Everyone talks about it but how do you actually do it? Introduction to some really simple technical analysis.
I am sure you are familiar with the phrase “Buy Low Sell High” when it comes to markets/investing and the reason why it is so popular is because in almost every finance/investment article or publication you would ever read, somewhere in there the author would have advised you to follow this principle. However, in most cases no one really ever tells you how to do it based on a set of specific rules and instead usually the focus in on general guidelines such as buying when the economy is doing well, buying at low valuations etc.
For those of you who have been doing investments in the past may recognize that making such a claim is way easier than it is actually to implement it in practice. There are many reasons for failure to implement it successfully over time but the primary among them are
- Emotional urge to sell in panic when market drops after purchase.
- Lack of any guideline on when is actually a good time to sell etc.
For individual stocks it is even more difficult to implement a buy low and sell high strategy as a cheap stock may become cheaper still or the company may even go bankrupt, so how low is low when making a buy decision and similarly how high is high before you should sell as many of us have watched with regret a stock continue to trend higher after we sold it off.
First of all, let me clarify that I do NOT have a magic formula and nor can I guarantee that the methodology I will share with you will work perfectly at all times. Secondly, I must categorically state that the method is designed to work with indexes (Index funds or ETFs can replicate Indexes) or diversified portfolios such as mutual funds.
Before I proceed further, please look at the charts for S&P 500 Index since 1975.
S&P 500 (normal scale)
If you have been an active investor, you would notice that although the markets are currently at their all time highs, there have been several periods of significant drops in value in 1980, 1987, 2000 and 2007 which are more apparent in log scale chart as given below.
S&P 500 (Log scale)
Although a buy and hold investor would be doing fine at this stage, the key to remember is how you felt in 2002 and 2008? Were you happy that you had exited earlier (sold high) and now were able to buy low? Or were you stuck holding paper losses wishing that you should have booked profits earlier? Or worse still, did you end up doing exactly the opposite and instead sold near the bottom of the marking due to panic and the fear that you may lose even more money?
So is there a system to help us in such situations and use it as a guide to help in making decision whether to sell or to buy? Well, the short answer is yes – there is, but as mentioned before, it works on diversified portfolios over long periods of time.
Buy Low (NOT LOWEST!) and Sell High (NOT HIGHEST!)
The methodology is based on trend following technical analysis but the trick is to keep it simple (i.e. only use one indicator), and use it only for long term charts and not over short periods of time as it is almost guaranteed to fail.
Here is how it works:
- Identify an investable index/diversified portfolio such as a mutual fund or an ETF.
- Obtain a weekly closing price chart for the index. Google finance is a good place to start as it carries data for most indices and provides the required technical analysis tools.
- Add 100 week Exponential Moving Average trend line for the selected price chart.
For the S&P 500 the chart would now look like this:
S&P 500 (Normal Scale) with 100 week EMA Link to this chart on Google Finance
S&P 500 (Log Scale) with 100 week EMA Link to this chart on Google Finance
The rule to follow strictly is as follows:
“SELL when the index closing value falls below the 100 week EMA trend line”
“BUY when the index closing value is above the 100 week EMA trend line”
That’s it! It is as simple as that! No need for complicated macroeconomic financial analysis or following financial news media on a daily basis. Market prices move in trends and long term trends last. Again, the method will NOT be effective for individual stocks! Reason for that is that individual stocks have much higher volatility range than an index and as such it may give too many exit and entry trades within a short interval.
Based on the rules above, you would be out of the US market in early 2000 and 2008 and save yourself a lot of heartache. Likewise you would be back in at 2003 and 2009. However as you may notice that it is not fool proof and there may be occasions when you sell and then may have to buy again a few weeks or months later maybe even at a higher price than you sold off. This is called a “whipsaw” in technical trading however over long periods of time the losses due to whipsaws are recovered by capturing majority of the trend with your investment.
Why does this system work and what is the rationale behind it is a huge topic by itself and not the intent of this article.
Some of you may also try to reduce the value of chosen EMA but as you do that although the potential returns may increase, the number of whipsaws will also continue to increase.
You can apply the same rule across markets and see similar patterns. For example (The titles are linked to actual charts on Google):
You can try using the system with some commodities as well however it becomes more volatile and primarily is usable only for gold and silver. Example:
As you can see from the examples above, a simple trend following approach with the decision making based on trend reversal confirmations would have saved you from most major bear markets and would have been a good exit indicator.
As I mentioned, no technical system is perfect for if they were, none of us would be reading such articles. The point is that the approach doesn’t have to be perfect for it to be profitable in the long run however the key is to stick with the system and not to stop following the rules if you get a few whipsaws at the beginning or in the middle.
About Trend Following
Famed Stanford University psychologist Leon Festinger once said, “A man with a conviction is a hard man to change. Tell him you disagree and he turns away. Show him facts or figures and he questions your sources. Appeal to logic and he fails to see your point.”
Although trend following has been one of the most successful trading strategies for decades, some critics downplay the massive profits accumulated by trend followers, arguing there are just a few chance winners — “lucky monkeys,” they claim. Not true. Large numbers of trend followers have found a way to outpace market averages. They have done so with hard work and the ability to stick with a trading plan — usually for a very long time. However, some detractors seem happy to snub their nose at success, perhaps even until they have wasted a lifetime on sub-par trading strategies. Others, however, choose to test, accept proof, and build toward a profitable life.
Who are some inspirational winners? The list of successful trend-following traders includes:
- John W. Henry, who bought the Red Sox through trend following.
- Bruce Kovner, who is worth more than $4 billion.
- Bill Dunn, who made $80 million in 2008.
- Michael Marcus, who turned an initial $30,000 into $80 million.
- David Harding, who is worth more than $690 million.
- Ed Seykota, who turned $5,000 into $15 million in 12 years.
- Kenneth Tropin, who made $120 million in 2008.
Most of these traders did not come from privileged backgrounds; many did not learn trend trading in college. They came from different disciplines, worked disparate jobs, and saved a nest egg to begin trading with trend-following rules. They are proof that anyone can rise to the top if ambitious enough.
The purpose of trading is to make money and not to be right about economy or market cycles — a distinction that separates trend-following from other trading philosophies.
Beta is good. Smart Beta is better.