Before you discover the most simple and effective method to determine the trend, let’s see what it’s good for. All the trend following systems are based on one common approach:
“Buy the dips in an uptrend and sell the rallies in a downtrend.”
Let’s reveal one simple trading system that actually made a fortune for one famous trader and his investors. The system “Donchian 5 & 20” is named after him. Here is the set-up.
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In the chart above, you see two indicators – the blue line and the red line. The blue line is the indicator SMA 5 (stands for simple moving average with period 5) and the red line is SMA 20 (simple moving average with period 20).Donchian’s idea was very simple:
1. Buy when the blue line crosses the red line upwards
2. Sell when the blue line crosses the red line downwards
Even a 5-year old child could do this! Actually, there is nothing special about this system. All trend following systems are like this. Some systems are more advanced, with more sophisticated indicators, but the common approach is to buy the dips and sell the rallies.
If everyone could do this, then what’s the money making secret?
The answer is that Donchian used this system in strong bull markets. Yes,trending markets! This important note is the key to consistent profits as illustrated in the chart below.
The first trade was profitable because it was made in the direction of the strong trend. The next trades lead to losses as the market was turning up and down without a clear direction. Profits made in the first trade would be taken back in a series of losses.
How Donchian dealt with it was smart. He ignored all trading signals when the red line was not going up on at least a 45 degree angle. He wouldn’t take any losing trades after the first trade because the red line is not trending at all. It is in a so called choppy zone. So why was Donchian able to make a fortune from such a simple system while others could not? Because others would throw this system away as not profitable! The only “trick” was to follow a good trend and not taking any other trades.
What is the lesson from this story?
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If you know how to determine the market trend correctly, it could make a difference between losing or break-even and winning. Donchian used a simple moving average to determine the trend and filter trading signals.
1. When the market was trending, he turned his system on.
2. When the market was in choppy zone, he turned his system off and ignored any trading signals.
What you can do is just the same with any trading system or robot.Determining the trend using a simple moving average can be replaced with a more sophisticated, versatile technique that you will learn in the next pages.