Selection of the appropriate trading method for the market conditions is an essential skill for succeeding at trading. Given that trend trading is very popular, I thought I might write a blog entry about how I characterize trends and then select the appropriate trading method.

How to Spot a Trend

If you open a chart and the price starts at the bottom left hand corner of the screen and finishes at the top right hand corner of the screen then you have a trend.  That’s it – there is nothing more to it than that. Well actually – there is a little more.

Dow Theory and Trends

I must admit in addition to being a closet trading book junkie, I am a bit of an arm chair student of Charles Dow. Dow theory is more than a hundred years old and many of his theories underpin modern technical analysis and are just as relevant today as they were in his time. When I get around to it I will write up a blog entry on how to apply his theories to the currency markets.

Charles Dow describes a trend as being made up of three components:

• The Primary Trend defines the trend that is driving the market over the long term (months or years). The primary trend is largely driven by the underlying fundamentals of the market, but can also be driven by a long running streak of irrational exuberance or pessimism about the market. In the case of the currency markets, when this blog entry was written, the primary trend of the day is the depreciation of the US dollar.
• Secondary Swings describe some of the major perturbations in the primary trend and tend to last for many days or a couple of weeks. Secondary swings capture the ebb and flow of buying and selling in the market. They are often driven by short term expectations, uncertainty or bullishness about the primary trend.
• Minor day-to-day fluctuations describe the noisy movements of individual bars

If some of this sounds like Elliott Wave theory, it is because Elliott was a student of the Dow.

The Life of a Trend

The primary trend and many of the secondary swings go through a number of phases in their life:

• The first phase is accumulation. At this stage of the market the smart money is starting to accumulate positions at deeply depressed prices because they see value in buying (or shorting). Long before Warren Buffet, Charles Dow was one of the first big value investors. He believed strongly in purchasing value and several of his students made a serious amount of money by accumulating positions just as the depression of the 20s was breaking;
• The second phase is increasing volume. At this stage greater investor participation increases volume and this leads to the steady growth of the trend;
• The third and final phase is the final explosive move. At this stage the public is participating in the market and the price is subject to exaggerated moves due to wild expectations and secondary swings;
• The fourth phase is distribution. At this stage some of the professionals begin selling and the positions are passed from strong to weaker hands;
• The fifth phase is panic. During this stage prices decline rapidly. Inexperienced leveraged investors start dropping positions quickly and the bottom falls out of the market; and
• The last phase is lack of interest where the market has suffered extreme erosion of prices and there are no major participants in the market.

Trend Character

When I look at trends in the market, I like to look for the primary trend, secondary swings and I like to see if I can pick what phase they are in (easier said than done). In addition to this I like to characterize trends by looking at how much the primary trend is disturbed by secondary swings. I know this isn’t classic Dow theory, but I tend to classify markets as “perfect trends”, “classic trends” and “volatile trends”.

When I analyse trends I like to use the Guppy Multiple Moving Average (GMMA). The GMMA consists of two sets of exponential moving averages which run as a ribbon across the screen. I find that the slower set of exponential moving averages is a reasonable proxy for the primary trend and the faster set of exponential moving averages is a reasonably proxy for the secondary swings. Note that these are just proxies, and you need to also track the soap opera of market expectations about fundamentals to get a real handle on the primary trend and the secondary swings.

The Perfect Trend

Just like in surfing there is the perfect wave, or in skiing there is the perfect turn, or in financial markets there is the perfect storm, some markets display what I would call the perfect trend.

The perfect trend is best described as a straight line which follows the primary trend, with very few if any fluctuations from secondary swings or minor day-to-day price action. The daily chart for the USD/CNY is a beautiful example. In this chart the price just moves in one direction – DOWN:

In this trend you can see that the both the fast and slow set of exponential averages are evenly spread out and the there is a nice wide gap between both sets. This shows that the primary trend is not disturbed at all by secondary swings. The Yuan in the above example is definitely in a phase of “increasing volume”. Given that only a few brokers allow trading of the Yuan, the public isn’t participating in the fun yet, so the trend is still being driven by the smart money accumulating Yuan.

These kinds of trends are less common in the currency market. When they do occur it is usually in a carry trade pair or an exotic pair. Many of the major pairs stopped displaying this kind of behavior almost a decade ago when the diversity and number of players in the market increased. In the case of the Yuan, this trend is also an indication of the strength of control the Chinese central bank has over the Yuan.

Trading such trends calls for a straight out position trading strategy using a “buy and hold method”. You simply buy at market, trail a stop down behind it and let the market take you out when the trend bends at the end. That’s it – there is nothing more to it – other then to sit back and watch the money accumulate in your account. The other twist you might consider is to consider pyramiding your position.

The final wrinkle I would worry about with such trades is the cost of carry. If the trend is accumulating slower or similar to the cost of carry, I would step aside from it. For example, the cost of carry for the USD/CNY is about 2% per year and the currency is appreciating at about 3-7% per year. Once you subtract the cost of carry from the appreciation rate, and factor in the risk of currency trading in general, it makes this trend less than “perfect” and you might find that it is more profitable to trade elsewhere.

A Classical Trend

A classical trend clearly displays the primary trend clearly and it also demonstrates classical secondary swings. The recent run on gold is an example of this:

In this trend the slower set of exponential moving averages is evenly spread out indicating the primary trend is in action. The faster set of exponential moving averages bounce off the slower set of moving averages, showing the classic action of secondary swings in motion. Gold in this case is still in a phase of “increasing volume” as it is being accumulated by funds who are concerned about inflation, but the public have yet to really join the party on gold yet.

Trading this kind of trend can be done through position trading. You can either choose to “buy and hold” or if you are skilled enough you can “buy the dip”. In this case the entry signal on the GMMA is when the fast group of exponential moving averages bounce off the slower group.

A Volatile Trend

A volatile trend has a primary trend, but the secondary swings and day-to-day fluctuations are so strong, that you would need to step a long way back from the chart to see the primary trend. For example, the recent trend on the Euro is a beautiful example of this:

In this trend you can see the slower moving set of exponential moving averages is roughly intact, but the faster set of moving averages keep on attacking the slower set. This shows the set of secondary swings are quite violent. Sometimes the secondary swing is so violent it upsets the primary trend and it threatens to collapse. This market is showing signs of a mix of explosive moves, distribution and the occasional panic.

Volatile trends are common in the more mature major currency pairs. This is because many different market participants are trading these pairs for different reasons, ranging from central banks adjusting their foreign currency reserves, international trade and rampant speculation.

If you have the nerve, you can position trade a volatile trend through a “buy and hold” style strategy. You could attempt “dip buying” as well, but you would be thrown out of this kind of trade quite frequently. A better strategy would be to swing trade this kind of market. However, swing trading is not easy and takes a reasonable degree of skill.

This entry was posted on Thursday, March 6th, 2008 at 9:17 pm and is filed under Technical Analysis. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.