|Trading systems||Trend following systems|
The most common method of system trading is the trend-following system. In its most fundamental form, this system simply waits for a significant price
movement, then buys or sells in that direction. This type of system banks on the hope that these price movements will maintain the trend.
Moving Average Systems
Frequently used in technical analysis, a moving average is an indicator
that simply shows the average price of a stock over a period of time. The essence of trends is derived from this measurement. The most common way of determining entry and exit is a crossover. The logic behind this is simple: a new trend is established when price falls above or below its historic price average (trend). Here is a chart that plots both the price (blue line) and the 20-day MA (red line) of IBM:
The fundamental concept behind this type of system is similar to that of a moving average system. The idea is that when a new high or low is established, the price movement is most likely to continue in the direction of the breakout. One indicator that can be used in determining breakouts is a simple Bollinger band overlay. Bollinger bands show averages of high and low prices, and breakouts occur when price meets the edges of the bands. Here is a chart that plots price (blue line) and Bollinger bands
(gray lines) of Microsoft:
Disadvantages of Trend-Following Systems:
• Empirical Decision-Making Required - When determining trends, there is always an empirical element to consider: the duration of the historic trend. For example, the moving average could be for the past 20 days or for the past five years, so the
developer must determine which one is best for the system. Other factors to be determined are the average highs and lows in
• Lagging Nature - Moving averages and breakout systems will always be lagging. In other words, they can never hit the exact top
or bottom of a trend. This inevitably results in a forfeiture of potential profits, which can sometimes be significant.
• Whipsaw Effect - Among the market forces that are harmful to the success of trend-following systems, this is one of the most common. The whipsaw effect occurs when the moving average
generates a false signal - that is, when the average drops just into range, then suddenly reverses direction. This can lead to massive losses unless effective stop-losses and risk management techniques are employed.
• Sideways Markets - Trend-following systems are, by nature, capable of making money only in markets that actually do trend. However, markets also move sideways, staying within a certain range for an extended period of time.
• Extreme Volatility May Occur - Occasionally, trend-following systems may experience some extreme volatility, but the trader must stick with his or her system. The inability to do so will result
in assured failure.
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