by Gerald Appel and named the Moving Average Convergence/Divergence(MACD)." In its original form, the two trendlines were produced using exponéntialsmoothing, and their difference resulted in the MACD value. This was further smoothed togive a signal line. The most common presentation of MACD uses the difference between a12-day and 26-day exponential smoothing. The signal line, used to produce trading rec-
‘From John D. Becker, “Value of oscillators in determining price action,” Futures (May 1994).
 
MOMENTUM
 
FIGURE 6-3 Momentum as relative strength, the difference between prices and a movingaverage, or between two moving averages (MACD). (a, top panel) 10-day and 40-day movingaverages plotted with I5-minute German bund prices. (b, center panel) Momentum as the dif-ference between prices and the 40-day moving average. (c, bottom panel) MACD as the differ-ence between the 10-day and 40-day moving average values.
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