How To Trade With The Trend
By Bruce Babcock
There are four cardinal principles which should be part of every trading strategy. They are: 1) Trade with the trend, 2) Cut losses short, 3) Let profits run, and 4) Manage risk. You should make sure your strategy includes each of these requirements for success.
Trade with the trend relates to the decision of how to initiate trades. It means you should always trade in the direction of recent price movement. Mathematical analysis of commodity price data has shown that these price changes are primarily random with a small trend component. This scientific fact is extremely important to those desiring to pursue commodity trading in a rational, scientific manner. It means that any attempt to trade short-term patterns and methods not based on trend are doomed to failure.
A good example of such a doomed method is Japanese Candlestick patterns. This theoretical conclusion is consistent with my previous research. Many years ago, just as Candlesticks came into vogue, I attempted to create a profitable trading system incorporating Candlesticks. I tried many patterns and many types of systems, all without success. I have never seen anyone else demonstrate the effectiveness of Candlesticks using objective rules either. Successful traders use a method that gives them a statistical edge. This edge must come from the tendency of commodity prices to trend. In the long term you can make money only by trading in synch with these trends. Thus, when prices are trending up, you should only buy. When prices are trending down, you should only sell.
While this important principle is well-known, traders violate it surprisingly often. They are looking for bargains so they prefer to try to buy at the very bottom or sell at the very top before new trends become established. Winning traders have learned to wait until a trend is confirmed before taking a position consistent with that trend.
Here's what consummate market expert Jake Bernstein said in my book, The Four Cardinal Principles of Trading: "Of all the common market principles, I put 'Trade With The Trend' at the very top. It's a lesson I've had to learn and relearn practically every year. All traders have the tools to find trends. That's what makes it especially frustrating when we go contrary to the trend or when we try to pick tops and bottoms."
The alternative to trend following is predicting. This is a trap that nearly all traders fall into. They look at the commodity trading problem and conclude that the way to be successful is to learn how to predict where markets will go in the future. There is no shortage of people willing to sell you their latest prediction mechanism. We all want to believe that predicting is possible because it's so darn much fun to make a prediction and be right.
Here's Jake Bernstein again with a little dose of reality: "It took me over nine years to realize that, although it may be a romantic and ego-satisfying goal, forecasting is not necessarily synonymous with profit. To anticipate trends is a difficult and often haphazard task, and it tends to lead to losses more often than profits."
Trading with the trend is hard to do because a logical give-up exit point will be farther away, potentially causing a larger loss if you are wrong. This is a good example of why so few traders are successful. They can't bring themselves to trade in a psychologically difficult way.
You can define the concept of trend only in relation to a particular time frame. When you determine the trend, it must be, for example, the two-week trend or the six-month trend or the hourly trend. So an important part of a trading plan is deciding what time frame to use for making these decisions. While it is perhaps easier psychologically to keep the time frame short, the best results come from longer-term trading. The longer you hold a trade, the greater your profit can be. Here's what Russell Sands said in an interview with Commodity Traders Consumer Report. Russell was an original member of Richard Dennis' Turtles group and has built a successful career as a money manager and advisor generally using the Turtle methodology.
"The best approach is to be a long-term trend follower. Trend following is statistically valid in the sense that everybody has tested it for years and years, and it works. "I acknowledge that the market trends maybe 20 percent of the time and chops back and forth in consolidation 80 percent of the time. The trick is how to define where the trend starts and where it stops. If when a market does trend, you get in at the right time, ride that trend and then get out at the right time, you'll make enough money to more than offset the losses you take during non-trending periods.
"Another part of the basic philosophy is that we don't know when the market's going to trend and when it's not. In fact, we don't know what the market's going to do at all. We can't predict anything it does. We don't believe in predictions. Instead, we react to the market."
For the greatest chance of success, your time frame to measure trends should be at least four weeks. Thus, you should only enter trades in the direction of the price trend for the last four weeks or more. A good example of a trend-following entry rule would be to buy whenever today's closing price is higher than the closing price of 25 market days ago, and sell whenever today's closing price is lower than the closing price of 25 market days ago.
When you trade in the direction of this long a trend, you are truly following the markets rather than predicting them. Most unsuccessful traders spend their entire careers looking for better ways to predict the markets. If you can develop the discipline to measure trends using intermediate to long-term time frames and always trade in the direction of the trend, you will make a giant step in the direction of profitable trading.