The basic action plan for a trend-following strategy is: –
- Identify a trend
- Determine how to enter it
- Determine how you will know it has ended
- Determine a reasonable target
- From the target and failure levels, make sure that the bet is viable, with a reasonable risk-return ratio
- Make your bet
- Adjust your stop loss as the trend continues
- Watch for and act on your exit signal when the trend winds up.
The technical analysis review looked at various ways to identify a trend, from simply observation of the raw chart, to the various additions that you can use to determine if a trend exists and how strong it may be. Here we look at and revisit the various tools to see how they are applied.
The most basic of definitions is that an up-trend is a series of higher highs and higher lows, and a down-trend is a series of lower highs and lower lows. This is easy to identify, but is typically more obvious after the event. A trend, even when found, can reverse at any time, so you need to keep an eye on your bet. Traders will draw trend-line on the chart, and consider that the trend is in place as long as the price is above the trend-line joining the higher lows, for an up-trend, and below the trend-line connecting lower highs, for a down-trend.
There are many other ways of looking for a trend, some more technical than others. For instance you can look at moving averages. In its simplest form, for an up-trend you might look for the price to be above a particular moving average; you could also require that the moving average was sloping upwards; you might use two different periods of moving average and require that the shorter term is above the longer; or use three moving averages, and require the proper sequence of the shortest term on top, then the mid-term, then the long-term underneath.
So how do you bet when you think that there is a trend? When is a good time to place the bet? You want to bet early enough to benefit from the maximum price move, and you want to wait for the trend to be certain, unless you are prepared to accept a higher proportion of losing bets.
There is no right answer to this, so don’t worry about trying to find it. Again, it really is a matter of what works out best on average, understanding that you will have losses through no fault of your own. One way to enter a trend-following bet is to find a strong trend, and wait for a pullback. In an up-trend you would wait for the price to go down a bit, and make your bet when you see the trend starting up again.
One method of timing your entry uses moving averages again. You can open your bet when the price moves above the moving average, if that’s how you are defining the up-trend, or use the two moving average crossover method, the shorter term average rising through the longer term. Obviously you can also use these techniques and signals in reverse for a down-trend.
If you concentrate on a particular security or type of bet, you may want to experiment with the periods of moving average and find what works best, but as a starting point for the two moving average method you might try 5 days and 20 days, and for the three moving average method 5 days, 10 days and 20 days.
If you want to look at indicators outside the moving average, you should refresh your knowledge of the Average Directional Movement Indicator, the ADX, found in Chapter 9. The higher the ADX, the stronger the trend. Some traders will use a level above 30 to show that there is a trend.
If you have been using chart construction, drawing trend-lines to identify the trends, you can use the proximity of the price to the trend-line to provide the trigger for placing a bet. In an up-trend, when the price comes down to touch the trend-line it is relatively low, and, provided the trend continues with the price respecting the trend-line and going back up, it is an excellent price level at which to place a bet.
Whatever way you choose to identify a trend, you must always bear in mind that you want to make it simple enough so that you will use it. Over-complication does not mean that the method is any more reliable, and a complicated system may be subject to errors, and deter you from using it.
With that said, you want to choose a specific way in which you will select suitable candidates for a bet. Assuming that you may want to look for new bets on a weekly basis, you may want to “shortlist” possible candidates for further review or to put on a watch-list. Here are a few particular ways that are used successfully by traders. First, as mentioned above, you can look for the ADX to be above 30. This is something that you can set up a stock screening routine to check for you, and reduce the number of potential trades that you have to consider. I suggest that you start checking with an ADX of above 30, using a 14 day indicator as previously demonstrated.
That’s not the finish of using the ADX, however, as you also need to look at whether the trend is up or down. You can simply look at the DI+ and the DI- for this – if DI+ is higher than DI- then it shows a potential long trade, and if DI- is the greater then a shorting position may be coming up.
The second method that you may want to look at using to provide an initial screening is to consider the stocks that are making new highs or lows. Generally, you might look back over the last 52 weeks, and see which stocks are setting new levels. Obviously, if the stock is making a 52 week high then it is a potential long bet, and a new 52 week low is a selling or shorting prospect. You can even find some websites that have done the research for you, so make sure that you use all the facilities available. An example of such a site is http://www.barchart.com/stocks/high.php, which gives access to British, American, Canadian and even Indian lists of stocks. But www.stockpickr.com and even www.nasdaq.com have similar “done-for-you” lists.
A third method of initial screening is to look at the strength or weakness of a stock relative to the general market sector it is in. Please don’t get this confused with the RSI, which as mentioned earlier is only relative to the extent it compares a stock’s performance to itself. Relative strength is usually referring to the strength of a stock in its particular market sector. You can set up a stock screen for this too in a charting program – start by looking for a stock that has out-performed its sector by at least 10% in the last couple of months, for an up-trend, or underperformed by the same amount for a down-trend.
These are three alternative ways to generate a shorter list of potential bets than the whole field. You can pick which you want or apply two or all three of the methods to cut the list down further. You might find perhaps 20 to 50 stocks out of the FTSE Index comply at any particular time. At least it is more manageable than looking at hundreds. Of course, you can use the same idea to initially screen any financial instruments that are traded and not just stocks, as we’re only dealing with a financial market.
Now you have a short list of stocks that may be good betting candidates. You need to see which are going to give you a good entry point, and you may need to watch them for several days – that’s why I suggest that you perform this short listing exercise on a weekly basis.
Even though we have a shorter list, we really need to cut it down more so that we can look in detail at each prospect. What this is called is looking for a set up, which is a particular pattern or other indication that shows the stock is ready for a bet. So if you are following this particular trading plan, you will look every day for a sign that you have a set up, so that you can place a bet. The set up could, at its simplest, simply be a temporary pullback in the trend, and you would set your own parameters on how much of a pullback would make the trade possible. You could use a technical indicator to check that it was only a temporary pullback rather than a change in the trend.
The final part of placing a bet is to wait for a trigger on this much reduced list of securities. You might choose that your trigger is when the price resumes the trend, and reaches a certain level; you might look for a particular pattern, whether in a bar chart or a candlestick pattern, that suggests the trend is resuming. You have a huge choice of triggers, and many have been pointed out in the technical analysis section. Some work better than others, and some financial securities are better suited to some than others.
Surely by now you have done enough work to place a bet with a reasonable chance of success? Not quite. What bet are you going to place? It’s not enough to say you want to go long or short, you have to choose how much to bet. This is not a standard amount for a given account size, but depends on your risk/reward calculations for the particular bet. Let’s just go over the process again.
You start by looking at the charts, and figuring what you think the stock could do. Specifically, you need to figure out the price at which you are going to admit that it did not perform as you had hoped and expected, and close your bet for a loss. If you are trying to enter on a pullback, for instance, it might be just beyond where you think the pullback should finish – if the price goes beyond this, then your assumption of a pullback is in error, and who knows where it might finish then? This might be if it broke through a previous support, or broke whatever you are taking as a reason for expecting the bet to work. This would also be the place that you would put your initial stop loss.
Then you must consider where your trigger point is, so that you can see the distance between the trigger and stop loss level. This will give you an amount that you can lose for your unit of betting, whether it’s a pound per pip in the Forex market, or an amount per penny for shares. Going back to the previous discussion, you don’t want this to exceed 2%, at most, of your account, and perhaps less, depending on your propensity for risk, and this will give you the maximum size of your bet.
While just reading the above you may think that I have complicated what was meant to be easy, the act of simply betting on a price move. You will find when you do it that it is really not that hard or long-winded, and by going through the process you will do the best you can to make the right choices and protect your account from losses.
Now that you have figured out how you want to select and enter a bet, you need to consider further how you are going to exit it. After all, no matter how well it performs your gains are only hypothetical until you close out, and a reversal could take away what you thought you had won. There are several different scenarios that you must consider when deciding to exit a bet. The bet may not go your way, and you may have to cut your losses before they become too great. This is a case that you will have considered before even taking the bet, and decided on a stop loss level. But there are many other things that can happen to the bet, including it going nowhere, when you may want to close and move on.
When would this happen? Say that the trend faded and you were left sitting on a bet that wasn’t performing as you had intended. There is no reason for hanging on, and the sooner you close the bet the more cash you have in your account to take up future opportunities. Then it becomes an issue of how long is too long? Considering that spread betting is a form of trading and not investing, you should be looking for a favourable move in a week or two, and if it is not happening as you expected you are better off closing the bet. That’s not to say that all your bets should be closed in a week or two, as you should be hanging on to winning bets while they keep going; just those bets that haven’t really started moving should be closed out. You can set yourself a limit, say 10 days for a minimum 2% move, and close if they don’t conform to your plan.
Another time that you want to close the bet is if the reason that you took out the bet goes away. This is bound up in your trading system, so will depend on what you originally looked for – say you short-listed the stock when the ADX became greater than 30, then you triggered an entry. If the ADX dropped below 30, you could exit as the reason that you chose the bet has gone. It’s worth looking at what the price is doing, so that you can exit at the most opportune time – if the stock had decided to go sideways, you might wait until the price came to a favourable part of the range; if it looked like the move was reversing, you might get out straight away.
Those are both unfortunate reasons for exiting a bet, but I repeat that does not mean that you did anything wrong (you might have done, but that’s up to you to look at and decide). Some bets just won’t go your way, and that’s an end of it. But what about when it does go your way?
If your bet is performing as you hoped, you have a different problem, though in some ways a good problem. Just how far is far enough? You don’t want to hang on to the bet all the way up and down again; also you don’t want to take a quick profit only to see that you could have got twice as much if you had held on.
Just as you couldn’t really predict the absolute lowest point at which to enter a long trade, or the highest point for a short bet, so you cannot tell exactly when to close a bet for maximum profit. What is clear is that losers tend to hang on too long to losing bets, and to take a profit too quickly on winning bets. That’s what makes them losers. Winners will do the opposite, riding winning bets for as long as reasonable while not hesitating to let go of the losers. So you are looking for ways to hang on to winners that won’t jeopardise the profits if they turn.
The handiest tool for doing this is the trailing stop order. This was explained in detail in Chapter 3, so I won’t repeat it all here. Suffice to note that it is a stop loss order that automatically moves up when the price goes up, keeping a certain distance from the highest price reached. The questions to be looked at when using a trailing stop include whether we should put it out there on the market or just have a note of it; and how far away from the maximum price should it be?
Thinking first about putting an actual order with your bookmaker, there is a lot of myth and some truth talked about the perils of revealing your hand. Some can be substantiated, a lot is just sour grapes. When starting out spread betting, it’s probably best just to put your order out there in the market, and ignore the talk of price manipulation, which is supposed to capture your money unfairly. This has the advantage that you don’t need to worry about keeping a check on the price, the order will trigger when necessary without your involvement. Unless you are dealing really large amounts, it’s not worth even a crooked dealer manipulating the prices to force the orders. If your trailing stop gets triggered, then the price goes off in the right direction without you, consider the possibility that you misjudged the security and had the stop too close to the price, rather than suspecting foul play.
Which brings us to the question of how far away the trailing stop should be. There’s no universal answer, and there’s no one answer even for a particular security. You should decide what you are going to do in the context of your trading plan and stick with it. You can initially trail the stop by a certain percentage or distance from the price, and this should take into consideration the typical volatility of the stock You can even choose, for example, twice the Average True Range (ATR – see Chapter 9) to have as recent a gauge of this as possible.
The circumstances when you might want to modify this are several – if you had a particular resistance level in mind as a target when you placed the bet, you could move the stop closer as you approach it, anticipating that the price is likely to rebound, and thus preserving more of your gains. If for other reasons you think that the trend is fading, again you could “tighten up”, as the saying goes, your stop to keep the best profits. You will seldom consider “loosening” a stop, even though some say that you can if the trend is strong and likely to continue. My feeling is that your initial choice of stop should give the price sufficient room for volatility, and you don’t need to increase it if your first choice was correct. The one rule that you should stick with is not to let the trailing stop go lower (for a long position), even if you change the way you are trailing it. The stop is on a “ratchet”, and that’s that.
Trend v Swing Trading
As regular people who follow my posts would know I was of course talking about Trend Trading strategies, but, it would be good to show the uninitiated the difference between the two by depicting how a trend trader would look at the chart and how a swing trader would look at it.
The point being, as a trend trader I would be looking for a BREAK THROUGH of support or resistance lines. When looking at the chart from a Swing Trader perspective you would be looking for the chart bouncing off the support and resistance levels and going back the opposite direction.
The difference, a swing trader looks for a “bounce” away from support and resistance levels, the trend trader looks for a breakthrough of the levels.