Trend following strategy
5MA's strategy - A strategy for trend followers.
Lesson 1: The Trend
A trader is only successful if he/she can identify a prevailing trend and trade in the same direction. I am sure you heard that one before. How many times did you hear the definition "Bull trend is when the market makes higher highs and higher lows"? Yet how many times did you see that happen, and when you attempted to trade, the trend reversed against you, and cost you dearly? Every single time you traded? two times out of three? Nine times out of ten? Did you think the problem lies within your trading capabilities? Well no, it's not! It's with the definition itself! You need to properly identify the trend, because otherwise, you'll keep wandering in that same vicious cycle in search for a profitable trading system.
Let's not waste more time and get into the heart of the subject, the trend. We will be approaching the market for some swing trades. However, if you want to do intraday trading, you can just use shorter time frames as we'll see later. As for the type of market, the beauty of those tools is that they are applicable on mostly all financial markets. So regardless of whether you're a stock trader, futures trader, FX trader, you can still apply those tools profitably.
OK. So how do we define a trend? It's pretty simple. We'll use a 5-period Simple Moving Average. Note: All moving averages used in the system are simple moving averages, however, you are free to experiment with weighted or exponential moving averages if they give you better results. For swing trades, we'll be using a daily chart with a 5-day Moving Average. And yes, this sounds too simple to be true. Oh well, that's one reality about successful trading: PLEASE keep it simple, and don't get shocked by the results. Just keep it simple and make money. Look at the 5-day moving average, and if it's pointing up then the trend is up. If it's pointing down, then the trend is down. This is ALL you need to know for now as far as trend identification is concerned. Someone might ask, what if the moving average is flat? Well that's when it's changing from bullish to bearish or the other way around. That's one of the cases when you should be paying extra attention to the market, as we'll see later. But for now, please only use a 5-day moving average, and trade in its direction. We'll be going long if the 5-day moving average is pointing up, and we'll be going short if the 5-day moving average is pointing down.
Lesson 2: The Setup - Candlesticks
Some pre-requisites are essential before we get into the heart of successful trading. The Japanese Candlestick method is one important aspect. And by the way, Candlesticks are not complicated at all. Actually, no previous candlestick knowledge is needed to understand and follow the method. Just focus on what we have to pick from that school, and that's all you need to know, in order to take the first steps towards successful trading. The beauty of candlesticks, is that it is the ONLY method capable of signaling a trend reversal at its earliest stages. Yes, I repeat the ONLY method capable of doing that, and therefore, we can't ignore it if we want to be successful traders. Can we? The Japanese method was there 300 years before any other school of technical analysis.
We will only pick some major indicative candlestick patterns, memorize them by heart, and use them whenever we can in our trading. But first, we need to understand what a candle is. When you draw a Japanese Candlestick chart, you'll realize it's similar to candles, and hence the name. Some candles are white, others are black. And sometimes, there are lines on top and below the candle. The Candle itself is the difference between the open price and the close price at any given period. When the body of the candle is white, it means the market opened at the bottom of the candle, and closed at the top. And when the color of the body is black, it means the market opened at the top of candle and closed at the bottom, i.e. the close is lower than the open. Then what about those upper and lower lines? Those are the highs and lows at any given session. The highest price reached during a specific period is connected to the body of the candle, and is called the "upper shadow", whereas, the low of the session is connected to the body of the candle, and is called the "lower shadow". Sometimes the high is also the open/close, in which case the candle won't have a higher shadow. And if the low is also the open/close, then in the same way, the candle won't be having a lower shadow.
Please find below detailed description of each candle pattern we will be using :
Continuation Patterns :
1) Long White Body: In a bullish trend, this candle is very healthy and confirms the continuation of the positive trend. It's simply a candle with a white body that is longer than usual. This should be easily detectable with the eye.
2) Long Black Body: In bear trend, it confirms the continuation of the negative tone.
That's all you need to know as far as continuation patterns are concerned so stick to those until we see how to use them in conjunction with Moving Averages.
Reversal Patterns :
1) Doji: That's when the open and the close are the same, and therefore, the candle has the shape of a cross. In which case, it signals indecision in the market, and is usually followed by a trend reversal.
2) Bullish Engulfing: That is when after a long bear trend comprised of several black bodies, a long white body engulfs the previous day's black body. The market usually goes up afterwards.
3) Bearish Engulfing: That is when after a long bull trend comprised of several white bodies, a long black body engulfs the previous day's white body. The market should be expected to fall afterwards.
4) Piercing Line: When after a long bear trend, the market hits a new low, and then ends up penetrating (but not engulfing) the previous day's black body. The market usually goes up afterwards.
5) Dark Cloud Cover: When after a long bull trend, the market hits a new high, but then closes lower, penetrating (but not engulfing) the previous day's white body. The market usually falls afterwards.
6) Hammer: When after a long bear trend, the market opens almost neutral, then falls sharply, before coming up again and closing near its open. In this case, we only have a long lower shadow (no upper shadow). The market usually rallies afterwards.
7) Shooting Star: When after a long bull trend, the market opens almost flat, then rallies to new highs, before coming down again and closing near its open. In this case, we only have a long upper shadow (no lower shadow). The market usually falls afterwards.
8) Morning Star: When after a long bear trend, a steep decline in the first day, is followed by small body gaping below the first day's body, and then finally on the third day the market opens up and rallies forming a long white candle. In this case, we have a long black body + a small body + a long white body. The market usually rallies afterwards.
9) Evening Star: When after a long bull trend, a steep rally in the first day, is followed by a small body gaping above the first day's body, then finally on the third day the market opens lower and falls sharply forming a long black body. In this case, we have a long white body + small body + a long black body. The market usually falls afterwards.
10) Bullish Harami: When after a long bear trend, a long black body is followed by a small body that is engulfed inside it. The market usually rallies afterwards.
11) Bearish Harami: When after a long bull trend, a long white body is followed by a small body that is engulfed inside it. The market usually falls afterwards.
12) Spinning Tops: This is when after a long trend, bullish or bearish, one or several candles are comprised of small bodies and small shadows. The market usually reverses afterwards.
But please note, that we only need to memorize 14 patterns: Two continuation patterns, and 12 reversal patterns.
You only need to properly understand the logic behind those 14 candle patterns. And that's what we did in this chapter. So please visit the link provided, and memorize those patterns by heart. Look at them one by one, see how the market behaved, where it started and where it ended, and hence why the pattern became bullish or bearish. That is ALL for now. Later on, we will see how to use those candle patterns in trading.
Lesson 3: The Entry - Leading Method
In this chapter we'll see when to enter a trade using the Leading Method. The Leading Method, is used whenever an early signal is generated by ANY candlestick reversal pattern discussed in lesson 2, "The Setup". Someone might wonder that in a bear trend the 5-day moving average might still be pointing down when a reversal signal is generated by a candlestick pattern, so how are we suppose to enter long when the trend is down? Very good question! Well this would be the ONLY exception, and it would have some strict criteria to allow its application :
1) In a Bear trend, the candlestick reversal signal must be generated AT or BELOW the 5-day moving average, or otherwise, it would be too late and too risky to enter, and vice versa.
2) The candlestick reversal signal must be associated with AVERAGE to HIGH volume, or otherwise it's unreliable.
3) The trade should be entered at the very end of the session, and since we're planning a swing trade and working on a daily chart, then we'll have to enter the trade before the session closes. It's better to wait till the very last minutes, preferably the last 5 minutes to make sure the candle pattern doesn't change at the close.
Lesson 4: The Entry - Lagging Method
In this chapter we'll learn the Lagging entry method. It's called so, because the entry takes place at a later stage than that of the Leading method. In other words, the market would have already reversed course when you enter the trade. It's pretty straight forward, and is applied in the following conditions :
1) The market crosses above the 5-day moving average, the 5-day moving average is pointing up, you enter long. The only exception is if the market crosses way above the 5-day moving average, in which case, you'd wait for the first pull-back as we'll see in case 3.
2) The market crosses below the 5-day moving average, the 5-day moving average is pointing down, you enter short. The only exception is when the market crosses way below the 5-day moving average, in which case you wait for the first reaction as we'll see in case 4.
3) The 5-day moving average is pointing up, the market is already above the 5-day moving average but is pulling back towards it. As the market closes near the 5-day moving average (but doesn't cross below it), you enter long.
4) The 5-day moving average is pointing down, the market is already below the 5-day moving average but is picking up towards it. As the market closes near the 5-day moving average (but doesn't cross above it), you enter short.
That's it plain and simple!
Sometimes the Leading Method would help you enter the market at an early stage, but if no leading signals are generated, you can still trade the market using the lagging method and make money. Next we learn about stops.
Lesson 5 : The Stop
It should come as no surprise that we'll be discussing stops before targets. Why? Because that's your risk factor. That's how much money you could lose in a single trade. That's the one MAJOR difference between technical analysis and the regular "Buy & Hold". That's how you can't go bankrupt. That's your peace of mind, and invaluable wisdom.
The stop is simply the level above/below which, if the market moves harshly against you, you would be taking your loss and getting out of the market. That simply means, that if you enter long, the stop would be below your entry level. And in the same way, if you enter short, the stop would be above your entry level. At least until you start trailing them.
So far it's easy I suppose. However, the hard part is the level where you are supposed to place that stop. Many people, think they're applying stops, when in reality, they're actually killing their trades, and giving their money generously to the market. How? By placing wrong stops. Is there a correct stop and a wrong stop? Of course! A wrong stop, is when the market knocks you out of your trade, and then reverses and goes to where you always wanted it to go. How many times did you suffer that horrible experience? You buy, you place a stop, the market breaks your stop, you take your loss and get out of the market, and at the end of the day your stock is way above your targets? You don't want to live that experience again, do you? Hence you need to apply a correct stop. And here is how:
The rest of the strategy (including stops and profit targets) is available only to subscribers to the swing trading portfolio. Please follow the link on the left to learn about subscriptions.
If you are already a member, please go to philstockwolrd.com and click on the "Optrader" tab. The strategy is available in the most recent post.