Posted by: Bevan | January 21, 2012

The Reason For Trends & Reversals

Although I use a trend following trading methodology, all traders depend on trends in some timeframe and duration in order to generate profits.  In the past few days the downtrend in the EUR/USD MAY have reversed.  As mentioned in a previous post the record levels of short positions in the pair (as reflected on the futures market by the weekly Commitments of Traders Report) have generated a few weeks of speculation that the pair was ‘oversold’ and an ‘overcrowded’ trade.  The pair continued grinding down despite these comments.

Last Friday (ironically the 13th) S&P finally confirmed the anticipated credit rating downgrade for France, along with a bevvy of other European countries including Austria (also losing its AAA rating), Italy, Spain, Portugal, Cyprus, Malta, Slovakia and Slovenia.  On the same day it was announced that a meeting to agree a haircut on Greek bonds (i.e. private bondholders agreeing to lose perhaps 50% on the value of Greek bonds they had bought) had been unsuccessful.  All this was happening in an atmosphere of disappointing earnings reports in the US.

Despite all this negative news, suddenly on Tuesday the Euro started climbing.  Stocktwits and Twitter went crazy with short term traders either jumping on or selling the rally, and the financial media pushed the button on a bevvy of stories about buying the news selling the fact, short squeezes etc.  My system closed out the short Euro trade (dating back to early November) on Friday, however many traders are debating whether the downtrend is over or not.  Some point to their broken trendline, others to the broken 50 day moving average.  The bears still say there are grave risks and the Euro is fundamentally over-valued, or that it is still under the 200 day moving average for those of a more technical bent.

Identifying the beginning and ending of a trend is subjective, and difficult.  I believe that it is not even necessary.  In fact top and bottom picking strategies, which are usually countertrend and try and grab on right at the turning point don’t seem to test very well in my observation.  The trait of trends that I have found most profitable is that trends tend to continue, all that object in motion stuff from physics seems to apply just enough that it can be used to grab a profitable bite.  I’m wrong more often than I’m right, in the sense that a lot of trends are simply movements within ranges.  A lot are destroyed by unexpected fundamental reversals due to supply or demand factors or, commonly these days, central bank intervention.  Enough do continue though to provide those rare ‘outlier’ trades that produce more than 3 times the risk taken and account for the lion’s share of profits.

Alex Elder provides an interesting section in Trading for a Living where he discusses the psychology of trends.  The reality is that although news and events are always occurring in the background, like this week with the Euro, it is the actions, feelings and decisions of traders which actually propel price action.  The following section describes it well (from page 63):

Winners feel rewarded when price moves in their favor, and losers feel punished when price moves against them.  Crowd members remain blissfully unaware that when they focus on price they create their own leader.  Traders who feel mezmerized by price swings create their own idols.

When the trend is up, bulls feel rewarded by a bountiful parent.  The longer an uptrend lasts, the more confident they feel.  When a child’s behavior is rewarded, he continues to do what he did.  When bulls make money, they add to long positions and new bulls enter the market.  Bears feel they are being punished for selling short.  Many of them cover shorts, go long, and join the bulls.

Buying by happy bulls and covering by fearful bears pushes uptrends higher.  Buyers feel rewarded while sellers feel punished.  Both feel emotionally involved, but few traders realise that they are creating the uptrend, creating their own leader.

Eventually a price shock occurs – a major sale hits the market, and there are not enough buyers to absorb it.  The uptrend takes a dive.  Bulls feel mistreated, like children whose father hit them with a strap during a meal, but bears feel encouraged.

A price shock plants the seeds of an uptrend’s reversal.  Even if the market recovers and reaches a new high, bulls feel more skittish and bears become bolder.  This lack of cohesion in the dominant group and optimism among its opponents makes the uptrend ready to reverse.

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