Most of the systems I have profiled produce the best results when the markets they trade are trending. Because of this, I often suggest adding a filter to these systems to make sure that they only trade markets when they are trending. This will allow our systems to trade freely when conditions are most favorable, and sit on the sidelines when conditions are not favorable.
The Simplest Method
The most common way to determine trend direction is using the 200 unit simple moving average (SMA). I often recommend using the SMA to determine trend because it is extremely simple to understand. If the price is trending above the SMA, you are free to place long trades. If the price is trending below the SMA, you are free to place short trades. This ensures that you are never attempting to swim against the powerful current of the market.
I recently read an article that tested the SMA against three other indicators to determine which was best able to determine trend direction. While the SMA did perform respectably well, it was overshadowed by the very impressive performance of the Rate of Change (ROC) indicator.
The results of the comparison showed that using ROC to assess trend direction resulted in less changes in trend than using SMA. This lead to much smoother trading and less whipsaws. One thing I found curious was that the article only tested long-side trades. It did not discuss how ROC and SMA might compare on the downside.
Using ROC To Determine Trend Direction
ROC is on the same level as SMA in terms of simplicity. All it does is determine the percentage that a given market is up or down over a certain amount of time. The recommended time values for ROC are 14 for short term trading and 25 for longer term trading. Since we are just using ROC to determine trend direction and not to time trades, we will use a time period of 200 to match our SMA.
This is the formula for ROC:
Rate of Change =
(Current Price – Price N Periods Ago) / Price N Periods Ago
This formula will give us a percentage that the market is either up or down over a specified time period. The more a market is up, the stronger the trend. However, for the simple task of determining trend direction, we can simply say that a positive number represents an uptrend, and a negative number represents a downtrend.
A Recent Example
The current daily chart of Microsoft (MSFT) provides a great example of how similar these trend indicators are. As you can see, MSFT broke above its 200 day SMA line at the end of March. Its 200 day ROC line confirmed this new uptrend when the price really started to move towards the end of April. Since then, both the SMA and ROC have indicated that the stock is in an uptrend.
The ROC slightly lags the SMA because it is based on price movement, rather than average price. In this case, it took MSFT a little while to get going after breaking the 200 SMA line. ROC only factors in the beginning and ending prices, while the SMA gives weight to everything in between as well. For this reason, the ROC is less likely to get caught in whipsaw markets.
Short Side Trading
Since I was curious to see how ROC and SMA would compare in a downtrending market, I checked them on the current SLV chart. Based on this single sample, it appears that SMA is a much better downside indicator than ROC. After the price dropped below the SMA line, the ROC line lagged longer than usual. It spent two months bouncing back and forth between positive and negative before finally confirming the SMA line.
While this could be a simple outlier, it appears that ROC is only superior when it comes to uptrends. If this hold true through further testing, perhaps it would be useful to trade using both indicators, having ROC confirm uptrends, and SMA confirm downtrends.
Regardless of what indicator you choose to use, the most important concept is to have an understanding of what a market is doing before placing a trade.