As retail traders gain more experience, many turn to longer term trading due to the advantages it holds. One of the definite advantages to holding positions for weeks or months is the lack of time required for trading. However, one aspect many find challenging is holding their nerve when there is a counter move against the main trend.
There are a number of steps you can add to your checklist to help you decide when a small market correction turns into a deep pullback and how to manage your stops to allow for some movement without giving too much equity back to the markets.
We will be covering the following items to help establish if a counter move is simply a bit of profit taking – or the end of the trend.
- Support / Resistance
- Chart / Candlestick patterns
When we have established how the trend, and our trade, is likely to be affected by the counter move then we can consider whether our stops need tightening – or not.
When profit taking turns into a deep pullback
Trend trading always has to allow for periods of profit-taking. Price rarely moves continuously up or down in a straight line – and never for extended periods.
Most of the time we welcome these corrections as – regardless of whether we trade breakouts or pullbacks – we get another chance to enter, or add to, our position.
But sometimes the counter-move is a little too deep and we start to notice a sizable dip in our equity curve.
Pullback duration can vary from one market to the next. Trend traders are usually looking for the charts with small pullbacks, of maybe no more than 10-20 bars.
The ideal counter-trend move is three to five bars, which would usually form a small flag. This gives us time to reevaluate the trade and see if we want to add to our position. We do not feel rushed or panicked in any way and our open positions should easily be well within the stop loss range.
Provided the pullback is not too deep (covered in the next section) a sideways / consolidation move of more than 20 bars is acceptable to many trend traders. While it is frustrating, to be in a non-trending trade, unless the situation changes (i.e. the trend changes) there is little that should be done about it. You just have to monitor the position until price breaks either the resistance or support level.
Generally, within 10-20 bars, we can get an idea of the behaviour of the pullback without it affecting our equity adversely, so we remain comfortable with the move and unconcerned with tightening our stop losses.
But when the pullback is deeper than we would like, we will notice a dip in our equity and we may wonder just how far we should let price move before protecting our profits by tightening our stops.
There are other ways to assess the depth of the pullback but for most beginners, on simple software, the 50ma is easy to calculate and identify. As price begins to approach this level then the pullback is probably beginning to get fairly deep.
Some trends hug the 50ma quite tightly so you may need to consider a buffer zone beyond this. But for most markets the 50ma acts as a good support / resistance to a well trending chart.
If price starts to close in on the 50ma, regardless of how many bars can be counted within it, you may want to move your stops closer to price action to protect your profits. However, there are few other factors you may want to take into consideration first so remain measured in your approach.
The 50ma is not only tool you have to provide levels of support or resistance.
Support or resistance zones
As price approaches the 50ma there may be other areas of support or resistance, which may help price bounce back in the direction of the trend.
Major pivot points (from previous price action) are a good example, as are round numbers or annual highs or lows. Even minor pivot points can help keep price on the right side of the trend.
Major pivots are those which stand out as major highs or lows. One example is a previous all time high or low. Minor pivots are those which happened recently – a recent high or low which price had to break to continue in the trend – such as a small pullback / flag.
Round numbers in multiples of 10, 50 or 100 for stocks (and some currencies) or 1s or 0.5s in currencies (e.g. 1.0000 or 2.5000) can also act as support / resistance.
If any of these occur just before the 50ma level, or just beyond, then price may well reverse at these points rather than at the moving average.
Often you will see further confirmation that the counter move is exhausted with a candlestick pattern or chart formation.
As previously mentioned, a three to five bar pullback is a popular move and is often a flag formation. When the counter move becomes more prolonged, such as 10-20 bars or more, then there are other chart patterns you may spot.
Being able to identify some of the more common chart patterns is useful as it will give you confidence that the trend is likely to continue – even if the pullback has grown to more than 20 bars or is a little deeper than you would like (such as touching the 50ma).
There are numerous chart patterns but in our experience, the more common and reliable ones for use in this situation, are flags, double tops / bottoms, head and shoulders and (maybe) a cup and handle.
If you can see any of these developing then you may want to hold off tightening your stops – even if price has retraced a little more than desired or the duration is beyond 20 bars. Without breaching any of your stop loss rules, see if you can allow a little more breathing space for these chart patterns to unfold.
With the exception of the cup and handle, you should use candlestick patterns to help you identify the axis of these chart formations as they develop. Again, this adds to your confidence that stops can remain further away (to prevent you getting stopped out by just a few ticks) as you read price action.
As with chart patterns, candlesticks can be a helpful tool – but you don’t need to know all of them. In this instance we’re only interested in ones that signify a possible reversal, such as doji, hammer, inverted hammer, shooting star, hanging man and engulfing candlesticks.
On their own, in our counter trend scenario, these candlestick formations are not of particular interest. But if you see them as the axis of a flag, double bottom / top or head and shoulders (as these chart patterns are under construction) you have yet another “tick” on your checklist that the pattern is more likely to develop – which means the trend is more likely to continue.
Stick to your convictions
So we now have four items we can use as the basis of our counter-trend analysis.
Sometimes we will only need one to remain confident that the pullback will have little impact on the overall trend – or that we need to tighten stops. We don’t want to tighten stops unless necessary as we have to let the trend develop at it’s own pace and in it’s own way.
But sometimes, if the move is prolonged or deeper than expected, we need other measures in place to stop us being panicked into tightening stops – a move we might later regret if the trend continues.
Having guidelines in place help us stick to the plan and have confidence in our trading.
TDT Tip: Trend traders never get out at the extreme of the trend so you will always have to give a little bit back to the markets. This can seem like a lot if you are trading multiple positions on one trade. Remember that any well thought out trade which is in the black is an excellent trade. So make sure your overall position is risk-free as soon as you can – then try not to worry about the monetary value.
Trend trading is not about getting in right at the start of the trend and out right at the end. There are all sorts of obstacles to overcome on the way. You can make these insurmountable or you can make them simple and logical. Successful traders choose the latter.
“The rich invest in time, the poor invest in money.” – Warren Buffett