Timing Market Tides

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Written by Book Reviews

Systems traders have long been known to employ profitable trend following strategies in the futures markets. Applying those concepts to stock trading has proven to be difficult, although the idea of trend following in stock markets dates back at least the days of Charles Dow. In a new book, Kedrick Brown, a former vice president at Knight Equity Markets, LP, redefines trend trading and offers readers a lot to think about, and readers of this book will find a large number of testable ideas.

Brown reviews the basic tenets of Dow Theory, and summarizes the underlying idea as, "Dow Theory thus assumes that it is only worth
owning stocks during confirmed bull markets in the major indices, and that one should be out of stocks otherwise." He also offers a straightforward definition of a trend following trading strategy as, "Any preplanned, rule-based strategy for managing open position P&L in which open profits could hypothetically grow indefi nitely under a limited
set of circumstances, while open losses are limited under all circumstances."

After developing a common base of understanding, Brown develops a relatively simple trend following strategy applying what he calls three dimensional technical analysis. In three dimensional technical analysis, traders need to consider not only price and time in a single stock, but they should expand their focus to similar information in multiple stocks simultaneously. In his book, Brown fully develops a sample strategy to trade any NASDAQ stock, such as MSFT.

This strategy, one of many in the book, relies on an objective method of defi ning a market's trend - the binary trend identification method using
Donchian bands:

1. Filter condition: Take long positions in MSFT only if the NASDAQ Composite is in an uptrend, defined as price having made a new 32-day high more recently than it made a new 32-day low.
2. Buy MSFT if it makes a new 24-day high while the NASDAQ Composite is in an uptrend.
3. Limit your losses by setting an initial fixed stop at the 24-day low at the time of trade entry.
4. If the initial stop is hit, reenter on a new 24-day high if the NASDAQ Composite is still in an uptrend.
5. Exit if the NASDAQ Composite enters a downtrend, defined by the price reaching a new 32-day low.

Buy and sell decisions in this example follow the trend of the general market. The strategy manages open position P&L by limiting losses and allowing profits to run in bull markets.

Interestingly, specific reentry points are precisely defined. This is often challenging for traders to do, and Brown points out that it is important to get back into positions after being stopped out if trend following in equities is going to be rewarding to traders.

Other trading strategies are comprehensively developed in the book, and the reader is always given a complete understanding of the underlying principles. Brown also devotes a large portion of the book to a detailed discussion on position sizing, and provides worksheets that traders can use or adapt for their personal use to develop trading plans. Overall, the book can serve as a complete "how to" manual for the beginning trader, but offers a great deal for more experienced traders.

In an interesting, but brief section, Brown addresses the institutional money manager's need to add alpha by outperforming, on a relative basis, a benchmark. Assuming the benchmark is the S&P 500, Brown notes, "If you hold a proxy for the S&P 500 at all times when not trading, you need only to outperform the proxy during the holding periods of your trades to beat its long term performance (before commissions and taxes)." The discussion and test results of this point are worth considering for all those attempting to outperform a benchmark.

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