Sunday, December 17, 2006

Trends and Reversals

So far, the Trend Trader has been quite successful. As I write this Article, 81.8% of my Trend Trader trades have been winners and I have had only two losers. My overall gains significantly outweigh those two losses. What has made this strategy so successful for me? Obviously, many factors enter into successful trading. Among those factors that lead to success are things like having and following a plan, good money management, learning to cut losses and let profits run, knowledge of strategies, and patience.

In this piece, I just want to talk about the plan and strategy I try to follow in Trend Trader. I intend to speak in general here, and the reader should be aware that nothing is set in stone. I am talking about my personal general guidelines when trading trends. There are exceptions to almost everything, but here is my overall picture to make a trend entry and exit. If we are to assume that I am going to be buying stock (as opposed to selling short or entering an option play), I want the stock to go up. I look at what the markets are doing. If all the major indices are climbing and I see no indication of a rollover, I can start looking for candidates. The old saying is "a rising tide lifts all ships" and that is part of the theory of trading a trend. If stocks are rising in general, isn't it more likely that a stock I select would also rise? I'll often then look at sectors and try to determine what sector or sectors are strong. Once the sector is identified, I will look for strong stocks in the strong sectors. So, I'll be hunting for a strong stock in a strong sector in a strong market and my aim will be to ride it until it breaks the trend.

Once I have identified some specific candidates, I look for a good entry. I generally am looking for a stock whose price has retreated to some trend line and bounced. The trend line I use could be defined in a number of ways. It could be a moving average such as the 200 day, the 50 day, the 40 day, etc. or a line I draw myself connecting a line drawn from a low to a higher low or lows. The bounce off the line gives me a potential entry because it also defines my exit. My initial exit is going to be below whatever trend line I have chosen. Now I need to see how far it is from my entry to my initial exit. If the stock bounced $5 off the trend line, for example, I probably won't enter at that time since my exit is more than $5 from my entry and I don't want to enter a position when I know a loss will be at least $5 a share. I try to find an entry where the loss is much more limited. In other words, as I preach in my classes, I want my initial exit to be close to my entry and I want the exit to be clear and established before I ever buy the stock. In that way I can attempt to cut my losses.

If I buy the stock and it moves up as I want it to, the trend line also is moving up. At least at first, the same trend line I used to enter is the line I use to exit. Of course, if the stock moves up rapidly and, therefore, up and away from the trend I used to enter, I may trail the move up based on Japanese candlesticks or I may raise the trend line as new points are formed in order to attempt to protect accrued but unrealized profit while still trying to let my profits run. I will exit only when there is a reversal in price that cuts below my candlestick exit or my trend. In that way I can attempt to let my profits run.

Buying stock is a bullish strategy and there needs to be some reason to believe the stock will go up. When markets are rising, sectors are up and stocks are in an uptrend, I believe that can be enough reason for me to buy provided I have a predetermined exit strategy. However, what can I do if the markets have been falling? In that case, I look for reversal signals and confirmations. Japanese candlestick charting provides some reversal signals in some of the formations such as hammers, morning stars, bullish engulfings and sometimes haramis. Since I trade for my own livelihood, I study these chart patterns, look for price and volume indications, and watch other indicators such as DMI, MACD, and stochastics to try to obtain early clues that a turnaround is occurring. Even when the markets are going down, there almost always are some sectors that are moving up. I look in those sectors and utilize the other tools I have mentioned to find Trend Trader candidates.

I believe one of the keys to successful trading is patience. When the markets and many sectors are moving up, there may be many more candidates to trade in uptrends. When the markets are headed down, candidates are harder to find and not as plentiful. I try not to force trades. I'd rather try to play when I think the odds are more in my favor; I'd rather try to take what the market is willing to give me. I try to remain patient and act when it looks like I have a decent chance to make a profit. I see many who want to be trading all the time and expect constant grand profits. That approach just doesn't work when the only strategy one is using is to buy stock. That strategy needs to be employed only when the specific situation is bullish and the downside risk is recognized.

For those who want trades all the time, it may be a good idea to look at Option Trader where money can be made on downside moves as well as move to the upside. For example, I sent an Option Trader alert on May 11th that I was buying puts on QQQQ. One way puts can be used is to make money on a downward move. I had decided that it looked like the Nasdaq 100 were going to fall and QQQQ is a stock that basically tracks the Nasdaq 100. The Nasdaq and QQQQ did drop and two weeks later, it looked like the Nasdaq was turning back up. I sold the puts on May 25th and realized a 62% return before a small commission. Of course, that is a different strategy and requires different skills than simply buying stock.

One of the points I am trying to make is that there is a wide variety of ways to make money in the markets. Each of us needs to assess ourselves and decide what fits our risk tolerance, our knowledge base and our comfort level before we enter any trade.

Bill Kraft, Editor
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