How to Trade in a Downtrend

In general, the overall equity market has been in a strong uptrend for the last several years. Some of this is due to the recovering economy and some can be attributed to the Federal Reserve intervention/stimulus called Quantitative Easing. This last phase of Quantitative Easing or QE3, as it has been commonly referred to, has mainly consisted of purchasing $85 billion worth of government bonds per month. For the last several months, the Fed has been “tapering” this QE3 back by $10 billion per month. As the Fed continues to reduce the stimulus, and with other market uncertainties abound, including potential inflation and potential higher interest rates, the market, at some point, may slide into more of a bearish market from the current bull market. We all know that the market just doesn’t go up forever; we will see some kind of correction eventually. When this correction happens, you can still trade the market on the downside, if you are prepared. Here are several strategies that are good to understand.

1. Short the Security
If you have a margin account, you can short the stock or EFT. Not everybody is comfortable shorting the market; however, many traders are becoming more familiar with this strategy as the market uncertainty becomes greater. Basically, you are borrowing the security from the broker and selling it at a higher price and then buy it back at a lower price as the security drops in value. This allows you to pay the broker back the security and you can profit from the difference between the top and bottom, less any transaction fees. The risk here is if the security goes up in value when you are short, which can be a significant loss until you “cover your short”. You want to be sure that you have a confirmed downtrend and that you use good risk management by using appropriate stop loss orders.

2. Buy Put Options
If you have a confirmed downtrend and want to short the market, an alternative to shorting the security might be to buy “puts” or put options. What is a put option? Put options are options that are inversely correlated to the underlying security, meaning as the underlying security goes down, the put option will go up by the ratio known as the ‘Delta Coefficient’. The higher the delta, the higher correlation there will be. For example, if the delta coefficient is -.8, then as the underlying security goes down a dollar per share, the put option will go up approximately 80 cents per share. This can be a very good strategy in a bearish move, as long as you use good risk management, using a stop loss and proper position sizing.

3. Inverse Exchange Traded Funds (ETFs)
Inverse EFTs are ETFs that you can buy long, but, like put options, will go up as the underlying securities go down. This is an easy way to short the security as the ETF managers are buying puts against the securities inside the fund so you don’t have to trade the put options directly. These are great for the larger index equity funds. Also, these are limited to the larger EFTs, like the S&P 500 and the Dow 30, for example.

In conclusion, these are the main bear market strategies just to get you started. While inverse EFTs may be more limited to just trading the market indexes, this may be the simplest and most effective way to start trading the downside of the market.

Using Support and Resistance for Potential Entry

Today we are going to look at how we can better use support and resistance to help us identify potential entry points into a trade. As you know, support and resistance is one of the most important things that we can identify in our trading. Knowing where the price may have difficulty moving beyond is very important. One of the hard things to know is exactly where this might happen, so having a way to determine this area is key. An important thing to remember is that the support and resistance on a chart is not a very specific point; a lot of times, it is an area or zone that acts as the barrier to movements.

As we look at a chart, it is, often times, quite evident that the price is not moving past certain areas. If we can visually identify these areas, our job becomes a bit easier. If the support and resistance is not that easy to identify, we may need to use some tools to help us better see where they are located. Some of the more commonly used tools are moving averages and trend lines. Of course there are others, but these two seem to be some of the more common ones. As we draw lines or put the moving average on, we can clear up what we are seeing when it comes to price areas acting as support or resistance.

Remember, the area we are looking at is more important than trying to find a specific point on the chart. As you get good at finding these areas, you will be able to use them in helping to identify potential entry points to go long or short. Here are a couple of examples of how you might do this.

Long Entry

One of the first things you look for, in order to take a long entry, is the direction of the trend. We will first decide that the trend is moving up. After that, we will try to see where support is located. We can use the tools above to help in finding support. Once we have done this, we can look for the price to bounce up off of the support area in the direction of the trend. As the price begins to bounce up and off of support, we can look to enter once the price has closed above the high of the past 2 candles. This price confirmation will help us know that the price is really beginning to move back in the direction we want.

Short Entry

This would be the opposite of the long entry, where we would be looking for a downtrend and the price bouncing down from resistance. A close below the last 2 candles would give confirmation that the price was moving in the desired direction.

There are many different variations of this type of entry. The key is that if we can identify support and resistance, we can begin to look for our entry points. Of course there are times when this type of trade will fail, so you will need to make sure you are using proper risk management in each trade. Take some time to review how you identify support and resistance to make sure they can help you become better in your trading.

Market Reversal Clues

Are there clues in the market to help us identify a shift in momentum? In the past, we have discussed the idea of different technical studies and price patterns that we can use to help determine when the current market might reverse. Today, I would like to discuss the clues for you to look for when the market momentum may be weakening and getting ready for a change.

Let’s first look at the potential reversal price patterns centering on double tops and triple tops in a bullish market, and double bottoms and triple bottoms in a bearish market. First, why are these double and triple tops or double and triple bottom patterns good indicators of potential market reversals? Simply stated, the double or triple tops are a function of the market looking to push above the current resistance level and are unable to find new ground or higher territory above that resistance or top. When you notice this double top reversal pattern, often referred to as an “M” pattern you then look to the bottom of the “M” for a confirmation of the pattern or, in other words, when the price moves below the short-term support level. See the chart below for the double top and notice when the price moves below the bottom of the “M”, the market confirms to go lower. For a bearish market, you can look for a “W” pattern for a potential bottom, which is just the opposite of the double top pattern, but you are looking for the market to bottom out and then move up through the resistance level at the top of the “W” pattern. The same also applies to the triple bottom, looking for a reversal off of triple confirmed support and moving up above the top of the resistance level. In the AUD/USD daily chart below, notice the double bottom pattern and the “W” along with it.

Figure 1: Double Bottom or “W” pattern

Another good clue you can look to for evidence of trend weakness, and a potential market reversal, is what I will refer to as the classic divergence patterns. What is divergence and how does it work? The way that divergence works is that when a new high or low in a security occurs, and it is not followed by the stochastic indicator, there may be an indication of a potential trend reversal. For example, when bearish divergence occurs, the price makes a higher high, but the stochastic indicator makes a lower high. This is bearish divergence and shows that the upside momentum is slowing, even though prices are continuing to make new highs, and a trend reversal lower is very likely. This divergence is a very strong indicator of current weakening momentum in the trend and a high likelihood of a change of direction.

Now let’s apply this divergence pattern to a chart to identify the market weakness and the potential shift in momentum. See the EUR/USD daily chart below and note that after the significant move lower, the divergence pattern sets up with the stochastics at the bottom moving higher, setting up the bullish divergence and the bullish trend takes over.

Figure 2: Bullish Divergence

So, in conclusion, to understand when a trend may be setting up for a change in momentum, look for the price patterns, double or triple tops or bottoms as one clue. Independent of these patterns, if divergence sets up, either at the top, forming bearish divergence, or at the bottom of the market, setting up bullish divergence, look for a market trend change. Once these patterns confirm, I generally wait for a confirming candle to close and then enter the market, especially if divergence is in play.

Civil Unrest and the Markets

It seems that, recently, there has been story after story in the news reporting of the civil unrest and violence all over the world, including violence within the US. We can hear about the infighting within some countries, the fighting between different countries, and we have seen a rash of airline tragedies, including one that was shot out of the air. Within the US, there has been a lot of violence in some of our major cities. We have political, economic, and immigration problems and one group that, literally and specifically, states that they are in the process of taking over the US from within. They will not attack us from outside of our borders; they are currently in the process of immigrating to the US and pushing current citizens out of neighborhoods and, eventually, cities and large metropolitan areas. How do we react to these events from a trading and investing standpoint and should we even be concerned about reacting or protecting ourselves at all?

When a war breaks out on the other side of the world or when citizens riot against their government, is this something that we, as traders or investors, need to concern ourselves with? Other than a story of this type being newsworthy information, do these events have any real or lasting effect on us and our portfolios or are they just something we can note as interesting, while treating our investment businesses as if they never happened? These non-technical events are fundamental events and where they happen in the world, and to whom they happen to, can be very important to our trading and investment decisions. Any trader or investor who disregards fundamental events altogether may not get hurt by them when they occur every time, but, at some point, ignoring them will probably lead to a bad situation.

The companies that we trade on a daily basis or that we hold on to for the long-term, regardless of if they are held individually or in a fund or ETF, can be greatly affected by external events. Any company that does business internationally is subject to events in the specific geographic regions that they do business in. They may also be affected by events in regions that they do not directly operate in if they have business dealings with companies in those areas. I believe that we need to be very defensive when we invest, not to the point that we choke off our ability to make a profit from investing, but we do need to be nimble and ready to move either into or out of the market. An example of a potential opportunity coming off of bad news is the General Motors announcement around the likely costs related to the traffic accident fatalities and more recalls, which have greatly reduced its expected earnings per share. This has caused the stock to drop relatively quickly and by a good deal. GM, as a company, isn’t likely to be going out of business any time soon, so when the stock bottoms out, there will likely be a good buying opportunity.

I have been investing in the equity markets for myself and others for over 30 years. During that time, we have seen approximately 5 major market downturns, company specific events that we thought we would never see, wars, assassinations, the overthrow of governments, climate or weather related catastrophes, as well as various types of economic bubbles bursting. This leads me to believe that we can expect to see much of the same events repeat themselves over the next 30 years or, at least, events that parallel past events and are similar in nature. We definitely do not need to panic every time something crazy happens on the other side of the globe or even here at home, but we should be paying attention to these events. Not only can we protect ourselves, by managing our current assets, we may also be able to spot some trading or investing opportunities, which may be born out of these events.

How to Determine the Trend

In our article today we are going to look at several ways to determine the trend of the chart we are trading. As you know, the trend is often the very first condition looked at to determine a potential trading setup. If the trend is up, we are looking to buy, and if it is down, we are looking to sell. Because of the importance of this condition, we need to make sure we have a consistent way to determine the direction.

The first thing we should look at is the overall price action. Often times, just this can give us enough information to say that the chart is in a trend. The pattern of higher highs and higher lows is what we see in an uptrend, while the pattern of lower lows and lower highs is what we see in a downtrend. Sometimes, this is an obvious trend and sometimes, it is not. When it is obvious that the trend is up or down, we can act on that information. When it is not as obvious, we can look for additional conditions in order to confirm the direction. Remember, if we use additional tools to identify the trend, we still need to have the price act as the ultimate confirmation of the trend.

One of the tools we can use the help us visualize the trend is the moving averages. An example is to use the 40-period simple moving average. If this indicator is moving up, and price is above it, we will consider that a sign that the trend is moving up. If it is moving down, and the price is below it, then we will consider it in a downtrend. Many traders like to see something to help visualize the trend direction and the moving average is a simple tool that we can use.

Another tool that we can use to help show the trend is to draw trend lines; this is done by connecting the lows and highs on the chart. This can form a channel, which, if it is pointing up, will indicate an uptrend, and, if it is pointing down, a downtrend. Generally, to identify the uptrend, you will connect the lows that are acting as support and to identify a downtrend, you will connect the highs that are acting as resistance.

Regardless of what you use, you need to have some way to identify if there is a bearish or bullish trend. This will tell you if you should be buying or selling. It doesn’t need to be complicated; in fact, the simpler it is the better it might be. Take some time to write down your rule you will be using to determine the trend of the chart you are trading. Then begin to practice using the rules in your trading to see if it will help improve your overall outcome of your trades. By starting with the trend, you will be putting yourself in at the best possible position to be successful in your trading.

The Key to Successful Trading

One big problem many new traders have is the constant desire to find the “perfect system”. This often leads to traders continually moving from one system to another without ever really getting consistent results from any of them. I refer to this as the “grass is greener on the other side” syndrome. The honest truth is there really isn’t a perfect system; it just doesn’t exist, no matter what the ads say. Don’t get me wrong, finding a good method is not only important, but essential. However, when you stop looking for the “Holy Grail” and start actually trading a good basic method consistently, that is when you can increase your chances to be successful, as opposed to constantly trying new systems and never letting one system work.

Regardless of the specific system, with its entry and exit strategies, risk management is a key element of any successful trader’s system. With good risk management you are more likely to control the emotions that come with trading and put yourself in a better position to be profitable. It is important to have a long-term view of success and not be willing to take larger risks on any one specific trade. Many small winners with smaller risk are generally better than a couple of large winners with large risk. Any trader can get lucky a few times by trading large position sizes and getting some big winners. Trading smaller, lower-risk trades, is better than putting too much money into fewer, larger-positions, which may go against you and put your entire account at too much risk. Keeping your position sizes with only 1-2% maximum risk per trade will keep your individual positions small and your risk at an acceptable level. By placing stop losses on each and every trade, you can limit the risk per trade as well. In addition to small position sizing, you should limit the total trades you have at any one time to around 5 positions, which will never allow your total risk to exceed 10% at any one time. So, even if all of the positions go against you all at once, your account risk will not be too large. All of us need to live with the possibility, each time we trade, that each and every trade could be a loser; therefore, we need to be aware of the specific percentage risk we take with each position.

In conclusion, consistently using a good trading method with specific risk management rules and proper position sizes are the keys to successful trading. The trader who can stick to a specific set of rules, has the best chance of success. Like most thing in life, the more consistent you can be, the better you will become. Not trying to “kill it” on every trade may seem counterintuitive; however, having many trades, with a small, fixed risk, can add up to your total trading success. Remember, like most things in life, slow and steady is the winning formula.

Moving Average Crossover

In our article today, we are going to talk a bit about a trading strategy that uses two moving averages. This is a commonly used trading strategy that many traders use to identify, not only possible entry points, but also to determine the direction of the trend. You can also use this to help with other trading strategies when trying to see which direction to trade.

The basic concept, when using two moving averages, is to try and catch the momentum as it begins to change directions. If we can identify where and when the direction will reverse, we can know a good time to enter the trade.

Typically, when trading this type of strategy, you will use a shorter-term moving average, along with a longer-term moving average. As the shorter-term moving average moves above or below the longer-term moving average, you will have a trigger signal to enter the trade. Because we are looking to catch the trends as they change, this type of strategy works great when the market is trending. If the market begins to move sideways, which can happen often, this type of strategy does not work very well and you get chopped in and out of the trades quickly.

The basic rule for trading with two moving averages is to look for the direction the shorter-term moving average is going. For example, if we have a 10-period simple moving average on the charts, along with the 20-period simple moving average, we would be looking at the 10-SMA to tell us how to trade. If the 10-SMA crosses up and moves above the 20-SMA, you would look to buy. If the 10-SMA crosses down and moves below the 20-SMA, you would look to sell. Entering in on these changes would be the trigger to the trade.

Once you are in the trade, based off of the crossing of the moving averages, you would then need to manage it like any other strategy. You would need your stop loss placed, as well as your target. Using appropriate position sizing, based off of the stop loss, will help keep your losses small.

In order to better understand how to trade this strategy, take some time to practice with it on your demo account. You will want to try out several different moving averages, as well as time frames. Because there are so many possibilities, you will want to make sure you find the time frames and moving averages that work best for you.

As a suggestion, try to use a 10-SMA, along with a 30-SMA, on a 60 min. time frame. This will give you an idea for how a moving average crossover might work. As you backtest this, you will see the times when it works really well, as well as times where it does not work. By practicing with this, you will also see how it may help with your other strategies by indicating when a new trend may be starting.

Use Trailing Stops

I have discussed in the past the importance of placing an initial stop loss order on your trades so that you can limit your risk or exposure to the market. However, your stop loss orders can also be used as a positive exit strategy in addition to just being a risk limiter. Let’s discuss the use of a trailing stop loss to manage your trades. To do this, you can adjust the initial stop order, or “trail” the stop, as the position moves in your favor. So what are trailing stops and how do they work? Just like initial stop loss orders, the trailing stop promotes trading discipline by taking the emotion out of the exit decision. A trailing stop is used to protect profits in the security by enabling a trade to remain open and continue to profit as long as the price is moving in a positive direction, either long or short, but then closing the trade if the price changes direction by a specified percentage, letting the trade exit, or being “stopped out”, at the trailing stop level.

There are two kinds of trailing stops – first, automatic trailing stops, and, second, manual trailing stops.

  1. Automatic Trailing Stops: The benefit of an automatic stop order is that can be set at a predetermined percentage away from the current market price. A trailing stop for a long position would be set below the position’s current market price and, for a short position, it would be set above the current market price. An example of an automatic trailing stop is a stock that is $50 dollars at market and you place an entry order. At the same time you place a trailing stop 5% or $2.50 away from the market price. As the stock price moves 5%, the trailing stop will move to break even and then continue to trail on up every time the stock moves another 5%.
  1. Manual Trailing Stops: As the name implies, you periodically will move the trailing stop as the market moves in your favor; it will not automatically move as the market moves. With a manual trailing stop, you would move the stop up or down, whether going long or short, in the direction of the trade using some method, such as the low of the last 3 bars for a long trade, or the high of the last 3 bars for a short trade, instead of a fixed percentage. The advantage to using manual trailing stops is that it allows you to scale the trailing stop using current market ranges, instead of a preset percentage, as in an automatic trailing stop. This will sometimes give you better results than the automatic trailing stop, being more dynamic to the current market conditions, and not being overly tight to the market.

In conclusion, the real advantage to using trailing stops is that you can eliminate your market risk once you move to break-even and then you can start to protect profits as you move your trailing stop. Remember, always use an initial stop loss order to limit your initial risk, and then start to trail it by using a trailing stop loss to exit your trades. This can, potentially, improve your winning trades by extending the trade’s potential, as opposed to using a set target.

Don’t Follow the Herd!

I am not a big fan of most technical indicators and I am even less of a fan of trading methods that use a lot of them; however, I see a lot of methods and different trading ideas that traders have from all over the world and the common theme among them is that most of them are heavily reliant on technical indicators. Trading is as personal and as individual of a concept as anything else that we do; you can be as creative around it as your imagination will allow you to be. The thing that I notice more than anything around many traders’ methods is the lack of creativity. A high percentage of the trading methods that I see other traders use employ the same indicators as most other traders using the trading platform’s default settings, which means that, generally speaking, most traders will achieve about the same results that most other traders achieve. This is a problem because many traders are horrible traders and probably shouldn’t be in the market at all. When you follow an individual or a group of individuals that really aren’t very good at what they are doing, it is likely that you will achieve the same, or similar, results, so why follow the crowd and underperform with everyone else?

Technical indicators are based on the price action of the security, which is old information by the time it is processed and melded into an indicator X number of time periods into the future. Does past information really tell you anything about where the price action is likely to go in the future? In a slower moving market, like the stock market, technical indicators may be a little more helpful, or, at least, a little less harmful. But, in a faster-paced market, like the Forex market typically is, the price action can move so quickly that by the time you gather the information from a few indicators and try to apply them, often times, it’s too late. One of the most common things that I notice occurs when employing a lot of technical indicators is that the combination of indicators and the settings chosen will work well for a finite amount of time and then they will stop working. I believe that the reason for this is that when the methods and combinations of indicators and settings were chosen, they worked well on the hundred or so bars that were showing on the screen at the time and, when backtesting, you can make yourself believe anything. When the market changes, becoming more or less volatile when volume changes, due to world and economic events, a rigid and highly technically-based method can quickly fail, though it may begin to work again at some point in the future. But, by then, most traders will have moved on to try something else, which will likely be equally ineffective.

My experience tells me that the more you look at a chart, the more you will see. So what do you see if you look at a chart with no crutches or indicators on it at all, you’re looking at just the price action? Are there recurring patterns that develop in the price action? Does the price action itself give you a roadmap as to where it wants to go? Technical indicators try to tell you where the market is likely to go, but the price action will do what it will do; it will lead you to where it wants to go.

If you do need to use a lot of indicators, you may consider at least trying to use them in a creative way. Apply an indicator to a chart with the standard platform settings and then adjust the settings. Learn what the components of the indicator are, what it’s trying to show you, and change it to make it work for whatever your trading style is. Change it to fit the speed that you need to see it at, showing you whatever it is that you are looking for.

The classic definition of insanity is repeating the same thing over and over while expecting different results. If you apply the same indicators, in the same way as everyone else, is there is no reason to expect that your results will be any better, or different, than anyone else’s? I remember a few years ago Forex brokers came under fire by traders and agencies, accusing some of them of trading against their clients. The most telling thing about most traders was the response that they used to defend themselves. They stated that most traders are bad enough traders that they do not need to trade against them, nor do they need to try to take their money from them; the vast majority of traders will lose their money all by themselves. This is somewhat of a blanket statement, but, at the same time, it drives the point home – don’t do the same things that unsuccessful traders are doing, while expecting to achieve success. If you follow the herd, you’ll just end up where everyone else ends up.

Stochastic Oscillator

In today’s article I want to spend a few minutes talking about a commonly used indicator and how to apply it to the charts we are trading. As you know, there is no perfect indicator, but there are some that are used by many traders and that makes them valuable. No indicator can tell us what is going to happen in the future, so don’t expect it to be correct every time. About the best we can hope for is that the indicator will continue to follow the patterns it creates going forward. Knowing this, we can use the stochastic indicator to help us identify some potential trading opportunities.

The idea around the stochastic indicator is that it can help us see when the price is potentially overbought or oversold. When price is in the overbought area, it has been bullish, and when it is in the oversold area, it has been bearish. In the chart below, you can see an example of when the price moves into and out of these overbought and oversold areas.

You can see that the stochastic indicator will move into and out of overbought and oversold areas, which are indicated by the 80 and 20 levels. If the price is above the 80, it will be considered overbought, and if it is below 20, it is oversold. As you follow the movement of the stochastic line, you will also be able to see the price is moving up or down along with it. Just remember that once the price moves into overbought or oversold, it can continue to stay in this area for an extended time frame. In that case, if the price is overbought, you may see the price continue to move higher, instead of falling back down. The key is to look at the indicator move out of these areas, which may be the sign that things are getting ready to reverse.

The stochastic indicator can also be used to help us identify areas of divergence. These are areas where the indicator is showing strength or weakness, opposite of what the price is showing. These are points where the price may be getting ready to reverse. In the chart below, you can see an example of divergences.

Here you can see an example of a bullish divergence. The red lines show the price making lower lows, while the stochastic indicator is making higher lows. This would suggest that the down move is becoming weaker and may begin to reverse. This does not guarantee that the price will move as shown, but it does give us a heads up as to the possible direction. As with any indicator, we will want to wait until the price action confirms the divergence.

The stochastic oscillator is a good indicator that can help us identify some possible direction changes. We just need to remember that the price is more important than the indicator, so we always wait for the price to confirm movement. Take some time to review this, as it might be something that you can use to help you become a better trader.