Fading the trend

Posted by Scriptaty | 12:36 AM

Some analysts prefer not to think in terms of trends. They think only in terms of “swings,” which could be described as mini-trends. For example, the trend is so choppy you could legitimately consider each move a “trend” in its own right.

There is no rule that says a trend has to last for years. You can define a trend any way that suits you. In conventional terms, the primary trend (as identified by the linear regression line) is clearly downward, but excursions away from the line are fast, violent, and sometimes prolonged.

The way to trade a choppy trend is to identify when a move away from the trendline has gone “too far,” which is relative. A key tool to identify “too far,” or an overbought or oversold condition, is the relative strength index (RSI), which divides the average of up moves over n number of days (usually nine to 26 days) by the average of down moves over the same number of days, and converts the outcome arithmetically to an index that ranges from zero to 100. When the index is rising, up moves are bigger than down moves over the lookback period. When down moves start getting bigger than up moves, the index falls.

The yen down move in April varied quite far from the linear regression trendline (blue line), and the 14 day RSI in the top window reflected that — the yen was becoming “oversold” as the index dipped below 30. As soon as the index started to climb from this oversold level, the correct trading decision was to buy it.

Notice the 10-day/20-day moving average crossover didn’t occur until two weeks later, reflecting the perpetual problem with moving averages — they lag. Also, the currency didn’t push above the down trendline (connecting the price peaks) for another four days, highlighting the fact this traditional technique also fell short the move is almost over.

Then the RSI peaked around 65 not reaching the overbought level of 70 — and started to drop. This is where you would exit the long trade with a profit and possibly also reverse back to the short position, which is consistent with the conventionally-defined big picture downtrend. Notice the two moving averages cross back a lot faster this time — only seven days after the peak.