The Life Span Of A Trend
By Dave McLachlan
One of the great traders interviewed by Jack Schwagger in the “New Market Wizards” was named Victor Sperandeo.Â Vic used to say that trends were like people – they had a certain lifespan that could be used to determine how risky a position would be if we were to take it.Â
For example – if we were to place a bet on a young 20 year old, we could be reasonably safe in assuming they wouldÂ live a long, full life.Â But if we were to place a bet on an 80 year old, even if they were in the finest of health, it would be fair to say that the bet would potentially not be as safe.Â
How does this relate to trading?Â It’s simple, and we can use it in three waysÂ -
1:Â We make the largest trades on “young” trends where we have the highest probability of winning, and smaller trades on “old” trends.Â This relates to money management – more on this below.
2:Â If the trend of the market is nearingÂ its typical lifespan, we can tighten our stops on positions we are in.Â For example, at the beginning of a trend, we can set our stop beyond the trend line to give it enough room to move.Â As the trend nears its end, we can tighten our stop to just below a previous trough (or peak when going short) to ensure we don’t give too much back.
3:Â If a trend has travelled past its usual life-span (see more on this below), we can simply elect not to take the trade.Â The market will always present another opportunity.
Of course we still only enter according to our solid and back-tested trading rules, but changing our money management by using these strategies can help increase our bottom line.
So What Is The Life Span Of A Trend?
In Market Wizards, Vic says that the average market move is around 20%, lasting between 6 weeks and 6 months.Â This obviously relates to American markets, whichÂ is fine, but I decided to do some research on our home markets – the ASX Top 200.Â
Looking at the history of the ASX Top 200 index over the last 20 years, I based a trend on the following:
1:Â Looking at a Daily Chart
2:Â Basing an entry on either a continuation pattern entry, or a trend-line entry signal
3:Â With the trend lasting more than 4 weeks (or else it was deemed a false breakout)
4:Â Measuring the trend from the entry signal breakout to the very top or bottom of its range, to get the full idea of its move
And here are the results!
Over a 10 year period:
Long Trades – Trend Line entry: 13.9%, Continuation Pattern entry: 12.2%, False breakouts occurred most in: Sep and Jun.
Short Trades – Trend Line entry:Â 11.5%, Continuation Pattern: 17.2%
Over a 20 year period:
Long Trades – Trend Line entry:Â 17.7%, Continuation Pattern: 12.5%, False breakouts occurred most in: Sep, Mar, Nov.
Short Trades – Trend Line entry:Â 10.1%, Continuation Pattern: 18.4%
So, you can see we have a clear winner – if you ever see a continuation pattern forming in a bear market, get ready to go short!Â It had the largest average move at 18.4%.Â The overall market would also move an average of 17.7% from a trend line entry, and 12.5% off a continuation pattern entry.
Using Life Spans With Your Back-Tested Trading Rules
As you probably can already guess, I do not recommend using life-spans of trends by themselves – but in conjunction with your back-tested trading rules for entry and exit.Â So how can we use them?
Well, if you usually risk 2% of your overall portfolio on a trade, but the market has moved 15% off a continuation pattern entry, then instead of risking 2%, risk 1%.Â This way we are still in the trade, but with a lower risk if the market does reverse around its average life span.Â Of course ifÂ the marketÂ has travelled well past its usual life-span, we can always stay out of the trade all together.
A simple and great (although slightly more advanced) way to determine our money management on a trade!Â If trading is all about tipping the odds of probability in our favour, then this is another great way to do it.
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