The Enlightened Stock Trader Certification Program Module 2: Section 2 Trading Strategy Description: Trend Trading Identifying a trading strategy that you understand and are comfortable with will allow you to focus your research initially to accelerate your trading system development. Once your trading system is complete you will be able to trade more consistently because you are inherently comfortable with the trading strategy that underpins your system. There is no need to reinvent the wheel there are several great trading strategies you can choose from! Adrian Reid Founder Enlightened Stock Trading 1
T 6 Trader Profile: Trading Strategy Objectives: Gain greater insight into Trend Trading to allow you to determine whether this is the right trading strategy for you. What is Trend Trading and how does it work? Trend trading (or trend following) is an outstanding way to profit from large moves in the markets without spending a lot of time in front of the computer. Trend traders identify trends and find low risk entry points from which they hold their position until the trend reverses. This style works in most asset classes and can be highly profitable given sufficient diversification, strong risk control and the discipline to stick to the system. What is a trend? A trend is simply a sustained price movement in one direction. This may occur in any financial instrument. Trends occur in stocks, futures and forex markets. They occur in all time frames, however, the longer the time frame, the larger and more rewarding trends can be. The nature and magnitude of trends varies by asset class, however, trend following can be used in stocks, futures and forex markets. Components of trend trading strategies: The great thing about this trading strategy is that similar (or indeed identical) trading systems can work across many markets. For example, one of our trend following systems works exceptionally well on stocks, but also works on futures and FX with no modifications at all. This is because most markets trend and the trading strategy is very robust. All it requires is: 1. A way to identify when a trend is in place 2. A low risk entry point 3. An initial stop loss to gets you out if you are wrong 4. An exit rule that gets you out when the trend changes If your trading strategy has all of these components, combined with good risk management rules, you are on your way to a profitable trend trading system! (Of course you will need to undertake the correct trading system development for yourself to be sure as there are no guarantees your rules will be profitable) Trend Following Stocks: Stock trends occur because of changing fundamental conditions for the stock and also because of overall market sentiment. Both long (up) and short (down) trends in stocks are tradable, although long side trends can be substantially longer than short side trends. By far the best trends in the stock market occur when a company is growing rapidly and the broader market sentiment is increasingly positive. However, strong stock trends can occur at any time. With a total universe of many thousands of stocks globally, there are always some good trends underway your trading system s job is to find them! 2
Trend following stocks on the long side also has the added benefit of the trader receiving dividends for the duration of the trend bringing the benefits of income as well as capital gain through the appreciation of the stock price. The strongest stock trends can last many years and provide a return of many hundreds or thousands of percentage return over this time. To illustrate the magnitude and duration possible in stock market trends, here are some historical charts of a number of very significant trends that a trend following system may have captured: Trend Following Stocks Example: Incitec (IPL:ASX) Trend Following Stocks Example: Cochlear (COH:ASX) 3
Trend Following Stocks Example: JB HIFI (JBH:ASX) You can see why trend following stocks can be so profitable you only need a couple of these great moves each year to offset your numerous small losses and you can earn substantial returns. With good risk control and diversification this strategy can perform very well indeed. These trends can be identified and exploited using simple mechanical trading systems which look only at price data it is not necessary to do hundreds of hours of fundamental research to identify a stock that is trending and profit from it. How does trend trading work? Trend trading is simply an approach in which you identify that a trend is in place, enter the market in the direction of the trend and hold the position until the trend reverses. After entering at a low risk entry point, trend following generally uses an initial stop loss point which is fairly close to the entry point. Once a trade is profitable a wide trailing stop allows plenty of price movement before exiting a trade. This ensures you remain in the trade for the duration of the trend and don t exit too early. The wide trailing stops work because trends can get volatile and may move against you quite a way before rocketing off in the desired direction again. If you use too tight a trailing stop then you will be forced out of the trend and miss out on the potential profit from the big move later in the trend. When your trend following system is right (around 30% of the time) and the trend continues, large profits are made on the trade. When the system is wrong (around 70% of the time) you exit quickly at a small loss and moves on to the next trade. Trend following systems make money overall, even with this low percentage of winning trades, because winning trades are much larger than losing trades. Trend trading can be emotionally challenging: The psychological difficulty most people have is that trend following requires you to be wrong most of the time. This can be emotionally challenging because most people have the subconscious desire 4
to be right (this comes from our school education system which was not designed to produce outstanding traders!!!) Trend following is practically very simple but can be emotionally challenging New traders looking for reassurance that they are doing well expect reassurance to come in the form of winning trades these may be infrequent with this trading strategy. However, total profitability is what we should really be interested in, not just being right. Can a trend trading strategy fit in with a day job? YES! Trend following is a form of trading that can be learned and can fit in easily with whatever else you have in your life at the moment. Trend trading systems require very little time each day to execute and can be run while you still have a full time job Once you understand the concepts and codify them into a mechanical trading system it becomes a matter of simply running your system scans each day and executing to the rules. Trend following strategies should not involve any judgment, so assuming everything is documented properly in your trading plan the decisions are very quick to make on a day to day basis. My major stock system takes about 30 minutes a day to execute. What are the components of a Trend Trading Strategy? Trend following strategies are simple systems that mechanically identify when a trend is in place. The system gets you in to ride the trend as long as it remains in place. They are applied to a broad range of securities or instruments and so need to be simple and robust to work effectively. The standard components of a trading following strategy include: Setup Entry Trigger Initial stop loss Exit rules Money management and position size rules Trend following strategies typically do not employ profit targets or time based exits because profits come from letting trades run and develop for as long as possible within your chosen timeframe. Profit targets and time based exits are more commonly used in swing trading and mean reversion systems. What does a successful trend trade look like? As an example of how a trader may benefit from one of these trades, let s say you entered Incitec Pivot (IPL - Australian stock shown in the chart above) on a 200 day breakout on 24 Dec 2006 at $0.79 with a 3 ATR initial stop at $0.7 and risked 1% of your $100,000 account on the trade. You then held the trade and used the 200 day moving average as a trailing exit point which kept you in the trade until 11 August 2008 at $6.23.
On the above trade, risking 1% of your hypothetical $100K account you would have risked $1000 on the trade, which would have allowed you to purchase 2000 shares (Number of shares = Dollar Risk / Risk per share = $1000/($0.79-$0.7)). This would give a position size of $19,70. According to the above example, when the position was closed the shares had appreciated to $6.23 per share, giving you a total profit of $.44 per share or $136,000 PROFIT. This translates to a 136 times return on your initial $1000 risk. Warning: This trade is a handpicked example and is not typical. There are no guarantees you will get trades like this. However, these monster trades can come along every so often though, and this strategy is a good way to profit from them. 6