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A Trend System for Stocks and ETFs

Scott's Investments

I previously wrote on a trend following study done by Blackstar Funds. Blackstar's article in full can be found on Scribd, here.

The system is fairly simple,

if today's close is greater than or equal to the highest close during the stock's entire history then buy tomorrow on the open. We chose this method to avoid ambiguity. A stock that is at an all time high must be in an uptrend by any reasonable person's definition. This is a trend following entry in its purest form.

Additional criteria are that the stocks must be at least $15/share and meet minimum volume requirements.

They also stated:

Exits are essential to any trend following strategy. We decided to use average true range trailing stops because they are universally applicable and commonly used by trend following programs. The average true is a derivative of the true range indicator, which measures the daily movement of a security by calculating the greater of:

Today's high minus today's low

Today's high minus yesterday's close

Yesterday's close minus today's low

For all 18,000+ simulated trades the average distance from entry price to exit was 27% for a 10 unit ATR stop; though it often ranged from 5% to 50% depending upon the volatility of the security in question. For the purposes of historical testing we chose to exit a stock on the open the day after our exit level was breached.

Blackstar did a study on all equities 1983-2004, including delisted securities. They found that:

The evidence suggests that trend following can work well on stocks. Buying stocks at new all time highs and exiting them after they've fallen below a 10 ATR trailing stop would have yielded a significant return on average. The evidence also suggests that such trading would not have resulted in significant tax burdens relative to buy & hold investing. Test results show the potential for diversification exceeding that of the typical mutual fund. The trade results distribution shows significant right skew, indicating that large outlier trades would have been concentrated among winning trades rather than losing trades.

The research described so far in this paper was only a small initial step in a complex process. Portfolio level money management is absolutely essential to the success of a trend following system. Controlling risk at the portfolio level encompasses initial position sizing, scaling into and out of individual positions, total open risk constraints, etc. However, at this stage we are comfortable answering the question "Does trend following work on stocks?" The evidence strongly suggests that it does.

Is it possible for an average investor to implement such a system? Screening for all-time high stocks is difficult when trying to find free tools. However, the underlying theory behind Blackstar's theory is to identify stocks that can most easily be defined as in a strong uptrend. Thus, I took the liberty of modifying the trend screener and still feel confident that the underlying theory remains in tact. In this case, we could use a criteria of stocks closing at a 52-week high. Below is a list of equities as of Wednesday's close, with the percent the issue is above it's most recent 52-week high. Note: a stock could have closed at a 52 week high close, but if it reached a 52 week high at a time other then the close, there could be a negative value in the 52-week high. All other requirements were kept as true as possible to BlackStar's system in the article. A 50,000 share average volume and $15 share price was required.

If this seems overwhelming, perhaps an easier approach would be to only screen for ETFs. For Wednesday's close, there were 2 results, listed at the bottom. In order to expand the results, I excluded a volume and price requirement for ETFs.


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Categories : Finance    Themes : Trading
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