point of having a signal is to have an external event that forces you to change
your position in the right direction.
What if in the summer 2009, a trader was bearish on the chart, and the initial
failure to breakout over the 200-day made him believe we were are doomed to
return to all-time lows. All he heard was bad news on television and online. He
was negative, saw no hope for a rally, and was ready to sell the market short.
This is what his chart might look like:
Charts courtesy of StockCharts.com.
What would he need to see to change his bearish bias? From the look of the
chart, he had some good reasons to be systematically bearish, and even short. If
he
was short then, he should have a stop loss level where he would be proven
wrong. Maybe a close back over the 200-day moving average would have made
him exit his short position. If he was in cash, he would need to know what level
would get him short again. A failure at the 200-day moving average and a
reversal might make him sell short into strength again.
Here is what I would look for a reversal out of this downtrend and a potential
uptrend starting:
- A bullish crossover of the MACD the black line crossing over the red line
signaling upside momentum.
- The RSI crossing over the 50 RSI and getting back on the bullish side of the
chart.
- Price closing over the 200-day simple moving average showing that the bulls
are willing to buy over that line, and that selling could be exhausted below it.
- These are momentum buy signals. We are looking for the market to confirm the
beginning of momentum and
the start of a new uptrend before we enter.
Here is what happened next:
Charts courtesy of StockCharts.com.
I tried to keep this chart as simple and clean as possible so you can see how the
signals we were already looking for played out, and how the chart evolved after
the entry signals were triggered.
Entry signals are just step one. Managing the trade through position sizing,
trailing stops, and targets are part of the bigger picture. We will cover these
signals in depth in future chapters, but I wanted to give you your first glimpse of
how everything can change in a market, and how you need to be flexible enough
to go with the flow.
The quote at the beginning of this chapter is from my friend and trend following
expert Michael Covel. He has spent many years studying what makes Trend
Followers successful in the markets. Trend Followers
create systematic ways to
capture trends in financial markets through technical trading rules for entries and
exits that put the odds in their favor. This school of thought had the biggest
impact on my development as a trader.
While I have evolved my trading for different market environments and shorter
time frames, Trend Following principles of reacting instead of predicting has
been at the core of my profitability. I have always been adverse to risk, so I had
no problem cutting my losses short because I hate to lose money. And because of
the bull markets in equities in 2003-2007, it was easy to let my winners run and
become very profitable. Most people have little trouble in bull markets, it’s when
asset values start going down and stay down when the trouble begins.
As technical trader, it is our job to create systematic ways to capture trends on
our
trading time frame, and we have to let price guide our entries and exits. We
are attempting to go with the flow of capital into and out of the market, and
develop signals that get us in at the right moment to capture a trend. Our exit
signals will get us out when we are proven wrong for a small loss or allow us to
lock in profits when it appears the trend is at an end and ready to bend. We aren’t
trading our emotions, beliefs, or predictions; price action will be our guide on
our journey to profitability.
Analyzing a chart to predict what will happen in the future is not the same as
looking at current conditions and setting buy and sell signals targets if a price
level is reached. Your signal has to be based on the current reality of price and
not the future expectations of price.
A systematic approach may not always work in the short-term, but it is designed
to keep the odds in your favor so that over the long-term you will be able to
capitalize on profitable trends. A price trading system
exposes your capital to the
Different types of markets
(range bound, volatile, trending)
"There is only one side of the market and it is not the bull side or the bear side,
but the right side." - Jesse Livermore
Many new traders will pick up a book titled
Buy Signals, Sell Signals and want
to go straight to the signals and trade them. I will share some key signals in this
book and how to use them, but there are a few things
traders need to understand
about signals before they rush into trading.
Please understand that no signals are magic and work at all times, in all markets.
This is called the “Search for the Holy Grail” in trading circles, and it is a
complete waste of time. No trading signals are profitable in all markets at all
times because markets change from trending to not trending, and from not
volatile to very volatile. Markets can go from smooth uptrends supported by
ascending key moving averages, to range bound with price levels that provide
upper resistance and lower support. Markets can trade in a very tight price range
day after day and then the daily price range can triple or even quadruple.
Trading is not about magic signals but about putting the odds in your favor with
the best entries for the market that you are currently invested in. First,
you create
valid entry signals that have the potential for putting you on the right side of the
trend in your time frame. Then you take your signal when it occurs with the right
position size to control risk, and then there is nothing else you can do but let the
next market move make you profitable or unprofitable.
Here are the different market environments that a trader and investor will
experience.
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