The Trouble of Trend Following in Bubbles

In this post, I will discuss a disparate series of charts that have caught my attention this weekend.  

First, we have a daily chart of the S&P 500:

What I find noteworthy is the extreme selling volume that took place on Friday.   Also, notice the bearish black candle that form on that day.   It is true that one bearish candle on one daily chart could just be noise, but other pieces of evidence appear to be lining up as well...

Second, let us examine what has been the leading sector propelling the American market higher: biotech.

The daily chart above illustrates the price of IBB (the Biotech ETF) slicing through the 50 day moving average.   This fact makes this ETF unbuyable for me, since it breaks Trend Commandment #3 (see previous post).    Furthermore, it did so on the highest volume in years.

Zooming out, we have next a weekly chart of IBB:

Notice the last 4 bars of immense selling volume.

Zooming out further still, we now have a monthly chart of IBB:

When I enter a position, I am looking for what is known as an asymmetrical risk to reward relationship. In other words, if I am wrong (and I am wrong a lot), I want to lose very little, but in the event that I am right, I want the potential gains to be extremely high.

This ratio of low risk and high reward no longer exists with IBB, and the relationship is now one of extreme risk, but, like any bubble, potentially high reward.   This is not a combination that I am seeking to trade.

The fact that the market's hottest sector is looking particularly vulnerable is problematic, but it gets worse.   Globally, other markets as a whole are looking weak.

Moving on, below is a chart of the Japanese Nikkei:

Admittedly, the Japanese stock market appeared bullish to me at the end of last year, but as the facts (the price action) changes, so must my opinion.

This whole enormous consolidation pattern has tragically (for the bulls) broken down hard.  The price action has gapped down, and the long term moving averages are rapidly closing in on each other, which would usher in a full blown bear market.

And it is not just Japanese stocks, but also German stocks that look sickish to me:

The chart above shows the German DAX entering a short term downtrend, as the 20 day moving average as plunged below the 50 day.   A classic head and shoulders pattern which is now complete adds further support to the bearish case.

Finally, here is a monthly chart of copper:

As a trend following trader, I am attracted to higher highs, and higher lows, which is why copper is something that I have no interest in buying.  At this current moment in time, copper is trading at a 3 year low, while also completing a massive head and shoulders-like top.

My Trend Following Trend Commandments

When it comes to trading, not only is it important to focus on "what to do", but it is also important to think about "what not to do".    So, here are ten pieces of negative advice pertaining to trend following trading:

1)  Do not risk more than 1% of your capital on each trade

This means that if you are stopped out of your stock, the total value of your account drops by 1%.    It does not mean sell your stock once it falls by 1%. 

For example, if you start off with $10,000 of equity in your account, get stopped out of a losing trade, then your account should be worth no less than $9,900. 

I am currently using a 0.50% risk on each trade, which allows me to enter more positions.  And having more positions exposes my portfolio to what is known as positive optionality.

If your win rate is 50% and you bet much more than this amount, it is a mathematical certainty that you will go bankrupt eventually, which is why this is rule #1

2)  Do not average down on a losing trade

Doubling down on a stock will inevitably lead you down the path to bankruptcy.

One of my favourite trading movies is "Rogue Trader".    In it, the actor who plays rogue trader Nick Leeson comments, "If you keep doubling up, you're bound to come out ahead".   He ended up losing over $1 billion.

Every blow up that has occurred in the investment world has involved averaging down, and this is one of the lessons taught in the excellent book, What I Learned Losing a Million Dollars

3)  Do not buy stocks trading beneath their 50 day moving average

This is a very flexible rule that can be combined with other forms of trading, even fundamental analysis. For example, if you love Apple's products or balance sheet (or whatever), wait until the stock clears its 50 day.   Following this simple rule would have resulted in you sidestepping that stock's recent 50% correction.

Buying into markets that are trading above key moving averages is not myth - it has been an objectively profitable strategy going back more than 50 years.  

4)  Do not buy a stock because it is "too low" or sell a stock because it is "too high"

It's hard for new traders to accept, but often what seems too high just keeps going higher, and what appears too low keeps going lower.  It's also equally difficult to let winners run.

5)  Do not make a trade based solely on news or fundamentals

It's okay to have opinions based on fundamentals, but I think it is a mistake to trade off that alone.   If you do incorporate fundamentals in your trading, wait until they line up with the technicals before getting in.  React rather than predict. 

6)  Do not trade against the long term trend

If silver goes from $50 to $30, it may be tempting to jump in, just because it is on sale, but this is a losing strategy in the long run.    Once a long term trend is in motion, it tends to stay in motion, so do not attempt to pick tops or pick bottoms

7)  Do not experience large losses

While you cannot control whether a stock goes up or down, you can control how much you are willing to lose on a trade.   Unless a stock gaps down massively, it is completely in your control to cut small losses before they become large losses

8)  Do not fight the trend of the general stock market

The stock market has been in a massive bull market since 2009, and yet I've seen so many instances of traders resisting this, and trying to short individual stocks.   A rising tide lifts all boats, so do not short individual stocks in a bull market

9)  Do not buy stocks that are illiquid or rising on light volume

A stock should do more than 200,000 shares a day of volume for me to consider it.   It is important to be able to get in or out of a stock quickly without slippage.   Also, a stock rising should be doing so on above average volume; trading with an increase in volume generally puts you on the same side as the smart money 

10)  Do not invest all of your money in one asset class or sector

A trend following stock trader should not be loyal to just one sector.    I personally trade whatever is making new highs - it does not matter what it is.    If gold is making new all time highs, then I'll buy gold.   If junk bonds are making new all time highs, then I'll buy junk bonds.  With over 10,000 stocks to choose from and over 1,000 different ETFs, it is easier now than ever before to become truly diversified.