Trading
the Trend ...
'The
Trend is Your Friend'.
We've all heard it before, but many of us overlook the value of
this cliche. As far as friends go, you can't find a more logical
and insightful companion to analysing the markets.
The Trend of the Dow
Take the most obvious example - the stock market. Since the low
of 1987 when the Dow dropped over 1000 points to a low of 1616,
the bull market has never looked back, making new recent all-time
highs in the 9600's.
Commodity Trends
A consistent long-term trend is not exclusive to stock indices.
Commodity markets have recently entered the public spotlight as
many of these markets make new all-time lows. However, these trends
have been in place for months and in some cases years. Take for
instance CBOT wheat. This is one of the best markets for private
traders as it requires small margin deposit and is relatively
less volatile. Let's look at how easy it is to accurately predict
and trade the wheat market by analysing the last bull run, using
basic trend theory as the foundation of our analysis.
Trend Theory
By definition an uptrend is a series of successively higher highs
and higher lows. A downtrend, is just the opposite - a series
of lower lows and lower highs. One tip I consistently repeat to
clients is to "let the markets tell you what they are going to
do'. This means let the trend establish itself before you enter.
Defining a Long Term Trend in Wheat
The end of the downtrend for wheat occurred in July 1986, when
it made a low on the continuous charts of 239 (point a). See chart.
The market then rallied to a high of 449 (point b) in January
1989. The next low was made on January 1991 when the market fell
to 244½ (point c). Thus this new low was higher than the old low
of 239. The new uptrend was not confirmed until the old high of
449 was breached in February 1992 at 453 (point d) ie a higher
high. Thus the uptrend is confirmed and the market is a buy.
Entering the Market
There are two ways to enter the market - either on a pull back
or on a break-out. Buying on a pullback means waiting for the
market to settle back to support. On the chart resistance at 310
(point e) - the high made in June 1991 becomes support. With a
stop below the old low of 244½, this would have been a relatively
cheap entry risking only US$3275.
If the market were not
able to retrace to this point, then the breakout entry would have
provided a second bite at the cherry. A buy at a break of 453
with a stop-loss below the last low of 339¼ would be a more expensive
risk of US$5800.
Exiting the Market
On a monthly chart the blow-off top at 717 was a good indication
of the end of the uptrend. Blow-off tops occur when the hype and
excitement surrounding a market are at their peak. Therefore,
despite the rapid and large movement that occurred in wheat in
April 1996, identifying this as a turning point would have been
just a lucky guess for most traders wrapped up in the excitement
of a massive bull run.
The following simple
exit method may have left some potential profit on the table,
but would have been a sensible and disciplined target. This method
involves measuring the point movement from the second wave top
at (point d) to the next low of 282.25 (point f) and add this
to point d. Adding 170¾ to 453 gives a target of 623¾, a profit
of US$15,687 on an entry at 310 (or US$8487 on entry of 454).
Another simple method to exit the market would be to use a trailing
stop. At each incremental move upwards, the stop-loss is trailed
proportionately. For instance, working a 70 point stop loss would
have an even better exit level of 649 with profit of US$16,950
on 310 entry (US$9750 on entry of 454)
Conclusions
The simple example above
is a long term play, and keeping in mind that 10% is the maximum
amount of capital that should be risked on any one trade, it require
a substantial account size. I use this example to emphasise the
substantial profit potential in sticking with the trend. However,
trend theory underlies all time periods, and can be used on intraday,
daily and weekly charts. Although in hindsight the bull run in
wheat was easy to spot, in reality by adhering to the basic principles
of trend theory, there were good opportunities to join the rally
and profit handsomely. Next time you are tempted to dismiss the
larger trend, remember the first principle of trading - the respect
your friend the trend.
** If you would like to comment on this article, or read
other interesting articles on trading and the futures markets,
please visit our website www.tricom.com.au, or call me on (02)
9251-6111.
