Why patterns are not meant to be broken.
The trend is your friend and we all know that. It simply means that until further notice, whatever has happened before, will continue to happen again. If the markets are going up, they will continue to go up and likewise, if they are going down, they will also continue to go down. Why is that? Some call that momentum, but it is also easy to understand and akin to the path of least resistance. Change is often seen as a “risk”, so also people don’t like to do it. We get used to things, develop habits, and the body likes a routine. It keeps things in balance when you do things you know over and over again, particularly if it is seen as being good for you – otherwise why do it in the first place?
But enough of the context, what we really want to look at, is how we can make money out of knowing more about trends? As it happens, there is a whole industry of practitioners who are dedicated to this very subject matter. They are aptly called trend following trading strategies, and the industry likes to refer to them as CTAs. That is because of the uses of financial futures when executing the strategies. In other words, you need to use leverage to make these trading models work. Now before anyone gets too concerned, remember, financial derivatives, leverage, and black-box computer models are all just tools to make things work. To use that old adage: “guns don’t kill people, people do”, and so it is with using all of these wonderfully complex creations of financial engineering, that allow us to do what we need to do.
Back to trends and making money, the difficulty is not finding or buying into trends. After all, it is only a trend when we can see tangible evidence of a pattern repeating itself. Say, the market goes up 1% every day for 5 days. Is that a trend? Of course, it is. We have a sequence of numbers, and they are all the same. But of course, every trend is not created equal and some are stronger than others. If something has gone up everyday for 300 days, then we would have greater confidence that it will also go up again tomorrow. Whereas, if something has only just gone up for 3 days, and it has never gone up more than that before, we may not have so much conviction that it will go up again. No, the difficulty is not identifying trends, the hard part is knowing when to get out. In other words, when does a new trend begin?
There is no reason why something would happen again, just because it happened in the past. The future is still random and things can always change. Some trends are longer than others, some change more quickly, others only happen every so often. We use machines to identify these trends that give us the highest probability that a pattern will repeat itself, based on what happened in the past. Then we use cost efficient financial instruments (futures) to execute these trades, and we take measured risks to see if we are right. What’s not to like? When there is no trend, if the markets just stay where they are and don’t move up or down by much, the strategy doesn’t work. Luckily, in this geo-political environment, there are no shortages of events which cause volatility, and entail some very nice trends (as in Oil of late). We may not like what is going on in the world, but at least by trading the trends, we can make some money out of it.