Sunday, July 13, 2008

Trend Following Using Renko Charts

Over the past year on this site, I have attempted to use technical analysis and intermarket analysis to help better understand the gold market. During this time I think I have made some fairly decent calls, but have also made mistakes along the way. One of the advantages of maintaining this blog is that I can go back and read old posts and see exactly what I was thinking. I can analyze what worked and what didn't.

One common theme of all my money losing trades is that they were made in the opposite of direction of the trend. Having learned from past mistakes and also from reading some excellent books along the way, namely from an author by the name of Michael Covel, I have formulated a series of rules that will prevent counter-trend trades from happening in the future.

The basic premise of trend following is that you want to be buying when prices are going up, and selling when prices are going down. This seems fairy logical, but, unfortunately, most amateur traders instinctively endeavor to do the opposite. Many beginners will stack up as many indicators on a chart as possible, and will start looking to buy as soon as one of them dips down past some arbitrary threshold to an oversold level.

Another common tactic amongst neophytes is to buy stocks making fresh 52 week lows. Like the previous tactic, this also results in buying stocks that are going down.

My trend following technique that I am now using uses Renko charts to help me avoid buying falling stocks. I used to maintain another blog called Trading With The Trend, and the technique there involved moving averages to define the trend. I still think that this is a valid method, but I discontinued this blog due to underwhelming demand.

Anyway, the advantage with Renko charts is that the only factor in their construction is price. They do not even factor the passage of time, which makes them distinct from moving averages. Moving averages can suffer from whipsaws in a sideways moving market, but Renko charts only react to changes in price and not time. If there is no price movement, then Renko charts will remain static. They are, in a sense, a Japanese version of Point and Figure charting.

Here is a chart of GLD over the past year and the signals that would have been generated:

The areas highlighted in yellow are the areas you would be long. The areas not highlighted you would not be in the market. You would not be permitted to short gold during this time. I am not willing to go through all the rules in detail for this technique, but here are the main criteria for any trend following technique:

1) Buy strength
2) Short sell weakness
3) Take small losses
4) Let winners run
5) Manage risk

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