Trendiness

Trends are like Supreme Court Justice Potter Stewart’s famous definition of obscenity (“I know it when I see it”). If a market is moving in a straight line with few retracements, we all can spot the trend. But defining it is difficult. Two accepted methods of defining when a market has serial correlation of returns, or a lowerthan- expected number of day-to-day sign changes in returns, are the Durbin Watson and Wald-Wolfowitz tests, which indicate the markets are close to being random in distribution. This is visually counterintuitive, but just as hikers get lost when they stop trusting their compasses, traders can get lost when their lying eyes get in the way of reality.

Other venerated technical indicators of trendiness, such as Welles Wilder’s directional movement index (DMI) and its associated average directional movement index (ADX) do a good job confirming when you are in a trend, but they tend to be slow to capture excessive movements and abrupt but significant trend changes. Moreover, the commonly used 14-day DMI period is a parameterized time period. (Not that this does not work: I learned a good deal of technical analysis from a bombast who insisted on measuring every indicator against a simple 14-day moving average, and who took great glee when one complex tool after another failed to pass the test. There is a powerful lesson here.)