“The Trend is Your Friend”
Being one of the oldest, and probably overused, trading axiom, this is all too often overlooked by new traders. Still, if you are using technical analysis – whatever asset you are interested in – the first thing that you should be looking for is the prevailing trend. Why? Because the trend is the single most reliable predictor of a position’s success. Trading in the direction of the trend, also called trend-following, significantly increases the success rate of your positions, although it doesn’t guarantee that you will be profitable in itself.
[ecko_annotated header=”Try to trade in a pleasant tailwind” annotation=””][/ecko_annotated]
Trading against a trend on a given time frame is like running into a strong headwind, while trading in the direction of the trend is like enjoying a pleasant tailwind. Without a doubt, trend-reversal strategies can be very lucrative, but they are more for the experienced trader, as the success rate of those plays is low.
How can a strategy be lucrative with a low success rate, you might ask. It’s simple; several small losing trades and one huge winner that can turn into a long-term position might make those strategies attractive. But that’s exactly why they are for more seasoned players—for a beginner, it’s hard enough to make profits with a high success rate strategy, let alone endure the frustration of numerous losing positions.
So, for now, we will take study the simplest trend-following strategies and look at real-world examples of how to use them. Let’s start with job number one, identifying the trend.
The Three Types of Trends
For some, speaking about three distinct types of trends might be a surprise. But rising and falling trends don’t cover the whole picture. The third type, neutral trend, is as important as the two obvious market phases. In fact, on average, neutral trends account for as much as 60-70% of the price action of a financial asset. Understanding that will help you make sense of the day-to-day movements of your preferred assets, as well as the changing profitability of certain strategies over time.
The trends are different in many characteristics too; volatility, liquidity, the suitable strategies, the ease of trading… all of those change when the underlying trend changes. On an interesting note, there are “fake” rising and falling trends, as some assets move inversely compared to the market. Without getting into details now, some ETFs, currency pairs, and even commodities (mainly gold) tend to gain when stock markets fall and negative sentiment is dominant. This will lead to rising trends with bearish characteristics and falling trends with bullish characteristics. First, we will take a look at a generic advancing trend.
Swing-lows and swing highs inside an uptrend in the S&P 500, 4-Hour Chart
As you can see on the chart above asset prices move in rising and falling “waves”. When a rising wave ends, we talk about a local (or swing) high or top. Conversely, when a falling wave ends, it’s called a local (or swing) low or bottom. These highs and lows are very important in trend analysis. Simply put, a rising trend on a given time-frame means that the asset reaches higher highs and higher lows with wave after wave.
Of course, real life trends are more complicated than that, but this simple analysis method is remarkably effective when judging the state of a market, even if irregular swings mess things up sometime. On another note, there is undoubtedly a subjective factor in defining highs and lows that could lead to somewhat different interpretations of the same price action.
With time, all traders develop a “feel” for swings that helps them in making quick and effective decisions. As you will see, identifying swing lows and swing highs is also essential for other analysis tools like trend-lines, divergences, support/resistance levels and so on… This means that every trader will have a slightly different analysis of the same asset even if they follow the same principles. Trend analysis (and technical analysis in general) is sometimes more an art than an exact science. That said, the strategies and the underlying logic remain the same for everyone, and in the long run, these small differences don’t matter that much— a trader’s success depends more on discipline and consistency.
The Characteristics of Rising Trends
A rising, or bullish, trend is generally a steady period. Volatility is low, trading volumes are also relatively low, and the steady rising waves are interrupted by short and usually shallow counter-trend moves. An increase in volatility or unusually high volumes might be interpreted as warning signs that the trend is about to end.
Trading in bullish trends is probably the easiest, but the least “exciting” for traders. Psychologically it can also be challenging to enter these trends, because of the shallow nature of the counter-trend moves, as you have to jump into the trend when ”it’s already up so much…”. As another old adage says,
“bulls markets won’t let you in and bear markets won’t let you out”.
Don’t worry we will help you in fighting those difficulties with our coming posts.
A basic swing trading strategy
Our first strategy will be a very simple one with lots of room for refinement, but the basic logic is the foundation of a vast number of profitable strategies.
- Enter the trend when the price closes above a new high (surpasses the prior swing high)
- Set the stop-loss at (or below) the prior swing low.
- Move up the stop loss on every new swing low
Let’s take a look at our previous example for entry and exit points according to this strategy:
Entry and exit points of a basic swing trading strategy S&P 500, 4-Hour Chart
As you can see the strategy gives two clear entry- and exit-signals that capture a healthy chunk of the bullish moves, without any refinement. That said, the exits are far from being optimal, and position-management techniques could boost the returns of the strategy as well.
This strategy is designed to benefit from strong trending moves on any time-frame and sometimes it is also used as an “overlay strategy”, meaning that being on a “bullish or bearish swing” is used as a condition to boost the success rate for certain other shorter-term strategies.
The Characteristics of Falling Trends
Now that we introduced swing lows and swing highs, identifying falling, or bearish, trends will be easy. As you guessed, a series of lower lows and lower highs defines a bearish trend. Apart from the same structure, falling trends are fundamentally different than bullish trends. Volatility is usually high, price action is vicious, and the counter-trend moves are also wild. In general, bearish trends are much harder to trade, even if the larger moves make them look attractive for the novice trader. In reality, even experienced players can struggle to make consistent profits in falling markets.
Let’s take a look at the chart below to see the differences in practice (method used is shorting):
Entry and exit points of the basic swing trading strategy, USO, Daily Chart
The structure of the bearish trend is similar to our bullish example (with two distinct trending moves and consolidation periods), but especially the counter-trend moves are strikingly different. Volatility is high, and highs and lows follow each other in quick succession. Although our basic strategy remains profitable, actually trading upon these entry and exit points is much harder. Why? Well, in real time, the wild moves and the relatively large change in your profits make things that much more difficult. Also, notice the false entry point towards the end of the period—those are much more common in the volatile environment of falling trends.
Of course, with adequate position sizing techniques, more refined strategies, and risk management, bearish trends can be traded successfully, but beginners should focus their attention on rising trends. You might have noticed the trend-lines that we drew on our example charts. Being the next logical step in trend analysis, we chose to put them on the charts to help you recognize the power of them.
Trend-lines can give you early warning signs for changes in the trend; they can help you in refining your entry- and exit-points, and much more. So in our next post, we will take a close look at trend-lines, and how to utilize them. We will also dedicate a whole post on neutral trends, as they need a bit different approach compared to bullish and bearish trends.
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Why I Switched to Momentum Investing
After sticking to various reversal trading strategies for a while now, I have started to look more into momentum and trend when it comes to investing in stocks specifically. Some people may find the idea of momentum a bit strange to begin with, and it is only after watching individual stocks, while also keeping an eye on the movements of the overall market, that you rally understand its meaning.
Seasoned stock investors, especially those that adhere to value investing, are often skeptical towards the idea of buying a stock that has already increased in price. It basically goes against their instincts of buying low and selling high. However, as people start to understand the mechanics of it, they tend to change their opinion.
Never catch a falling knife
An unwritten law in any market is that a trend tends to continue. Hence, if a stock has been moving up three straight months, it is more likely that it will continue to move up for a fourth month instead of turning down. A “cheap” stock can always become cheaper and an “expensive” stock can always become more expensive. These are well-known principles that explain the basics behind why momentum and trend trading works, and it is the idea behind old cliché’s like “never catch a falling knife” and “cut your losses, let your profits run.”
Over time, however, any financial asset has a tendency to revert to its mean. As such, when a trend has been overextended, a reversal in price can be expected to follow. This is the idea behind reversal trading. However, it is important to understand that it can take a while for this to happen, and you may very well get wiped out in the process.
The trend is your friend
The concept of buying stocks on their way up makes a lot of sense from this perspective, as you are then buying something that the market is starting to like, which is about to be valued higher. Trying to catch the falling knives is simply to risky from a risk:reward perspective, and in my opinion it should be avoided altogether. Why would you buy a stock that is falling when you instead can buy it at its way up?
Still, there are situations that arise in the grey areas, where a stock seems to have gone so low that it can do nothing but go up again. It may be tempting to give it a try, but remember that this is an extremely difficult thing to do, and the stock may just as well continue its steady decline. When the stock finally turns, there will still be plenty of time for you to jump on the bandwagon.
Mining companies, some companies within the maritime shipping industry, and the entire Japanese stock market are all examples of great bargains from a value standpoint, where the investor would sometimes have to wait for decades to earn his initial investment back. Don’t fall into this trap by picking stocks that are still falling and appear “cheap.” Don’t try to outsmart the market.
Combining momentum with value
In my opinion, a killer long-term strategy in the stock market is to combine sound value-investing principles with momentum. In other words, you should look for undervalued companies that have been badly beaten up for years, and that are just starting to turn. Oftentimes, this is where the greatest potential is and I believe it is one of the best ways to beat the index over the long term.
We can find two examples of how well value investing with momentum works in the US after the stock market crashes in the mid-70s and the 2008 financial crisis. Following these two events, only value investing yielded a clearly higher return than value combined with momentum.
However, if you were a value investor before the crash started, chances are you would get wiped out before the market finally turned. If, on the other hand, you were a value investor with momentum as one of your criteria for holding, you would automatically get rid of all the stocks that were in decline, and instead buy them again after the crash was over.
Because of this, momentum indicators like the MACD can be of great help when making these investment decisions. When combined with value-principles, you have a killer approach to long-term success in the stock market. I’m definitely looking more into crafting a robust investment strategy based on this for myself, and I will come back and share more specifics on potential strategies later.
Featured image from Pixabay.
Trading 101: Intro to Forex Trading
When you are first getting introduced to the world of forex trading, things can seem a bit overwhelming. There is so much information available online, but very little of it is aimed at beginners who may not be familiar with the terms and concepts they refer to. In this article we will cover the basics of forex trading, explain the most important terminology, and tell you how you can get started trading forex for yourself.
To start off, let’s define some terms. Forex stands for “Foreign exchange” and is the name often used for this market where traders can buy one currency by paying with another currency. Other names used for this is the “FX market” or the “currency market.”
A pip, often referred to as “point in price”, is simply the smallest price move that is possible in a given currency, also known as a basis point. Forex traders often talk about their gains and losses in terms of pips instead of percentages or monetary values.
Long/short are confusing terms that often get tossed around by forex traders as well as other traders. To put it simply, long means that you are buying an asset and will make a profit if that asset goes up in price. Short, on the other hand, means that you are trying to make a profit from declining prices. The way it works is that you sell an asset that is borrowed from another market participant. After the price has dropped, you can then buy back the asset in the market for a lower price than you sold it for, and thus make a profit.
Stop-loss is the level a trader decides on where he would like to exit his trade if it is not working out for him. In other words, it is the maximum loss the trader is willing to take on one particular trade. Alternatively, a stop-loss order can be used to secure a profit on a profitable trade in case the market turns.
Leverage is the practice of taking a larger position in the market than your trading account size would otherwise allow. Basically you are borrowing money from your broker in order to boost your buying power in the market. Leverage offered in the forex market is often in the range of 200-400:1
Spread, also known as bid-ask spread, is the difference between the buying and selling price of an asset in the market. The broker will offer you to buy a currency at a slightly higher price than they will let you sell that currency. This is where brokers make most of their money, and it is important to compare spreads when choosing a forex broker.
Since the forex market works by participants buying one currency with another currency, the price of a currency must always be quoted in another currency. For example, when you see that EUR/USD is trading at 1.20, it means that you need 1.20 US dollar to buy 1 euro.
The worlds largest market
The forex market is known as the largest of the world’s financial markets. Approximately $5 trillion changes hands in the forex market every day, far surpassing the global stock markets and commodities markets.
It is important to understand that the trading activity that retail traders (traders like you and me) account for is just a small, but rapidly growing, share of the total activity in the forex market.
Fundamental or Technical Analysis
When you are deciding to become a trader, you also need to decide on what type of trader you want to be. Broadly speaking, there are three types of traders; fundamental traders, technical traders, or a combination of the two.
Fundamentals take into account news, valuation, interest rates, etc. when trying to determine what price a currency pair “should” be trading at.
Technicals, on the other hand, focus strictly on what the price of the currency pair is doing. Technical traders study and analyze price charts to try to determine the future direction of the price.
Majors and Minors
Forex traders often talk about majors and minors when referring to currencies. Majors is a list of the most actively traded currency pairs in the world, and it consists of these pairs:
- EUR/USD: The euro and the US dollar.
- USD/JPY: The US dollar and the Japanese yen.
- GBP/USD: The British pound and the US dollar.
- USD/CHF: The US dollar and the Swiss franc.
Forex majors often have the lowest spreads in the forex market and they are also among the most liquid instruments you can trade in the financial markets.
Forex minors is a list of the next most actively traded currencies. This list includes currencies such as the British pound (GBP), Canadian dollar (CAD, aka “Loonie”), Australian dollar (AUD, aka “Aussie”), and New Zealand dollar (NZD, aka “Kiwi”).
Lastly, there are the exotic currency pairs. These include the remaining currencies from European countries outside the Eurozone (NOK, SEK, DKK) and smaller yet important Asian currencies like the Singapore dollar (SGD) and Hong Kong dollar (HKD). The exotics have less trading activity and the spreads are usually higher than for the majors and minors.
Benefits of Forex Trading vs. Stock Trading
A benefit of trading in the forex market rather than the stock market is that the forex market is trading 24 hours a day, from Monday morning in Australia until Friday evening in North America. The great thing about the market being open 24 hours is that there are no overnight “gaps” like you can find in the stock market.
A gap simply means that the market opens at another price in the morning than it closed the night before. For traders, gaps are considered a big risk, since the trader cannot control what is happening with his trade while the market is closed.
A market that is open 24/5, like the forex market is, opens up great opportunities for medium-term traders (swing traders) to for example take positions during the beginning of the week and exit those same positions before the week is over. That way, the trader takes no risk over the weekend when the market is closed.
Additionally, the forex market is much more liquid than most stocks, and it’s easy to find technical and fundamental analysis of this market everywhere on the Internet.
Choose a Forex Broker
Once you have decided to give forex trading a try, you need to choose a good broker that you trust with your money. This is the first, but still a critical step, on your way to become a successful trader. Pay particularly close attention to regulation, withdrawal policies, spreads, and trading platforms offered when choosing your broker. Fore more on this, read our earlier article on how to choose a forex broker.
Featured image from Pixabay.
Trading 101: Moving Averages and Moving Average Strategies
What are Moving Averages?
Moving Averages are among the most popular trend indicators in Technical Analysis. They provide a simple, yet powerful visualization of the ongoing trends in an asset. They are used for a wide variety of reasons, primarily for trend following and reversal strategies.
Simply put moving averages are connected points calculated for every day (or whatever the timeframe is). The calculation itself is simple; you take a given number of previous days and calculate their average. Of course, you don’t have to do the calculations yourself. All basic charting software and trading platforms do the math for you and plot the moving average (or up to dozens of averages for that matter) on the chart of the asset.
How to Interpret Moving Averages?
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