Trading in the direction of the trend is a must for putting the odds of success in your favour. It doesn’t matter what timeframes you use as a trader. If you’re trading against the overall trend, you’re essentially swimming against the current and are therefore more likely to fail. As a trend trader you should be aiming to trade higher time frames to eliminate intra-day noise. This will make trading far simpler and require less time per day to take trades and manage existing positions. So how do you identify the most profitable trends?
The 200 period moving average (MA) on the daily and weekly time frames are one of the most important indicators in my trading. The 200MA is the simple way to identify whether you should be going long or short in a particular market. If price is trading above the 200MA on the weekly and daily time frames you should only be looking to buy. The opposite is true for shorting. This simple 200 period MA rule gives you your trading bias, but this doesn’t necessarily mean that there is a good trend.
The 50 MA is the best mechanical way to identify if there is a trend. If price is trading above the 50 MA on the weekly and daily time frame then we’re in a confirmed uptrend. If we’re below then we are in a down trend. This rule eliminates any subjectivity to identifying the trend. Meaning you can execute your trend identification everyday with no inconsistencies or emotional bias. I find this method of identifying a trend far simpler and less subjective than Elliott Wave Theory.
Once we have established the trading bias and the trend we can then look to analyse how good quality the trend is. We also then need to establish which sort of entry would be the most suitable for the trend in play. The 20 day MA will give us an idea of the linearity of the trend. If price is regularly interacting with the 20MA or even the 50MA during pullbacks then generally speaking, the trend is less linear and more suited to a pullback entry. If price is rarely interacting with the 20 or 50 day MAs and continually making higher highs with shallower pullbacks then the trend is more suited to breakout entries.
Although this is hugely counter-intuitive, your stop losses should be wider for a more linear trend. A linear trend with small, shallow breathers will at some point want to come back to its preferred MA. This is because in a linear trend there will be fewer significant pivot points forming during pullbacks because they are mostly short and shallow. Therefore price is unlikely to be able to find a static price pivot point. Therefore, a wider stop loss will give the trend space to breath and enable it to come to retest its preferred MA. This is then likely to form a good base for price to make its next leg up. During this deeper pullback hopefully you would not have been stopped out. The pullback or the next breakout could offer you an opportunity to compound to accelerate profits. (See my post on compounding here).
When you have a limited risk tolerance, say 12% of your account you need to be incredibly selective of where you allocate risk. This is because of course you don’t want to lose money but also you don’t want your capital stuck in an instrument which is moving slowly or going through a consolidation.
During a strong bull run in the stock market there will likely be hundreds of good looking stocks complying to the rules above. So how can we be even more selective to find the best of the best?
Stocks should have plenty of volume to ensure liquidity. This is essential to give you the best chance of a guaranteed stop loss. But also you should be looking at high volume and above average volume in breakout bars to confirm strength in the trend. Ideally we’d like less volume on pullbacks, especially when the pullback in an uptrend is finding its bottom. I don’t trade US stocks with less than 500k volume (ideally more than 1million) and UK stocks with less than 100k volume)
This is not likely to apply to markets like Forex because its a 24/5 market. The market is always open to so no orders can go in after the daily close. This is what causes gaps on the following open. In the stock market, trading only takes place 8-5 ish, meaning that orders that go in after the open can cause gapping the following day.
A gap up in a bull trend confirms strength in the trend. This gives you extra confidence that we are in a profitable trend or a trend will emerge. Just be aware of gap ups that form overstretched bars as these can be more volatile and lead to consolidations. That being said, gaps can be a double edged sword. Gap downs in a bull trend can put a spanner in the works because if a stock gaps down past your stop loss you may not get the fill you wanted. Ultimately you could lose more than you bargained for as your stop loss could not be honoured.
Another important way to put the odds in your favour is to look for support and resistance. In an uptrend you should be looking for support below price and no resistance above price. Of course the opposite is true in a bearish trend. If there is support below your entry price, you should position your stop loss below this level. This should act as a technical barrier and lessen the chances of stopping you out for a loss.
As a trend trader you want to look ahead of price for the path of least resistance. If you enter a long position into a stock just below the major figure resistance $100, then the likelihood of a profitable trend is significantly reduced. (see my post on support and resistance here).
Looking at the past performance of an instrument you’re looking to trade could give a good idea of how the current trend will perform. Of course instruments that have never trended well before could trend phenomenally well. Likewise, instruments that show a history of profitable trends could well disappoint. But if you have a selected few trends you can trade within your risk tolerance, then you’re better off trading trends in instruments that have shown profitable trends previously. The monthly time frame is ideal to identify the quality of an instruments trending history.
Combining all of the above will give you a checklist to use when doing your analysis. This will make your trading mechanical and efficient. Your checklist should find the most profitable trends that will last for several months. These are the trends that should cover your losses and add significant gains to your account year after year.
To sum up, you should be looking at the 200 weekly and daily MAs to identify the bias. The 50 weekly and daily MAs should be used to identify the trend. The 20 day MA should be used to identify the linearity of the trend. Volume, gaps, support and resistance and trend history should be analysed to shortlist the candidates that have confirmed trends.
A good technical charting package is essential for bringing all this analysis together. I use TradingView, which offers excellent clean easy to use charts and tools for efficient trading analysis.
Remember to keep your trading consistent, stay disciplined and you will find the most profitable trends over and over again!
If you’re interested in my approach to the market, get in touch using the email below: