The price chart offers us the gift of hindsight; we can all see where the price has been so we can all see overall trend. However this gift of hindsight can be a misleading one. It is all too easy to recognise what you would have done now that you have seen where the price has ended up. If hindsight is somewhat misleading then foresight would be invaluable. Unfortunately we don’t have the gift of foresight when trading the hard right edge of the chart (if anyone does they keep it extremely quiet) so we need to find a way of identifying what the market is doing at this precise moment in time. This can give us a good indication of what is to come and an opportunity to position ourselves appropriately.
Practical Context
Let us put this article into the practical context of swing trading US equities. For a swing trader, his or her goal is to trade predominantly in the same direction as the market wide trend. This means identifying the trend on the DJIA, S&P 500 and the NASDAQ Composite and 100 depending upon which stocks you wish to trade. Once the trend has been identified a swing trading method can be applied and trade opportunities ascertained.
Why Identify the Trend in the First Place?
You have probably heard the phrase ‘the trend is your friend…. until it bends’. Let us first deal with ‘the trend is your friend’. This is based on the principle that a trend is a very powerful mover of prices. During a trend the vast majority of market participants have the same outlook and this demand (in a bull trend), or lack of it (in a bear trend), drives the market in the same direction for long periods of time. The presence of a trend attracts those participants that are currently on the sidelines and they jump in pushing the market further. The fact that the majority hold the same opinion and sentiment points so strongly in one direction means that swings with the trend generally last longer and move further than swings against. Therefore you are increasing your odds of success on every trade you take that coincides with the prevailing trend. The second part of the phrase ‘until it bends’ is just as important. Given that sentiment is pointing so strongly in one direction it becomes very important to know when this shows signs of waning or altering completely. When this happens prices become stagnant, choppy and begin to form pullbacks and ranges. When this happens the success ratio of your trades is likely to fall if you are still trend following and the direction you place your trades may need to be reviewed. In essence trading with the trend increases your odds of success while it is trending but not while it is bending.
Finding the Trend on the Hard Right Edge
So we have established that identifying a trend as it currently stands is very important, but how exactly can we do this? When trading it is important to keep things simple and the method that we are going to explain is no exception. In fact it is based on a simple moving average (SMA). Many traders tend to use two or more separate MA’s that range from short to long-term periods. These are plotted on the price chart and signals are generated as the MA’s cross each other. As the short term MA crosses above the long term MA it indicates that the trend is up and a buy signal is generated. Once the short-term MA crosses below the long-term MA the opposite signal is generated. The problem with trading a moving average cross system is that moving averages are lagging indicators. The chances are that a substantial move has already occurred by the time the moving averages cross which removes a great deal of potential from a trade. There is also the issue of the excessive false signals that are generated when the market is in consolidation mode. At times like this the MA’s are very close to each other and become entwined, crossing regularly. In order to successfully trade an MA cross during consolidation periods it is useful to add a momentum or volume indicator to the chart. If there is an MA cross with high volume/ momentum after a consolidation it can be a very nice signal but we’ll save that for another article. So, for our MA to act as an effective measure of trend health and direction we need to remove as much of the lag effect as we possibly can. To do this we will only use the one simple moving average so there will be no need to wait for a cross. But if there is no cross how do we get our signal? At this point it is useful to remember that the SMA isn’t a system, it is helping our existing swing strategy. It will not be able to give you an entry or exit point; this is down to your swing trading rules. However it will be able to help you select which potential set-ups have the greatest profit potential. We are interested in the direction that our SMA is currently pointing. This will be either up, down or flat (side ways).
What do you do When the Trend Bends?
During a trend, pullback or a consolidation of the major market indices a good swing trading method will identify longs, shorts and a host of ‘no potential entry’ trades on individual stocks. Using the SMA to determine whether the market is in up, down or flat mode helps you to decide what to do with these potential trades. For example:
Your SMA is pointing steadily north and climbing consistently.
In addition to this your swing method is indicating several potential longs and one of two shorts on the horizon. This is a good opportunity to position yourself with the trend by opening several longs and possibly one or two shorts to hedge yourself should the market suddenly take a nose dive. During every up trend there will be some stocks that lose value. This is because individual company fundamentals outweigh market sentiment.
Your SMA has been dropping steadily over the past few months indicating a strong down trend.
However in recent days the SMA has flattened out indicating a consolidation period. In addition to this your swing method has been identifying very few opportunities and signals are mixed between long and short. This is an excellent opportunity to adapt your method. If you are used to risking 2% per trade you may wish to drop that down to 0.5% and tighten up on stops and targets. This will help preserve your capital during a time of uncertainty and choppy price action in the market.
Your SMA has been trending steadily upwards for some time.
Recently you observed that a consolidation period was in effect and now your SMA has begun to point lower indicating the first leg of a potential pullback. The overall trend is still long but right now prices are taking a breather and making a natural, corrective move lower. This is not the time to trade with the long-term trend and go long. Provided your swing trading method is indicating some potential shorts it is wise to follow them. These are likely to be relatively short-term moves until you have evidence that the trend has changed direction completely. Therefore targets should be modest in order to account for this.
Every Trend is Different.
Trends are like snowflakes; from a distance they all look very similar (if not completely the same) and they share the same characteristics but when examined closely each one is slightly different. We have covered the reasons for this in ‘Technical Analysis: What You Need to Know Before You Look at a Chart’. Therefore your ability to adapt and remain flexible is vital to your trading success and you should always trade what your charts are showing you and not what you think. There may be occasions in a raging trend that your trading method does not show any good entries at all. In this instance it is common for traders to forget their rules and jump in headfirst only to be hurt by a sudden market correction. A strong trend does not guarantee potential entry points and many potential entry points do not necessarily indicate a strong trend.
Final Thoughts.
The use of a 50 period SMA is an excellent example of simply identifying current market direction. It can be valuable in helping the decision making process when it comes to trade size and the number of positions to have open at any one time. We think that this method proves that simple can be effective. Of course as a trader becomes more experienced he or she will be able to use price action alone but the SMA is a visual indicator that keeps things easy on the eye and the brain.
Practical Context
Let us put this article into the practical context of swing trading US equities. For a swing trader, his or her goal is to trade predominantly in the same direction as the market wide trend. This means identifying the trend on the DJIA, S&P 500 and the NASDAQ Composite and 100 depending upon which stocks you wish to trade. Once the trend has been identified a swing trading method can be applied and trade opportunities ascertained.
Why Identify the Trend in the First Place?
You have probably heard the phrase ‘the trend is your friend…. until it bends’. Let us first deal with ‘the trend is your friend’. This is based on the principle that a trend is a very powerful mover of prices. During a trend the vast majority of market participants have the same outlook and this demand (in a bull trend), or lack of it (in a bear trend), drives the market in the same direction for long periods of time. The presence of a trend attracts those participants that are currently on the sidelines and they jump in pushing the market further. The fact that the majority hold the same opinion and sentiment points so strongly in one direction means that swings with the trend generally last longer and move further than swings against. Therefore you are increasing your odds of success on every trade you take that coincides with the prevailing trend. The second part of the phrase ‘until it bends’ is just as important. Given that sentiment is pointing so strongly in one direction it becomes very important to know when this shows signs of waning or altering completely. When this happens prices become stagnant, choppy and begin to form pullbacks and ranges. When this happens the success ratio of your trades is likely to fall if you are still trend following and the direction you place your trades may need to be reviewed. In essence trading with the trend increases your odds of success while it is trending but not while it is bending.
Finding the Trend on the Hard Right Edge
So we have established that identifying a trend as it currently stands is very important, but how exactly can we do this? When trading it is important to keep things simple and the method that we are going to explain is no exception. In fact it is based on a simple moving average (SMA). Many traders tend to use two or more separate MA’s that range from short to long-term periods. These are plotted on the price chart and signals are generated as the MA’s cross each other. As the short term MA crosses above the long term MA it indicates that the trend is up and a buy signal is generated. Once the short-term MA crosses below the long-term MA the opposite signal is generated. The problem with trading a moving average cross system is that moving averages are lagging indicators. The chances are that a substantial move has already occurred by the time the moving averages cross which removes a great deal of potential from a trade. There is also the issue of the excessive false signals that are generated when the market is in consolidation mode. At times like this the MA’s are very close to each other and become entwined, crossing regularly. In order to successfully trade an MA cross during consolidation periods it is useful to add a momentum or volume indicator to the chart. If there is an MA cross with high volume/ momentum after a consolidation it can be a very nice signal but we’ll save that for another article. So, for our MA to act as an effective measure of trend health and direction we need to remove as much of the lag effect as we possibly can. To do this we will only use the one simple moving average so there will be no need to wait for a cross. But if there is no cross how do we get our signal? At this point it is useful to remember that the SMA isn’t a system, it is helping our existing swing strategy. It will not be able to give you an entry or exit point; this is down to your swing trading rules. However it will be able to help you select which potential set-ups have the greatest profit potential. We are interested in the direction that our SMA is currently pointing. This will be either up, down or flat (side ways).
What do you do When the Trend Bends?
During a trend, pullback or a consolidation of the major market indices a good swing trading method will identify longs, shorts and a host of ‘no potential entry’ trades on individual stocks. Using the SMA to determine whether the market is in up, down or flat mode helps you to decide what to do with these potential trades. For example:
Your SMA is pointing steadily north and climbing consistently.
In addition to this your swing method is indicating several potential longs and one of two shorts on the horizon. This is a good opportunity to position yourself with the trend by opening several longs and possibly one or two shorts to hedge yourself should the market suddenly take a nose dive. During every up trend there will be some stocks that lose value. This is because individual company fundamentals outweigh market sentiment.
Your SMA has been dropping steadily over the past few months indicating a strong down trend.
However in recent days the SMA has flattened out indicating a consolidation period. In addition to this your swing method has been identifying very few opportunities and signals are mixed between long and short. This is an excellent opportunity to adapt your method. If you are used to risking 2% per trade you may wish to drop that down to 0.5% and tighten up on stops and targets. This will help preserve your capital during a time of uncertainty and choppy price action in the market.
Your SMA has been trending steadily upwards for some time.
Recently you observed that a consolidation period was in effect and now your SMA has begun to point lower indicating the first leg of a potential pullback. The overall trend is still long but right now prices are taking a breather and making a natural, corrective move lower. This is not the time to trade with the long-term trend and go long. Provided your swing trading method is indicating some potential shorts it is wise to follow them. These are likely to be relatively short-term moves until you have evidence that the trend has changed direction completely. Therefore targets should be modest in order to account for this.
Every Trend is Different.
Trends are like snowflakes; from a distance they all look very similar (if not completely the same) and they share the same characteristics but when examined closely each one is slightly different. We have covered the reasons for this in ‘Technical Analysis: What You Need to Know Before You Look at a Chart’. Therefore your ability to adapt and remain flexible is vital to your trading success and you should always trade what your charts are showing you and not what you think. There may be occasions in a raging trend that your trading method does not show any good entries at all. In this instance it is common for traders to forget their rules and jump in headfirst only to be hurt by a sudden market correction. A strong trend does not guarantee potential entry points and many potential entry points do not necessarily indicate a strong trend.
Final Thoughts.
The use of a 50 period SMA is an excellent example of simply identifying current market direction. It can be valuable in helping the decision making process when it comes to trade size and the number of positions to have open at any one time. We think that this method proves that simple can be effective. Of course as a trader becomes more experienced he or she will be able to use price action alone but the SMA is a visual indicator that keeps things easy on the eye and the brain.
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