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Revisiting Basics – III
  • : April 25, 2021
  • : B. Krishnakumar
 
Revisiting Basics – III
 
We have been discussing the basics of price behavior in a trending phase. The simple definition of a trend is a sequence of higher highs and higher lows or lower highs and lower lows. We can of course use any other indicator or a tool to identify trend.

This week, I wish to discuss more about trend following and the even more interesting topic of whipsaws. Let us stick to the MAST indicator for identifying trend. The simple trend definition using MAST is:
 
  • If the MAST cloud is green, the trend is up.
  • If the MAST cloud is red, the trend is down.
 
I saw a lot of messages about the whipsaws using the MAST indicator in Nifty Futures. For the sake of clarity, let me list of the rules for the popular stop & reverse system using MAST.
 
  1. It is a stop & reverse system. Hence the trader will always have a position open.
  2. When the cloud turns green from red, then short positions will be exited, and long positions will be initiated.
  3. Once the long trade is triggered, the L2 line in MAST will be used the trailing stop loss.
  4. If the trailing stop loss or the L2 line is broken, the cloud colour change will happen. And the long position will be stopped out and a short position will also be triggered in this example.
  5. Use the L2 MAST line as your stop loss / trailing stop loss for the short positions until such time your L2 line is not violated.
 
You can of course create more rules like having a stop loss at 2-brick move beyond the L2 line. There are so many other possibilities. But we will stick to the simple rule of stop & reverse on a cloud colour change in MAST.

The chart below is Nifty Futures, 1-min closing price in 0.1% brick size. Have a look at the number of long and short trades triggered from March 19, 2021 till date.



There were 7-long trades (captured by alphabet L) and 6-short trades (captured by alphabet S) triggered in the above chart. The last long trade is still open, and we do not know the outcome of this trade. The previous three long trades were losing trades.

The remaining long trades were mostly marginally profitable or breakeven trades. Missing a long trade or entering a long trade a bit late would not have been a big problem in this phase. But missing a short trade could have proved costly as there we quite a few sharp cuts along the way.

Let us look at the short trades.

Except for the last short trade, most of the remaining short trades were extremely profitable.

I presume every trader likes to reduce whipsaws. If so, ask yourself how this is possible? In the above example, the short trade was more profitable compared to the long ones and quite a few long trades resulted in deep loss.

Would it not be logical to devise a rule so that long trades could be reduced? If that is achieved, we will focus on short trades and reduce the long trades. The flip side to this approach is a few profitable long trades might be missed or the profits in long trades will be smaller.

You need to ask yourself:
 
  • Do you want to reduce whipsaws? Or,
  • Participate in trending moves without missing some portion of the trend.
 
There is nothing right or wrong here. If you reduce whipsaws, it will compensate for a late entry in a trend and vice-versa.

For most of us, whipsaws are a more damaging factor psychologically. In a whipsaw phase, you lose money, and the capital is eroded. But, if you enter a trade a bit late, it may not hurt that much because you are still making money, but probably a little less. This may be psychologically more manageable for most.

If you are someone who wants to be in a trade early, then stop & reverse approach will suit you. But remember the price you pay for ensuring early entry is the whipsaws. You cannot have the cake and eat it too.

Choose your approach and understand the pros & cons of that choice. Before we wrap up this week’s post, let me share the chart of Nifty Futures in 1-min time frame, 0.1% brick size. This pertains to March 2020 when the price was crashing big time.


The above chart covers the price action from Feb. 20, 2020 to March 13, 2020. For the sake of simplicity, I am using the same brick size and same entry-exit rules. I am also not considering the impact of gaps etc. This is just to drive home a simple point.

I have marked the long trades in the above chart and ask yourself if it made sense to go long in this down- trending market. In a strong trending market, it is easy to make money by just participating in the trend.

Losing trades can be avoided by ignoring the counter-trend trades. This is fairly simple I presume.

If you used stop & reverse approach, you would have ended with a lot of losing trades on the long side. If you could avoid or reduce those long trades (counter trend trades), your net profit would have been higher.

The problem gets compounded in a choppy market. If there is a trend accompanied by volatility spike, it makes life hell for trend followers.

The nifty has precisely been through such a phase in the past few months. The Nifty 50 spot index has dropped by 1,200 points from the high of 15,431 recorded on Feb. 16, 2021. But it was not that easy trading this move, because of the increased volatility. In fact, I would not be surprised if most trend following traders ended up with net drawdown during this period.

In both the charts shared above, the price was drifting lower. In 2020, the fall was accompanied by momentum and the trend was not accompanied by choppiness. But in 2021, the trend has been down in the past few months, but the price action has been very choppy.

But, in both these instances, ask yourself would it be better if the long trades were avoided or reduced. Are you getting the drift and the message here?

Let us take this discussion forward next week. Stay tuned!