Tuesday, April 21, 2015

Dow Theory Update for April 21: Dow Theory, Trend following, noise and non parametric systems

Nothing has changed. Primary and Secondary trends remain the same. 


Trends have not changed. So what I wrote in my last post remains valid.

So let’s take advantage of the lack of news, to ponder a bit about trends, their nature and how to make money out of them. Now we have time to get somewhat philosophical, as the markets are giving us pause.

Let’s put it bluntly: To succeed as a practitioner of the Dow Theory you have to have faith in it. There is no way around it.

However, to believe in the Dow Theory you have to believe that trends exist and that the market is not random. A good book to convince you about the existence of trends and why they exist is “Trend Following: Learn to Make Millions in Up or Down Markets” by Michael W. Covel.

The book makes a conclusive case about the nature of trends and why they work. Personally, it helped me do years ago the leap of faith necessary to forget all about fundamentals and just trust the trend. On the other hand, maybe due to my own incompetence, the book did not teach me how to make millions or how to successfully trade the trend.It just helped to be sure that trends exist and are reliable.

The bottom line of all technical-based investments is to recognize a trend, jump on it, and know when to run for the exits. As one succesul trader said in one of the Market Wizards books: "The trend is your friend until it bends in the end".

However, recognizing the trend is not an easy feat. And even more difficult is to know when it really bends and ends.

First, of all there are many trends. One day, one month…one year…Most of the publications I read talk about the trend, but they are not precise enough to tell me what kind of trend. What is to be expected? A trade lasting one day, or one year?….

Secondly, there is a crosscurrent of trends, while the primary trend may be up, there may be a correction running against the main trend and such corrections of themselves are also clearly established trends (although expected to last less than the primary trend).

Thirdly, and irrespective of the time-frame, when many trends are finally recognized (i.e. by a 200-day  MA) it is too late, and the market is ready to stage a reversal. If the reversal is just a secondary correction, then it is not the end of the word, but if it is a change in the primary trend, then you are toast.

So to succeed as trend followers we have to:

a)     Know why trends exist and why it is more likely than not that once started, a trend will tend to last. This is the “faith” element which is vital.

b)     Know what your time-frame is: Are you chasing as a day trader an intra day trend, or are you looking for longer-term  trends (one month, one year?)?.

c)     Know whether your trend recognition tool (be it a moving average, trend line, or the Dow Theory) is well aligned with the time frame in which you intent to trade or invest.

d)     Be very aware that non-parametric trend following (i.e. the Dow Theory) is much less prone to curve fitting and more dependable when looking forward than parametric trend following (i.e. moving average). More about the net superiority of non parametric Dow Theory versus parametric moving averages, here.

We also have to know that the shorter the time frame:

a)     Noise is more pervasive, hence shorter term trends are more difficult to identify and to trade (even a tougher roller coaster). I have developed one indicator that clearly shows that the shorter the time frame, the higher the noise (“noise” being the likelihood of an aborted trend, whipsaw).

b)     There is a marked tendency to mean reversion, thus making trend following more difficult.

After having toyed with trend lines, moving averages, etc. for many years, I came to the conclusion that the Dow Theory is the perfect match for the trend follower really intent on protecting capital and making money. It is sufficiently long-term to avoid the noise plaguing shorter terms, while it is not so prone to whipsaws as moving averages, and not so long term to be a “buy and hold” in disguise (i.e. if one gets obsessed with the “secular” trend, which I find misleading at best, as I have written here).

This is why, after all is said and done, the Dow Theory shines and will likely shine for a long time provided trends continue to exist, which I think they will do as it is imbedded in human nature.

The Dow Theorist

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