Playing the Odds: Follow the Trend

The trend is your friend.

Market Saying

The trend is an expression of probabilities. The most closely followed trend is the trend of prices. But, as we shall see, the trend of the Spread has an important bearing on trading success.

Defining the Trend

First, a few simple definitions:

Rising Market: A period during which both relative-strength leaders and RS laggards are rising. Specifically, the average RS leader and the average RS laggard are above their respective 30-day moving averages.

Falling Market: A period during which both RS leaders and RS laggards are falling. Specifically, the average RS leader and the average RS laggard are below their respective 30-day moving averages.

Mixed Market: A period during which RS leaders and RS laggards are moving in different directions. Specifically, the average of either RS leaders or laggards is above its 30-day moving average, while the other is below its 30-day moving average.

Rising Spread: The Spread is above its 30-day moving average.

Falling Spread: The Spread is below its 30-day moving average.

The Effect of the Spread on Price Trends

In the matrix below, the combined effect of market trend and the trend of the Spread are shown in detail.

Percentages under “Leaders” and “Laggards” compare the Average Daily Change (ADC) in each category with the maximum ADC registered by any category. The maximum Average Daily Change was experienced by RS leaders when the market and the Spread both rose; the ADC in that case equals 100%. All other ADCs are given as a percent of that maximum.

A negative ADC is indicated by a minus sign. For example, when the market and the Spread both fell, RS leaders experienced an ADC nearly as large as the maximum (92% of maximum) but in the opposite direction, indicated by a minus sign.

The percent of total time spent in each category is shown under “Time“. Our study of eighty industrial groups from 1986 to 1999, a generally bullish period, shows that the market rose 56% of the time, fell 25%, and was mixed 19% of the time.

Rising Market

ADC ADC
Leaders Laggards Time
Rising Spread 100% 61% 29%
Falling Spread 54% 80% 27%

Mixed Market

Leaders Laggards Time
Rising Spread 52% 7% 11%
Falling Spread 3% 45% 8%

Falling Market

Leaders Laggards Time
Rising Spread -25% -88% 13%
Falling Spread -92% -50% 12%

By comparing entries in this matrix, we get a sense of the odds of success for long and short bets under different market conditions. As you can see, some bets are better than others. Mixed markets produce relatively meager ADCs. Trending (rising and falling) markets offer the highest ADCs and, hence, the best trading opportunities. Exceptional combinations have been highlighted in the matrix above.

Rising Market, Rising Spread

The most bullish market periods–when odds of success on the long side are greatest–feature a rising market and a rising Spread. During these periods a strengthfollowing strategy emphasizing RS leaders works best (review: The Nature of Strength-Following Markets). RS laggards perform relatively poorly during these periods, with an historic ADC of only 61%, against and ADC of 100% for RS leaders.

Rising Market, Falling Spread

A falling Spread tends to dampen the overall profitability of a rising market. Nevertheless, a falling Spread during a rising market produces a relatively high ADC for laggard issues. During these periods a contrarian strategy emphasizing laggards is best (review: The Nature of Contrarian Markets). RS laggards did 50% better than RS leaders (80% ADC for laggards versus 54% ADC for RS leaders).

Falling Market, Rising Spread

When the market is falling, a rising Spread favors shorting laggards.

Falling Market, Falling Spread

The most bearish configuration–when the odds of success on the short side are best–is the combination of a falling market and a falling Spread, the inverse of the most bullish configuration (see Rising Market, Rising Spread).

Managing the Odds: Pareto’s Rule

Eighty percent of your trouble comes from twenty percent of your problems.

Pareto’s Rule

On the principal that capital should follow opportunity, recent history is a useful guide. Out of the twelve possible combinations shown above, only four show themselves worthy of a substantial commitment of capital. Indeed, had one elected to commit capital only during those periods highlighted above, one might have sat the market out 20% of the time, selecting the choicest opportunities while avoiding risk during periods which offered only modest odds of success.

 

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