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You may not like the simple trend following method I have been talking about. There are many ways to generate your Buy
and Sell signals. Listed here are just a few variations.
As described earlier, the trend following method I follow uses a moving average to generate BUY and SELL signals.
The primary signals are generated by the price movement above and below the moving average. As the price moves above
the moving average that is a BUY signal. As the price moves below, that is a SELL signal. Although the
Fabian system was developed using the 39WMA for signals, today the 200 day moving average or the 40 week moving average
can be used.
The one big drawback to trend following is what's called the "whipsaw". That is where you get one signal, a move across
the moving average, followed shortly by an opposite signal, a move back across the moving average. Whipsaw trades almost always
result in a small loss. A trend follower was once asked "how do I avoid whipsaws?", his answer, "don't trade". Whipsaws can
and do happen, you just need to learn to deal with them. One thing to remember is that it's only a whipsaw later. Today it's
a signal. Think about that. The discipline is to take the signal. Only later will you find out if it was a whipsaw. This is
the price you pay to be a trend follower.
Whipsaw trades are one of the reasons I use the 40 week moving average. It helps smooth out some, not all, of the
market movement.
This is the Wilshire 5000 with the 40WMA.
Another way to try and reduce, not eliminate, whipsaw trades is to slightly modify your trading
rules. A simple alteration to your signal rules, that hopefully will reduce whipsaws, would be to use an envelope
around your moving average. This will give you a little cushion for your signals and should help reduce whipsaws. The
change to your BUY or SELL signal becomes the breakout to the top of the envelope for a BUY and a breakout to the bottom of
the envelope for a SELL. This type of deviation from the exact moving average signal is sometimes refered to as
a penetration. You wait until the price line penetrates the moving average by X%. You can set your envelope to whatever
range you want. Remember, your BUY signal ia a breakout thru the top of the envelope and your SELL is a breakout thru
the bottom of the envelope. The moving avergae itself is no longer used. The cushion then becomes the range between
the top of the envelope and the bottom of the envelope.
Here is the Wilshire 5000 with the 40WMA and a 1% envelope around the 40WMA.
Here is the Wilshire 5000 with the 40WMA and a 2% envelope around the 40WMA.
A method that AL Thomas talks about uses is the 200DMA or 40WMA. Using this method, changes are not made until
the slope of the MA changes. For example, if the price line breaks below the MA (200 DMA or 40WMA) there is no SELL signal
until the slope of the MA (200DMA or 40WMA) reverses from ascending to descending. That's to say you take no action until
the moving average starts to go down. The same would be true on the BUY signal. No change is made until the slope of the MA
changes from descending to ascending.
Another method used is what is called the Moving Average Crossover. That is where you use two moving averages and the
signal is generated when one crosses the other. Typically, you would you one shorter and one longer moving average. Many crossover
systems I have looked at use a 3:1 ratio.
The Investopedia.com definition for simple moving average actually shows an example of the 15 day simple moving average giving a crossover signal with the 50 day moving average. You
can play around with them to see which one you might like. For example: 10DMA & 30DMA
20DMA & 60DMA
30DMA & 90DMA
40DMA & 120DMA
50DMA and 150MA
If you go to BigCharts.com you can try some out.
Yet another method, that some use, is to look at a daily view of the Wilshire 5000 with a 200 day moving average. You
then would look at a weekly view of the Wilshire 5000 with 40 week moving average. Your confirmation is when both views are
above, or below, their moving average.
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