Absolute Top

The Catch-22 of catching a trade

It’s many years since I read the book ‘Catch-22’ by Joseph Heller but the phrase has been in popular use since it was published more than 50 years ago.

Clearly, I am not referring to you having to be crazy to be a trader but more to the paradoxical dilemmas we are often faced with in trading situations.

Trading the trend

There are many ways to make money from the markets – my preferred method is longer term trend trading. I have found it to be less stressful and more profitable than other methods I have used. But that doesn’t mean it isn’t open to some very frustrating practical and psychology obstacles.

The normal state of the markets is equilibrium – as documented in Burton Gordon Malkiel’s book ‘A Random Walk Down Wall Street’. So waiting for the trends is an intrinsic part of my style of trading. But how do we determine when to get into a trend? Too early and it may fizzle out but too late and the trend could be about to reverse. What is the optimum time?

First, we need to find the trend and that can be a challenge in itself. Usually there is something trending somewhere so the questions become: is it liquid enough to trade; how do I find the trend; and, how good will the trend be?

Liquidity

I generally stick to the more popular Forex currency pairs and stocks within the S&P 500, NDX 100, DOW 30 and Russell 1000. These have many market players, large and small.

Even during the quiet summer months there are usually enough players to support a trend if it develops, or continue it if already developed. Volume may be lower than average, but will be high compared to less liquid markets.

Finding the trends

Again, by sticking to a few markets it is easier to manage the number charts I am required to analyse. From time to time I will look at commodities or other exchanges just to check I’m not missing out on any big developments. However, liquidity can be an issue so I have to be more careful. Also, check your broker is able to handle lesser-known markets (and can give you a reasonable rate, too).

I tend to scan my preferred markets for easily identifiable events, such as 52 week highs and lows. I may add a few parameters to narrow the list down if there are too many to analyse.

My raw weekly list of stocks can be anything from 20 to 200, but is usually about 40 to 70. I then apply our Three Second Rule to pare it down to about 10 to 30.

TDT Tip: The Three Second Rule should be applied to any chart you want to trade. Most standard software will load about 500 bars as default. This should give you enough information, whatever your prefered time frame, for you to see the behaviour of the chart. If you cannot see a good trend (either underway or at its inception) within three seconds then move on to the next chart.

From this shortlist I will pick out the very best charts I would like to trade if a set-up develops in the next week.

How good will the trend be?

The next stage is the Catch-22 of trend trading:

  • Should you get into an established trend (which could be about to end), or
  • Should you try and anticipate a price reversal (even though you will be wrong far more often than you will be right)?

Most new traders want to get in right at the very start of a trend. The trouble with this is that a trend takes time to develop. It may be easy in hindsight to see exactly where it started, but there can be several false starts – or prolonged periods of consolidation – before it truly takes hold.

More hesitant traders wait for the trend to develop so they can see it is strong and linear. But then they worry that they have missed the main body of the move – and getting into an established trend means they may only catch the very end.

Of course, no-one can predict the future – all we can do is look for clues in the chart in front of us. Past behaviour is a good indication of future action, but it’s not foolproof.

In general you need to be aware of the market type you are trading – commodities and currencies are generally cyclical. Stocks, on the other hand, can be affected by seasonality and the long term trading cycles.

TDT Tip: Cycles can be years or even decades long. Commodities can go practically as low as zero if there is no demand and there is always a ceiling as substitutions come into play. Currencies trade in pairs so as one strengthens the other must, by definition, weaken (and vice versa) – each currency will have a point below or above which it cannot break, without the country it represents going bankrupt. And stock prices are affected 80% by overall economy, market and sector strength – and only 20% by individual company standards.

So how can you get into trade and avoid the Catch-22 of trend trading?

The 200 daily simple moving average

A simple rule is to only trade long when price is above the 200 moving average and only trade short when it is below the 200 moving average on the daily chart.

This is an excellent rule for new traders to follow. If price is trading at above its 200 day average then there is a better probability that price will move up than down.

When price comes to the end of a long trend it will take some time before it can turn around. Be patient and wait for the change to take hold. The 200 moving average is a good indication that the trend is ready to changed.

Breaking out of consolidation

Single or double bottom / top chart formations are not a reason for trend traders that a long established trend has come to an end and is about to reverse – usually price zigzags between an upper and lower narrow price range for weeks or months.

By identifying this range and waiting for price to clearly break beyond it will give a second indication that price is beginning a new trend. You can draw two horizontal lines on your charts and wait for price to clear either the top or bottom one before taking a trade.

Chart is consolidation in an uptrend

Take care to clear round numbers

If price is heading to a major figure wait for price to clear it before confirming a new trend has begun. Major figures will vary depending on current price. 100 is always a big one, but a stock at $9.60 may stumble at $10.00.

And then wait just a little longer…

It’s always worth just waiting a little longer to check price action is heading in the right direction. A good trend will last weeks, months or even years. Waiting a few more bars isn’t going to matter in the long run.

It requires patience to wait for the trend to become established so remember to instil patience when looking to enter a new trend trade.

TDT Tip: Failure is more likely than success (see my blog “You can’t be a winner without being a loser”) so enter a new trend cautiously.

Conclusion

Catching a trend is the Goldilocks of trend trading – not too early, not too late but just right. Make sure you have steps in place to protect you against either scenario.

However careful you are you can never be certain of how the trend will develop – clean and linear, messy and full of deep pullbacks, or multiple fake breakouts. The first trade of a new trend is the most risky trade you can take. So make sure, once you catch a trend, you add regularly and consistently to your position to get the very most out of the move.

I hope you found this article informative. Please feel free to leave your comments below.

Good trend trading…

Anne Chapman

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