October 22nd, 2013

Trends?

Everyone seems to agree on the notion and existence of a "trend", but no one seems to agree on its definition. Some want a universal definition with no compromise; like in: this is "the" trend, period. Geez, it's evident, see, it starts here and stops there; it can plainly be seen by anyone of age on any chart of past stock price data what ever the selected time frame.

They want a one size fits all definition that a trend spans a microsecond, a week, a month, 100 years, anything in between or longer. Not only that, but this "trend" should apply to all classes of tradable assets at the same time in the same direction. Please...

Most, with a little hindsight, will see a trend as: it started there. But with its other end point undefined since this other end point is in the future somewhere. Then the question becomes: will the trend continue or not? Was it a "trend" in the first place? If one looks at population growth, for instance, the answer will have to be yes on both counts, and to say the least, the trend has been up for quite some time now... It's another matter for stock prices, their history is much shorter.

Technically, you should not care what the trend definition of somebody else is. All that is important to you is that the trend definition you use is consistent within your trading methodology. If you swing trade for weeks to months at a time, why should you care for the minute wiggles here and there since it might just be random noise in your chosen time frame. The intrinsic value of a 20 year trend on your few weeks swing trade might amount to pennies, so again why worry about the value of this long term drift?

What seems important is your style of trading, your methodology and this methodology "must" be consistent with what the market has to offer or can offer on "your" selected stocks and trading time frame. If your specialty is the 100m dash, you might get the early lead in a marathon, but I don't expect you to reach the finish line!

The simplest definition of a trend, as related to stock prices, has to be: the line between two end points. That this line be flat, going up or down; it nonetheless defines the trend: the general behavior of price movements. And this trend, in its simplest form, can be defined as: ΔP, the difference between the two end points P(t) – P(0); your entry and exit prices. You now have a "trend" definition for what ever duration Δt and direction: ΔP = P(t) – P(0).

It's simple: ΔP > 0 → trend is up; ΔP < 0 → trend is down; ΔP = 0 → trend is flat; not only flat, but no profit: P(t) – P(0) = 0, and for sure, no loss either. You need a change in price to make a profit, you need: ΔP <> 0, and your bet should be in the same direction as this price variation ΔP what ever the time span |Q|ΔP > 0 . However, note that over the long term (20 years or more), and over a large number of stocks, the average ΔP of US price indexes have tended to be greater than zero with a probability measure approaching asymptotically to one. Meaning that with time (long term), stock prices, on average, tended to be up: ΔP > 0. With this notion, it would appear just holding your positions for the long term would be sufficient to finish ahead: Σ(H.*ΔP) > 0.

You can't make any money on past trends, they are gone. You can only bet on their future continuation or reversal; this translate to: at P(0) you take the trade or not. You can rely on your experience and expertise, on all the information you can gather up to your entry decision point: P(0), and there make your bet. But you are faced with uncertainty, P(0) is the now price, it is always available, you just press execute on your keyboard, or let your program do it, and the purchase or sale is done in a split second.

The Point of Interest

Your real end point of interest is P(t), what will it be at some time Δt in the future? You could simply gamble and see what happens, there is nothing wrong with that. I have back tested some trading strategies that do just that and win. That, like many other trading strategies might not be "your" cup of tea or best way to play the game. There are so many different and profitable trading strategies out there. A lot of discretionary traders do make money in the markets and some without even using trading software.

Nonetheless, you want to play the game, and hopefully to win. Therefore, what ever your methodology, you will need to back test to show that at least over past data, your own trading strategy, your style of trading, not only survived but thrived sufficiently to, as a bare bare minimum, beat the long term Buy & Hold scenario. And there, when I say back testing, I do mean making a good job of it.

Not back testing your trading methods is like a shot in the dark. What makes you believe that your trading idea has value? What could make you believe that your idea is new and has not been tired or tested before? Maybe an alternative might be to use already developed systems. But even there...

Say you adopt the idea, the concept developed by someone else who "says" that his trading strategy outperforms the Buy & Hold long term. Say something like the Turtles; however, statistical proof is not provided, not even a portfolio simulation test, only a few chosen profitable examples. Why would you accept this without testing the trading strategy for yourself? You say you don't trust any one in the market and yet you would seem ready to fork out some $3,000 on a Turtles course without system verification! And then wonder why you are losing money.

I do think that the only way to see if an outside trading strategy has merit is to test it yourself. This way you can get a better understand of the trading procedures used, their objectives, their strengths and weaknesses, even maybe gain the ability to modify them to your own needs. As a minimum, I would want to see backtests where the trading strategy generated thousands of trades over a long term trading interval over many stocks.

I have often taken ordinary and even non-performing trading scripts, modified them to my needs and produce what I would call outstanding trading scripts by adding my own trading procedures and software routines that back tested real fine. But you need to backtest properly otherwise you might be just curve fitting. See a related article on trends: Trends or No Trends.

If you don't do your testing properly, you start an over-fitting iteration process that will extract more and more profits on your past data. But the future is not over-fitted, it is there to unfold without regards for your particular trading strategy. You have to work hard to design long term trading strategies. At each stage of development and as portfolio size grows you will find new challenges and problems to solve, which if not incorporated in your trading strategy design from the start, will deliberately and inexorably restructure your portfolio to the down side. The market is not designed to be kind to anyone. It is just a market place where you can exchange cash for shares or vice versa at any time during market hours.

Designing a profitable trading strategy must comply with what is out there. It must comply with all the academic research and trading history. You must build on the shoulders of the best. Your trading strategies need to comply with the Markowitz, Sharpe, Jensen, Fama, and the list goes on and on. When I see academics describing their unique view of the market using a Sharpe ratio for comparison purposes, I view their research and mathematical models holding up as long as they describe their trading universe within their Gaussian environments.

But the big question is: is the market really Gaussian? To that, I answer no; with all its implications. I prefer to look at the market as a chaotic universe where Gaussian distribution are at best a low approximation process and where randomness is stronger than admitted in most of those research papers.


Created... October 22ndh, 2013 © Guy R. Fleury. All rights reserved.

 

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