I’ve said in the past that nothing bad happens above the 200-day moving average. Similarly, I’ve said that nothing bad happens above the clouds (referring to an Ichimoku chart). When I make those comments I mean that major market catastrophes do not occur when the market is trending higher. They almost always occur when the market is already trending down.
We had a good example of that this week. Here’s what happened to the Egypt ETF (EGPT) on January 18:
On 1/18/11 EGPT closed down by more than 8%, signalling trouble ahead. But notice that RSI was extremely oversold. If EGPT were on our RSI Reversal list (it’s not) we might have bought it for a short-term bounce. However, it also closed below the Ichimoku cloud that day and we don’t buy anything that’s significantly below the cloud. It’s too dangerous. It’s in a downtrend. And that’s when really bad things happen.
So let’s see what happened:
Ouch! As the Egyptian uprising reached a fever pitch EGPT continued to plummet without any bounce at all — down another 14% or so. And EGPT is not leveraged. A leveraged version may have been down 30 or 40 percent.
The point is that only buying leveraged ETFs that are extremely oversold within an uptrend has tremendously reduced the risk of RSI Reversal trades. It doesn’t mean that there are not going to be significant drawdowns. There almost certainly will be. But it does mean that the impact of the reduction of risk by only trading with the trend cannot be overemphasized.
Having said that, there are exceptions to a trend following strategy. For example, we know that commercial traders of futures markets (the smart money) will tend to increase their short hedges as markets are trading higher and reduce their short hedges are markets are trending lower. And in many markets when they have the most bullish position (or least bearish position) that they’ve had in many months it is often a great time to buy.
That is happening right now in gold.