Trend - Friend or Foe?
What about when those averages are flat?
What's true in life is also true in the markets - when presented with an obstacle, there are all sorts of ways to skin a cat. The obstacle in the markets of course is how to make money, or at least not lose enough to have to flip burgers in our senior years.
For most traders and investors, there are two broad ways to skin that cat - be reactionary and "trade with the trend", or be anticipatory and trade according to other metrics.
I tend to gravitate to the latter, as that has what has provided me the most profit with the least risk over the years. But, as Toddo likes to say, we always want to see the other side of the trade.
Below are a couple of charts that show what kind of results we could have expected when trading with the trend in the Nasdaq Composite index over the past 30 years. What we're looking at are your expected profits when you are trading in sync with the 20-day and 200-day moving averages.
For example, "- -" on the chart means that both the 20-day average and 200-day average are trending lower; "- +" means the 20-day is down while the 200-day is up; "+ -" means the 20-day is up while the 200-day is down; and "+ +" means both the 20-day and 200-day are trending higher.
First, let's look at the average return you would have received by buying the close after the various scenarios and selling the given number of days later.
By buying the Nasdaq any day both moving averages were trending higher and holding for 20 days, you would have earned an average of +1.5%. But doing the same thing when both were trending lower would have given you an average of -0.5%.
Now let's look at the percentage of time you would have had a profitable trade:
Again, looking out 20 days, we see that you would have closed out at a profit 65% of the time when both averages were uptrending, but only 45% of the time when both were downtrending.
While I'll be the first to admit that this is a crude study, there is something that I found interesting. For all of the timeframes, the best combination to be a buyer was when both the 20-day and 200-day averages were trending higher. That's no surprise. But what stands out is the 2nd-best time to be a buyer - when the 20-day average was pointing down but the 200-day average was pointing up.
Buying dips in uptrends and shorting rallies in downtrends are time-tested methodologies that work consistently. Using these two moving averages is one way to determine trend, and there are a whole host of other measures available to gauge "dips" and "rallies", one of which I showed in early May. My personal preference is using sentiment to determine those peaks and valleys, but no matter what you use, try to stick with the long side when we have "+ +" and the short side with "- - ".
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