The search for the perfect trading strategy

The words “perfect trading strategy” will mean different things to different people. In this article however, the perfect trading strategy is one that combines the following elements:

  • A systematic, rules based approach. No discretionary buy or sell decision making.
  • Risk management, i.e., protection against big losses.
  • Simple to execute.
  • A repeatable process.
  • Requires no market prediction. No one can do it consistently.
  • Profit in up or down markets. No inherent bias.
  • Requires no need research into supply, demand, business models, profit and loss statements etc.
  • Does not require 24 hour news monitoring. Or any at all.
  • Let profits run for maximum reward and does not exit too early.

The strategy the combines all these elements is of course trend following. Trend following takes advantage of mass psychology, i.e., the movement of the herd, and because it rides the horse that’s winning, it does not require a diversified portfolio.

Trend following is simple to execute but requires tremendous rigor. The strategy explored here uses the principals of trend following in conjunction with trend channel analysis (TCA), and looks to take advantage of markets or sectors that are in powerful uptrends – something that makes sense in an environment of unlimited money printing.

The strategy outlined here is best understood by looking at an example. Below is a chart of Sherwin Williams (SHW), an American company in the general building materials industry (not that it’s relevant).

A chart of Sherwin Williams: May 2011 – Today (Click on the chart for a larger version)

A chart of Sherwin Williams: May 2011 - Today (Click on the chart for a larger version)

Chart courtesy of stockcharts.com

SHW made a double bottom back in the summer of 2011. It then began to form a clearly visible uptrend (as indicated both by the 20/45-day moving averages, and the blue dotted trend channel). The buy signal was given by a strong bounce off the lower blue trend line, and the sell signal was not seen until both the lower blue trend line was violated and the 20-day moving average crossed down through the 45-day moving average.

Searching for the perfect market to trade

The search for the perfect market to trade concentrated on those sectors of the S&P 500 that are among the best performers so far this year, i.e., consumer staples, health care and utilities.

A 1 year (daily) chart of the Consumer Staples ETF (XLP) (Click on the chart for a larger version)

A 1 year (daily) chart of the Consumer Staples ETF (XLP) (Click on the chart for a larger version)

Chart courtesy of stockcharts.com

A 1 year (daily) chart of the Health Care ETF (XLV) (Click on the chart for a larger version)

A 1 year (daily) chart of the Health Care ETF (XLV) (Click on the chart for a larger version)

Chart courtesy of stockcharts.com

A 1 year (daily) chart of the Vanguard Utilities ETF (VPU) (Click on the chart for a larger version)

A 1 year (daily) chart of the Vanguard Utilities ETF (VPU) (Click on the chart for a larger version)

Chart courtesy of stockcharts.com

All three of the ETF’s shown above are testing support at the lower dotted trend line, and in each case a decisive bounce would represent an opportunity to go long. The Vanguard Financials ETF (VFH) shown in Friday’s market wrap would also make a good candidate were it to pull back and bounce off support.

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