Trading Strategies – Knowledgebase

Table of Contents:

Heikin Ashi – How To Trade with Heikin-Ashi Candlesticks

Traders have an array of indicators to look to when it comes to identifying setups, patterns, trends and reversals. These are all viewed on a price chart, which is arguably the most important piece of information a trader can have. Heikin-Ashi (HA) is a charting technique that is often overlooked, but offers valuable insights for those who know how to put this derivative of Japanese candlesticks charts to good use.

What is Heikin-Ashi?

Heikin-Ashi candlesticks are an offshoot of Japanese candlesticks, a form of charting developed in Japan by Munehisa Homma in the 1700s.

The purpose of HA charts is to filter noise and provide a clearer visual representation of the trend. For new traders the trend is easier to see, and for experienced traders the HA charts help keep them in trending trades and able to spot spot reversals, while still being able to see traditional chart pattern setups.

How Does It look?

Heikin-Ashi price bars are averaged, so each one won’t reflect the exact open, highs, lows and closes for that period like a normal candlestick would. HA candles are calculated using the following formulas:

HA Close = (Open + High + Low + Close) / 4
HA High = Maximum of High, Open, or Close
Low = Minimum of Low, Open, or Close
Open = (Open of previous bar + Close of previous bar) / 2

Figure 1 shows an uptrend on a AAPL candlestick daily chart, while Figure 2 shows the same chart in Heikin-Ashi. All charts created using StockCharts.com

Daily Apple Candlestick Chart
Figure 1. Daily Apple Candlestick Chart

There are several differences noticeable immediately on the Heikin-Ashi below relative to the candlestick chart above.

See also How to Read Stock Charts

Daily Apple Heikin-Ashi Chart
Figure 2. Daily Apple Heikin-Ashi Chart

The differences include:

  • The Heikin-Ashi chart appears smoother, making the short-term trend easier to see.
  • There are no gaps on the Heikin-Ashi charts since the current price bar uses the prior price bar in its calculation.
  • Heikin-Ashi charts don’t reflect the most recent price; because of averaging, the price on the right of the chart will be different than the last transaction price.
  • Many traditional candlestick chart patterns aren’t as effective on the Heikin-Ashi charts due to the averaging.

There are some similarities though:

  • Both are highly visual.
  • Some candlestick patterns are still relevant, such as Dojis, which show indecision.
  • Traditional chart patterns, such as head and shoulders and triangles, are tradable on both types of charts.
  • Big down bars with little or no upper shadow signify strong selling pressure.
  • Big up bars with little or no lower shadow signify strong buying pressure.

How to Interpret Heikin-Ashi

Heikin-Ashi charts help traders view trends and spot potential reversals. Therefore, they are most applicable to trend traders. The figures below show how to interpret bullish HA candles and bearish HA candles in context of uptrends or downtrends.

The HA candles change dramatically in appearance when a strong trending move is underway relative to pullbacks. Upward trending moves typically have long upward (in this case, white) candles with very little or no lower shadows.

The shadows are the thin lines that extend out from either side of the fat part of the candle – called the real body. These shadows represent the maximums and minimums of the Low, Open, Close and High (see formula above). When a strong uptrend is underway, and the buying is aggressive, the lower shadows (sticking out the bottom of the real bodies) will not typically appear.

During pullbacks or weak trending moves there are interspersed down (red) bars, as well as lots of bars with lower shadows. This doesn’t necessarily indicate a reversal, but it does mean the trend is in a corrective phase or slowing.

Heikin-Ashi Bullish Candlestick Interpretation
Figure 3. Heikin-Ashi Bullish Candlestick Interpretation

The same concepts apply to downtrends, except strong down trending moves will be composed of HA price bars with little or no upper shadows. The bars will also typically be long and moving lower (red in this case).

If there are up bars (white) interspersed, or lots of bars with upper shadows, the trend is either very weak or the price is in a corrective phase.

Heikin-Ashi Bearish Candlestick Interpretation
Figure 4. Heikin-Ashi Bearish Candlestick Interpretation

Typically during strong trending moves we see strong up bars with no lower shadows for an uptrend, and strong down bars with no upper shadows for a downtrend.

Just because one up candle, or a couple of candles with upper shadows, appear during a downtrend doesn’t mean the trend is reversing – it may just be pausing. The same is true for uptrends.

See also Trend Trading 101

To spot reversals or trend continuations there needs to be a breakout, or a major shift in price just like what is required with traditional charts.

Using what we know about strong trending moves and weak trending moves from above, combine it with other technical analysis concepts, such as trendline breaks, to spot reversals.

Combining Heikin-Ashi with Technical Analysis
Figure 5. Combining Heikin-Ashi with Traditional Technical Analysis to Spot Reversals

How to Trade Heikin Ashi

Like using other types of charts, trading on Heikin-Ashi charts requires finding an entry, a stop loss location to limit risk as well as a profitable exit point.

Since HA charts make it easier to spot trends and isolate pullbacks the charts are great for trending trading.

Figure 6 shows a downtrend. The trending moves are easily separated from the pullbacks due to the color changes. Due to the averaging, the pullbacks are also often easy to mark with trendlines. When the price breaks back below the trendline, it indicates the trend is continuing and a short trade can be initiated. A stop loss is placed just above the recent high and profit can be taken when an up bar occurs, or at a pre-determined profit target.

Active Trading with Heikin-Ashi
Figure 6. Active Trading with Heikin-Ashi

Getting in and out in this fashion isn’t for everyone. Longer-term traders can use one of the entries, but then stay in the trade for as long as the trend persists. Using long-term trendlines can aid in this regard. Stops are still utilized in a similar fashion when entering.

Longer-Term Trading with Heikin-Ashi
Figure 7. Longer-Term Trading with Heikin-Ashi

Chart patterns are also tradable. Figure 8 shows a triangle pattern which developed following a strong move higher.

Heikin-Ashi Chart Pattern Trading
Figure 8. Heikin-Ashi Chart Pattern Trading

The Bottom Line

Heikin-Ashi charts appeal to traders because trends are easier to spot and the way the bars are calculated creates a smoother appearance. Traditional forms of technical analysis and chart patterns can still be used and traded with HA. Long up bars with no lower shadows, or long down bars with no upper shadows signify strong up and down trends respectively.

HA charts won’t show the current price on the y-axis due to averaging. Also, many traditional candlesticks patterns will lose relevance due to the smoothing.

Trading on Heikin-Ashi charts is similar to trading on other charts. Focus on trading in the direction of the overall trend. Use HA price bar characteristics to determine trend strength, when the trend is slowing down and apply other technical analysis concepts (such as trendlines) to isolate major price reversals. Apply stop loss orders to trades, and use slowdowns in the trend as exit points, or wait for a major reversal if a longer-term trader. Pre-determined profit targets can also be used.


Moving Average Crossover – Moving Average Trading Strategies: Do They Work?

Moving averages are one of the simplest technical analysis tools, getting lots of exposure in the media as well as in educational articles. Yet the full range of how moving averages can be used is generally unknown by many traders and investors. Moving averages are applicable to both short- and long-term traders alike, providing trade entry signals, market warning signals and simplifying market data. While a moving average (MA) and moving average crossover—which you’ll learn about shortly—are great tools, technical analysis and trading involves utilizing multiple tools and looking at the overall price and trend picture, never just relying on a signal indicator.

Simple and Exponential Moving Averages Explained

Two common types of moving averages are the simple and exponential. The difference between them is how each one is calculated.

Modern trading software means that calculating a moving average by hand has become obsolete, but the distinction between the different calculations is important. A five-day simple moving average, for example, tallies the closing prices for the last five days, and then divides that total by five. An exponential moving average does the same thing, except a “multiplier” is added to give the most recent price(s) more weight.

By giving the most recent prices more weight, an exponential moving average reacts quicker to price movements than a simple moving average.

Please note that all chart examples were created using Freestockcharts.com.

See Also: 25 Stocks Day Traders Love

The data used to calculate a moving average can come from a daily bar, as in the examples above, or it can come from five-minute or 15-minute price bars, for example. If you are looking at a daily chart, your charting software will calculate the moving average using daily price data. If you are looking at a 15-minute chart, the moving average uses the price data from these bars.

SPY Moving Average
Figure 1. SPDR S&P 500 with Simple (Yellow) and Exponential (Red) 50-Day Moving Averages

Figure 1 shows these two types of 50-day moving averages. The exponential moving average fluctuates a bit more since it reacts quicker than the simple moving average.

One type of moving average is not necessarily better than the other, but some traders may prefer one over the other. Short-term traders want to get in and out at opportune times, and therefore want a moving average that reacts quickly to current conditions. In this situation an exponential moving average is preferred.

Longer-term traders or investors don’t want as many trade signals; therefore, a simple moving average that is slow to react to short-term price fluctuations is generally preferred.

There isn’t a perfect moving average length; rather, the ideal moving average(s) will depend on each individual’s trade strategy and investment horizon.

The most popular moving averages are the 200-day, 50-day, 20-day, 10-day and five-day. Each of these moving averages generally appeals to a slightly different group of traders and investors. Day traders may also use a 20- or five-period moving average, but instead of being based on the last price of the day, the moving average is based on a one-minute or five-minute chart.

Long-term traders and investors will generally monitor a 200-day simple moving average, as they are only concerned with the overall direction of the market. A 200-day moving average is slow to react to market fluctuations; it filters out of a lot of the “noise” and shows traders visually the long-term market trend.

Which Moving Averages Are Most Important?

Longer-term investors as well as swing traders often monitor the 50-day simple moving average. This moving average will react quicker than a 200-day moving average. The 50-day moving average is useful for spotting medium-term trends, while the 200-day moving average is only focused on the long-term trend.

Swing traders will mostly focus on short-term trends, as they want to get in and out of the market within a matter of days or weeks. These types of traders will typically use a 20-day, 10-day, five-day simple or exponential moving averages, or a combination of them. Since these moving averages will react quite quickly to price changes, trade signals appear more often, hopefully alerting the short-term trader to opportunities.

Figure 2 shows 200-day, 50-day, 20-day and five-day simple moving averages applied to the SPDR S&P 500 (SPY) ETF.

The lower the length of the moving average the more closely it tracks the price movement. The 200-day moving average shows only the overall price trajectory, while the progressively shorter length averages track smaller and smaller price trends.

There are two general types of crossover trading strategies – a price crossover and a moving average crossover. When the price crosses a moving average it is called a price crossover. Many traders use two (or more) moving averages, so another type of crossover occurs when one moving average crosses another, such as a 50-day crossing a 200-day.

The price crossover will be addressed first. When the price crosses a moving average it indicates that a trend change has possibly started in that time frame, and therefore many traders view crossovers as important events. Depending on the length of the moving average being watched, it is possible that the trend actually changed some time before, which is often the case with longer-term moving averages such as the 200-day, but the price crossover still helps to confirm the trend reversal.

There are two types of price crossovers, bullish and bearish.

See Also: Best Stock Market Investment

SPY Moving Average
Figure 2. SPDR S&P 500 with Multiple Moving Averages

What is a Crossover Trading Strategy?

Crossover trading strategy generates a BUY signal when the fast moving average (or MA) crosses up over the slower moving average and a SELL signal is generated when the fast moving average crosses below the slow MA.

Bullish Crossover

A bullish crossover is when the price moves back above a moving average after being below. This action signifies that a correction or downtrend (on that time frame) is over and an uptrend is possibly commencing.

During trending markets the signals can be quite reliable, as shown in Figure 3 below. During choppy or sideways market conditions a bullish crossover is less meaningful, since there is no trend in either direction present. In such cases the trader should wait for the price to move out of the range before applying a bullish price crossover strategy.

A 50-day moving average can be used to re-enter medium- to long-term terms when the trend resumes. It can also be used to exit trades. Trade direction (long or short) should align with the overall trend. For example, during a long-term uptrend, traders and investors should focus on buying bullish crossovers.

Bullish crossovers are less important, however, when a long-term trend is down. A 200-day moving average can be used to determine the overall trend direction.

In Figure 3 the price has been moving in an uptrend, as indicated by the price remaining well above the 200-day moving average, but on a couple occasions it drops below the 50-day moving average. When the price climbs back above the 50-day moving average, this is a bullish crossover, and a buy signal. Any number of exit strategies could be used once in a trade, but one strategy is to exit the long position when a price bar closes below the moving average.

A problem with the bullish crossover strategy is that just because the price crosses above or below the moving averages, it doesn’t mean a trend is going to commence in that direction.

The iShares Dow Jones US Real Estate Index Fund (IYR) went from an uptrend to a downtrend in aggressive fashion. Figure 4 shows a bearish crossover in May, signaling to get out of any long positions acquired during the uptrend. The next bearish crossover is a signal to go short, since the trend is now down and the price passing back below the moving average indicates the downtrend is about to resume.

A bearish crossover is when the price drops below a moving average. This signifies a potential change in direction on that time frame. A bearish crossover can be used as a signal to exit long positions, as shown in Figure 3, or it can be used to enter short positions as shown in Figure 4 below.

SPY Moving Average
Figure 3. SPDR S&P 500 with 50-Day and 200-Day Moving Averages

During choppy or sideways market conditions a bearish crossover is less meaningful, since there is no trend in either direction present. In such cases it is best to wait for the price to move out of the range before applying a bearish price crossover strategy.

The next type of crossover is a moving average crossover. This occurs when two or more moving averages of different lengths are used, and one crosses the other. Moving average crossovers are often called golden crosses and death crosses, depending on the direction of the crossover. Moving average crossovers, similar to price crossovers, can also be referred to as bullish and bearish crossovers.

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Bearish Crossover

A golden cross is any time a shorter moving average crosses above a longer-term moving average. It signals that the recent trend is moving higher and is an indication to buy.

Several golden crosses occurred in the SPDR Dow Jones Industrial Average ETF (DIA), shown in Figure 5. The moving averages used—a 10-day and 15-day—will only reflect short-term to medium-term trading signals (weeks to months).

Ideally, trades are only taken in the direction of the longer-term trend. Since the trend is up (price is making higher highs and higher lows overall) the golden crosses are used as buy signals. When the shorter-term moving average crosses below the longer-term moving average, this signals to get out of the long position; this is called a death cross.

The most popular golden-crosses, which are often referenced in the media, are when the 50-day moving average crosses above the 100-day or 200-day moving average. It indicates that the longer-term downtrend is ending, and an uptrend is potentially underway.

See Also: Ten Commandments of Futures Trading

IYR Moving Average
Figure 4. Dow Jones US Real Estate Index Fund with 50-Day Moving Average

Golden Cross

DIA Moving Average
Figure 5. SPDR Dow Jones Industrial Average ETF with 10-Day and 15-Day Moving Averages

In Figure 6 the SPDR Gold Trust (GLD) has been in a long-term uptrend. The price is trading above the 100-day moving average (pink), and the 50-day moving average is above the 100-day. In early 2013, the shorter moving average drops below the longer moving, indicating a trend change to the downside.

A death cross is any time a shorter moving average crosses below a longer-term moving average. It signals that the most recent price action is moving lower and is an indication to sell or short.

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Death Cross

Since the 100-day and 200-day average are often used to determine the long-term trend, when a 50-day moving average crosses below it, it usually indicates a significant downtrend is already underway. When the signal occurs, long positions are exited and short positions can be taken.

Death crosses can occur on shorter time frames as well, such as utilizing a 10-day and 15-day moving average like in the golden cross example. In such cases, investors should ideally only take short positions when the overall trend is down (overall price is making lower highs and lower lows).

The most popular death cross, which is often referenced in the media, occurs when the 50-day moving average crosses below the 100-day or 200-day moving average.

GLD Moving Average
Figure 6. SPDR Gold Trust with 50-Day and 100-Day Moving Averages

Moving averages can also be applied to almost any indicator. Adding a moving average to volume can show whether volume is rising with the price—a confirmation signal—or if it is falling as the price is rising – a warning signal.

Figure 7 shows a moving average (15) applied to a 14-day RSI. In this case the moving average is not based on the price, but rather smooths the RSI data. Similar to a golden or death cross, when the RSI crosses through the moving average, it signals a potential change in direction.

The Silver Trust (SLV) ETF is in an overall downtrend; therefore, similar to other moving average strategies discussed, the most powerful signals are those that align with the trend direction. Several potential short trades have been marked on the chart. When the RSI drops back below the moving average it indicates the downtrend is resuming and short trades can be taken. When the RSI crosses above the moving average, those short trades are closed.

If the overall trend is up, look for buy signals as the RSI crosses the moving average from below. Exit the long trades when the RSI crosses back below the moving average.

Applying a Moving Average to Other Indicators

Moving averages provide multiple ways for traders and investors to trade and analyze the market. There isn’t a single moving average or combination of moving averages that is ideal; rather, each individual will need to find moving averages that suit their trade timeframe or investment horizon. Traders shouldn’t rely solely on moving averages, but should use these tools in conjunction with price analysis and other technical analysis methods.

Disclosure: No positions at time of writing.

SLV Moving Average
Figure 7. Silver Trust ETF with RSI and Moving Average


Darvas Box – Darvas Box Trading Strategy Explained

Darvas Box is a great technical analysis indicator, with an interesting background and creator. Nicholas Darvas, a dancer by trade, made $2,000,000 in an 18-month period trading stocks using the Darvas Box method, while traveling the world on dance tours. The method is designed to capture emerging trends, and ride them for big potential profit, all while keeping risk contained.

What Is the Darvas Box?

The Darvas Box strategy was developed by Nicholas Darvas. Aside from being a well known dancer, he began trading stock in the 1950s. Based on his success in trading, he was approached to write a book on his strategy. The book, “How I Made $2,000,000 in the Stock Market,” outlines his rather simple approach … simple once you understand the basic concepts and rationale of the strategy.

Darvas originally started with $10,000. He was willing to plunk the whole amount into one stock. This is because he always used a stop loss to control risk, so the whole amount of capital was not fully in jeopardy. As his capital grew, he would allocate capital to various stocks.

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Darvas Box Strategy

As the name implies, Darvas Box is based on boxes that a price was trading in. For example, if the price is moving between $45 and $50, that is a box. Mr. Darvas’s goal was to only buy stocks that were moving into higher and higher boxes.

If the price moved above $50, to $50.50, Mr. Darvas bought the stock because it was now moving into a higher box. If the price dropped below $45 (of the $45 to $50 box), to $44.50, then the stock was moving down a box, and therefore was negated as a purchase candidate.

The box limit is not set, but is determined by market forces. If the price is moving between $47 and $48, that creates a box. If it moves higher, the next box may be between $50 and $53, which is the next point where the price stalls and moves back and forth.

A price can stay in a box for as long as it wants. As long as it doesn’t drop below the low of the box, it remains a buy candidate if it moves above the upper limit of the box.

Mr. Darvas gives the following example in his book, of a stock breaking higher into a new box:

If the stock acted right, it started to push from its 45/50 box into another, upper box. Then its movement began to read something like this: 48 – 52 – 50 – 55 – 51 – 50 – 53 – 52.

It has now quite clearly establishing itself in its next box—the 50/55 box.

Darvas Box is an indicator that simply draws lines along highs and lows, and then adjusts them as new highs and lows form. The indicator is available on many trading platforms, such as Thinkorswim. Traders may wish to draw their own boxes though, based on recent highs and lows; Darvas was able to do so (based on telegram quotes) more than half a century ago.

Darvas Box Rules

Darvas established some rules, not just for his strategy, but for himself. After going though his initial learning period of subscribing to a whole bunch of “advisory services,” he found that none of them worked, and they often contradicted each other. Therefore, he proposed seven basic rules to impose on himself.

The following are summarized from his book.

  1. I shall not follow advisory services.
  2. I shall be cautious of broker advice.
  3. I shall ignore Wall Street sayings or truisms, no matter how ancient or revered.
  4. I shall only trade stocks on major exchanges with adequate volume.
  5. I shall not listen to (or trade off of) rumors or tips, no matter how well researched they may sound.
  6. I will use a sound strategy instead of gamble…I must study this strategy (originally this approach was fundamental analysis, which didn’t work for him, so he developed his Darvas Box trading method).
  7. I will hold one position for longer, as opposed to juggling a bunch of positions for a short period of time.

See also 7 Rules Every Contrarian Investor Must Follow

These rules helped Nicholas Darvas develop his strategy, and have the discipline to stick to it. The basic Darvas Box strategy rules are as follows:

  • Darvas looked for increasing volume when selecting stocks to trade; this alerted him to stocks that were being accumulated and were likely to see strong trends.
  • Darvas believed in buying stocks that presented an upper box limit breakout, but also had an upward Earnings trend. This was especially the case when the major indexes had experienced a decline.
  • When an upper box limit is broken, buy. From his book, the entry price was usually about 1 to 2% above the upper box limit.
  • If you enter a trade and the price proceeds to drop out of the new box, and back into the old box, exit the trade.
  • Entry and stop loss orders should be set in advance, so trades aren’t missed and risk is controlled.
  • Place, and trail the stop loss order to below the low of the most recent box. This initial stop loss was pretty tight, because Darvas assumed when a price broke out of an old box, it was entering a new box. Therefore, the stop was placed just below the high of old box which was just broken (low of new box).
  • Record trades, including reasons why you entered and exited.
  • General conditions of the market must favor buying. Don’t buy stocks when the major indexes are in a bear market, or when volume is flat or declining.
  • If you are stopped out, but the price moves back into the higher box again providing another buy signal, buy again, using the same stop loss location.
  • Since the stop is being trailed up, more funds can be added on each consecutive breakout.

Figure 1 shows Darvas Box in action.

Darvas Box Applied to AAPL Daily Chart
Figure 1. Darvas Box Applied to AAPL Daily Chart – Source: Thinkorswim

Risks and Considerations

During choppy market conditions the strategy is likely to produce many small losses in a row. This is a trend following method, so a trend needs to develop to produce a profit.

Based on his book, the initial stop loss was set just below the breakout price (likely low of the new box). It was then trailed up as new boxes formed. This method takes a lot of discipline, and a trader can’t get emotionally attached to a stock. Buy and sell when the signals say so.

Traders also need the intestinal fortitude to get back into a trade, if the signals say so, even if they were stopped out. Darvas also added to positions as breakouts to higher boxes occurred. This means bigger gains on trades that work out, but if the trend doesn’t continue, adding to positions near (what ends up being) the top of a move can work against you.

The method could also be employed using short selling when the boxes are dropping. An entry occurs when the price moves below the lower limit of the box; a stop is placed just above the entry price (in the old box) and then trailed down above the top of new lower boxes.

A stop loss won’t save you from losing more than expected if the price gaps through your order. Consider this when assessing how much capital you are willing to commit to a stock.

See also Which Position Sizing Strategy is for You? Equal Risk vs. Equal Dollar

The Bottom Line

Nicholas Darvas was a dancer, but committed a great deal of time to developing and then mastering his stock trading method. It’s a trend following method based on breakouts to higher boxes. Risk is controlled by placing a stop below new higher boxes as they form. During choppy conditions the strategy won’t be profitable. This is why Darvas also attempted to only trade stocks with increasing volume and rising Earnings. Trading his method requires a lot of discipline, but can produce big profits when strong trends develop.


Position Trading – Position Trading 101

Position traders, often known as “buy and hold” traders, take longer-term positions usually based on long-term charts and/or macroeconomic factors. These traders operate in nearly every market, including stocks, ETFs, forex and futures.

They aren’t only relegated to buying either; they can also hold long-term short positions making money as an asset declines in value.

For beginners, be sure to read the Top 21 Trading Rules: A Visual Guide.

Position Trading Appeal

man pointing higher on graph

Position trading is taking a position in an asset, expecting to participate in a major trend. Position traders aren’t concerned with minor price fluctuations or pullbacks. Instead they want to capture the bulk of the trend, which can last for months or years.

The main appeal of this approach is that it doesn’t require much time. Once the initial research is done, and the position trader has decided how they want to trade the asset they’ve selected, they enter a trade and there’s little left to do. The position is monitored on occasion, but since minor price fluctuations aren’t a concern, the position requires little maintenance or oversight.

Position trading is the opposite of day trading, where traders make trades each day and spend hours trading. Swing trading is less time-intensive than day trading since trades last a couple days to several weeks; this still requires time to monitor and find new positions each week. Position traders make between zero and three trades a year in assets they own. Swing traders will likely make 25 to a few hundred trades a year, and day traders make hundreds to thousands of trades a year.

See also 7 Psychological Traps Every Trader Must Face.

Finding Position Trades

There are several approaches to position trading, including buying assets that have strong trending potential but haven’t started trending yet, or alternatively buying an asset that has already begun to trend. Buying assets that have already begun to trend is a less research-intensive endeavor and therefore preferred by many position traders.

Finding a trend is thus the main component for a position trade. This will usually exclude any assets trading within a range, unless the price range is extremely large and spans many years. In this case, it could take years for the price to move from one side of the range to the other, which suits the position trader just fine.

See also: Range Trading 101.

Trends often begin with a breakout of a range or other chart pattern that had confined the price action (non-trending). The price is like a spring being compressed by the pattern, so when the price breaks out of the pattern it can often trend for some time. This is especially true if the chart pattern lasted for a number of years, indicating the price could trend for a number of years once it breaks out. Chart patterns ranges, triangles, cup and handles, head and shoulders and inverse head and shoulders—all indicate a trend could commence or re-emerge.

Breakout of Long-Term Chart Patterns
Figure 1. USD/JPY Breakout of Long-Term Chart Patterns

Indicators are also useful for spotting trends that are underway. One way is to monitor stocks that pass above their 40-week (200-day) moving average from below (if looking to buy). While this method isn’t perfect, looking for this signal will produce a list of stocks (or other assets) that recently began moving higher. The trader can then initiate more research into which one (or more) of the stocks he or she wants to purchase based on the overall outlook.

Be sure to see our list of the Best Investments of All Time.

Basic Position Trading Strategy

Even though a position trade may be held for a long period of time, it requires three elements to be successful: a planned entry, a planned exit, and controlled risk.

The basic strategy is to buy when the price crosses above a 40-week (or 200-day) moving average from below. Hold the position until a weekly price bar closes below the 40-week moving average. When the trade is initially placed, a stop loss is used to cap the amount that is lost should it immediately move in an unfavorable direction. Where this is placed depends on the volatility of the asset and the time frame of the trader. Setting a stop loss 5% below the moving average will serve to protect capital but still allow for upside potential.

In Figure 1, AAPL is moving in a choppy fashion on the left of the chart, highlighting the main problem with this strategy. A trade signal may occur but a trend doesn’t develop; a number of buy and sell signals occur in quick succession, resulting in losses.

Position Trading Strategy
Figure 2. Position Trading Strategy Using 40-Week Moving Average

In 2009, another buy signal occurs when the price crosses above the 40-week moving average. The signal is given at $16.61, so an initial stop loss is placed 5% below, at $15.78. The trade isn’t closed until there is a weekly close (weekly chart) below the 40-week moving average. The exit occurs in 2011 between $46.57 (weekly close) and $46.76 (opening price the following week).

Another long trade develops shortly after the prior exit and that trade lasted until late 2012. Another buy signal occurs in 2013 and that trade remains open until a weekly close below the moving average.

Position Trading Risks and Limitations

The main risk of position trading is that minor fluctuations, which are commonly ignored, can turn into a full trend reversal and result in a significant loss or drawdown if the trader fails to monitor the position or puts safeguards in place to protect their capital (such as a stop loss or trailing stop). While this is a danger it also works in the trader’s favor, as the position will also accumulate profit while they’re not looking.

Unlike day trading or swing trading where positions are converted back into cash on a regular basis, position traders are locking up their capital for extended periods of time. Make sure the capital won’t be needed for at least a year or more, as being forced to liquidate the position interferes with the original strategy.

The effects of compounding are also negligible with position trading, since profits aren’t locked in very often and the account balance doesn’t actually increase until the position is closed at a profit.

The Bottom Line

One style of trading isn’t better than another; certain styles just suit different people’s personalities and circumstances. Position trading is for people who like to do some research initially, but once a trade is placed, the position requires very little time to monitor or manage. Position trades take place in nearly all markets and can include both buying or taking short positions. Trades are found based on research that indicates a stock could begin to trend, or chart pattern breakouts and technical indicators signaling the potential start of a trend or that a trend is underway.


Doji – How to Identify & Trade Doji Candlestick Patterns

Candlestick patterns provide instant insights into market sentiment. For example, candlesticks with a small real body suggest indecision in the market, whereas candlesticks with a long real body suggest strong directional moves. Candlestick shadows also provide insight into intra-session volatility, which can be critical when looking at the underlying market psychology. Doji patterns are a great example of how these patterns can provide critical insights.Let’s take a look at how to identify and trade the doji candlestick pattern, as well as an example of the doji patterns in action.Click here to learn about the Day Trading Rules applicable to U.S. investors.

What Is the Doji Pattern?

The doji candlestick pattern is a cross-, plus- or T-like pattern that indicates indecision in the market. Traders can use the pattern on its own or in combination with other candlestick patterns to identify potential reversals in the prevailing trend.
Doji candlestick patterns
Doji candlestick patterns are very simple to recognize:

  • Very thin or no real body
  • Shadows of any length

The very thin real body suggests that there’s a lot of directional indecision in the market – that is, bulls and bears are fighting over control. Longer shadows usually indicate a larger fight with a lot of volatility, while shorter shadows suggest a quieter market with little volatility. Doji patterns with long shadows are usually the most reliable trading signals.

How to Trade Doji Patterns

Doji patterns are interpreted by varying positions and length of shadows, so traders have given different names to different shadow arrangements.The most popular doji patterns include:

  • Doji Star: Doji stars indicate indecision in the market with low activity. If it proceeds a gap higher or lower, it can signify a near-term reversal, but in most cases, it represents only the early signs of a reversal.
  • Long-legged Doji: Long-legged doji indicates indecision in the market with high activity. As with the doji star, the pattern works best when it follows a strong directional move, but it usually only represents the early signs of a reversal.
  • Dragonfly Doji: Dragonfly doji appear like the letter “T” and is most reliable when it appears after a significant downtrend. After opening lower, the doji signals that bulls regained control over the price and will likely remain in control of the following session.
  • Gravestone Doji: Gravestone doji appear like an inverse letter “T” and is most reliable when it appears after a significant uptrend. After opening higher, bulls lose control over the price and bears take over throughout the session.

When trading in these patterns, it’s important to take the previous trend and volume into consideration. The most reliable trading signals are generated following a strong previous trend with higher than average volume during the doji session. It’s also a good idea to consider other forms of technical analysis as confirmation, such as trend line support or resistance levels.

Examples of Doji Patterns in Action

Let’s take a look at an example of a dragonfly doji in the SPDR S&P 500 ETF (SPY).
Doji candlestick in action
Source: TradingView
In the above chart, the dragonfly doji is immediately followed by a sharp increase in price as the bulls take over control of the price from the bears. The strong volume just before and on the doji pattern provides a strong signal that a directional move is about to occur. When zooming in, the breakout also occurs from a key trend line resistance level, which further confirms that a bullish move higher is likely to occur.

The Bottom Line

Doji candlestick patterns indicate indecision in the market. Depending on the length of the shadow and other factors, the indecision can translate to an imminent reversal in price or a mere suggestion that a reversal will eventually occur. The key is to look at the prior trend and volume for context, as well as using doji candlestick patterns in conjunction with other forms of technical analysis that can serve as confirmation.


Trading Exit Strategies – 3 Ways To Exit A Profitable Trade

You’re in a winning trade, and now you need to figure out how you will exit the trade profitably. How you will exit a trade should be planned before you enter. Below we outline a number of different ways to exit a profitable trade; no matter which you choose to use, the goal is to strike a balance between letting profits run and not getting so greedy that you fail to realize the market is reversing on you.

Why Having an Exit Plan Is Important

Traders are told to “let their profits run,” but unfortunately that’s pretty vague advice.  Let a profit run long enough and it will eventually turn back into a loss. Traders need a plan that allows them to let their profits run beyond what they typically lose on a losing trade, but also realize that the market will not move in their direction forever.

If you plan your profitable exits and find that over time they are bigger than your average loss, winning only 50% of your trades (or even less) can still make you a highly successful trader. Here are several methods to help you do it.

Trailing Stop

The trailing stop is probably the most well know profit extraction technique. In simplest terms, as the price moves in your favor, an exit order moves along with it, trailing the price by some set amount.

For example, suppose you buy a stock and place a $0.50 trailing stop. As the price moves up the trailing stop moves up with it, always staying $0.50 below the most recent high. It only moves higher though, never back down.

This is appealing because it allows the market to run in your favor indefinitely, but gets you out when the stock moves $0.50 against you (from the highest point). A trailing stop works the same way for a short position, except it will always trail the lowest price.

A trailing stop can be implemented in many ways. In an uptrend, a stop may be moved up to below recent lows. Thus, if the price creates a lower swing low you exit your trade. But if the price keeps making higher lows, then you keep moving the trailing stop up to lock in more and more profit. Please note that all chart examples were created using Freestockcharts.com.

See Also: 25 Stocks Day Traders Love

Google (GOOG) stock chart
Figure 1. Trailing Stop Behind Recent Lows – Google (GOOG) Daily Chart

Certain indicators have a trailing stop built right in. For example, apply the Parabolic SAR for an idea on where to place your trailing stop. With each new price bar the indicator value will change, locking in a bit more profit. Other indicators that can be used for this function are Volatility Stops, Chandelier Exit, and even Bollinger Bands and Keltner Channels.

Facebook (FB) stock chart
Figure 2. Trailing Stop Based on Indicator – Facebook (FB) Daily Chart

The trailing stop works best in strong trends, but if the trend is choppy it will often result in poorly timed exits. In Figure 1 and 2, the price did continue higher after the trade was closed, but it is impossible to squeeze every penny out of a trade. A trailing stop allows the market to run, but gets you out when there is a potential reversal underway.

Price Target

Establishing a price target is a great way to establish your potential reward relative to risk. If you are risking $300 on a trade, but will make $900 if the price hits your target, your reward outweighs your risk 3:1. Also, if you set a stop loss and a price target, you can “walk away,” knowing that eventually one of the orders (stop or target) will get filled. This is advantageous to all traders, but especially those who lack time to constantly monitor their trades.

Price targets can be established for any trade using Fibonacci Extensions or support/resistance levels (discussed below). Commonly, price targets are used for trading chart patterns, with the target based on the size of the pattern.Price targets can be established for any trade using Fibonacci Extensions or support/resistance levels (discussed below). Commonly, price targets are used for trading chart patterns, with the target based on the size of the pattern.

See Also: 50 Blogs Every Serious Trader Should Read

General Electric (GE) stock chart
Figure 3. Price Target Based on Chart Pattern – General Electric (GE) Daily Chart

The rule of thumb with any chart pattern is that you can add (for an upside breakout) the height of the pattern to breakout price to establish an approximate price targets. If the breakout is to the downside, subtract the height of the pattern from the breakout price.

If the price has been struggling to get higher than a certain point (resistance) you may opt to place a price target just below the resistance region. If you have a short position, you may opt to place a price target just above support.

In Figure 4, Citigroup © was moving in an uptrend, but then failed to significantly move higher, and began to range. Once the price showed a tendency to stall at the support and resistance areas, profit targets could have been placed near the resistance zone for long trades, and near the support zone for short trades.

Citigroup (C) stock chart
Figure 4. Price Targets Based on Support and Resistance – Citigroup (C) Daily Chart

The downside of using a fixed price target is that there is no leeway. The price could come just shy of the target, and reverse. To avoid this you may wish to monitor the price as it approaches your target; if it almost reaches the target and then starts to move against you, exit the trade.

Entry Criteria Disappears

If you’re in a profitable trade and the reason you were in the trade disappears, you have probable cause to get out.

Assume a stock is trending higher—making higher swing highs and higher swing lows—and so you enter a long position. If the price makes a lower swing high and lower swing low the trend could be over, so you would exit the trade.

If you use indicators, you may get into a trade because the indicator gave you positive signals. When the indicator “flips” and no longer confirms your trade, you can book your profit and look for other opportunities.

Figure 5 shows a scenario during a downtrend. Assume you are short because the trend is down, and/or an indicator is bearish.

Apple (AAPL) stock chart
Figure 5. Exit Based on Trade Criteria Disappearing – Apple (AAPL) Daily Chart

The chart shows two potential profitable exits, although there are many others that could be used.

  • When the downward trendline breaks you can exit the trade.
  • When the MACD moves into positive territory (above zero) you could exit the trade, assuming you were short because the MACD was bearish prior.
  • When the price makes a significant (slightly) higher low, and then begins to makes smaller higher highs and higher lows you could exit because there is evidence to suggest the trend is no longer down.

The downside to this method is that it requires some analysis, and can be very subjective. Just because an indicator “flips” or a trend is broken doesn’t necessarily mean it is the best time to exit a trade. It just tells you the reason you were in the trade is now gone.

The Bottom Line

There is no best way to exit a profitable trade. For some trades, one method will work well, but will fair worse on other trades. The key is to decide on a method and stick to it, potentially using some of these methods in conjunction with one another. By coming up with a game plan you will be able to see what works and what doesn’t, so you can make slight adjustments if needed. All these methods can help you “let your profits run,” but will get you out if the price moves too much against you. You’ll never squeeze every penny out of a trade, but utilizing the exit strategies outlined here will help you capture the bulk of a move.

See Also: Ten Commandments of Futures Trading


Zero Cost Collar – Costless Collar Options Strategy Explained

Assume you’re holding 100 shares of a stock, and believe it could trade a bit higher over the next six months, but you want to protect your downside in case it doesn’t. A costless collar option strategy allows you to do this. While the strategy won’t require additional cash, it isn’t “free” -there’s a trade off, as your profit potential is also capped.

Understand the costless collar thoroughly, and run the numbers before attempting to implement it so you can see if it’s worthwhile. Here’s how to do it, and what to consider.

The Costless (Zero-Cost) Collar

figuring out costless collar

The costless collar is an options strategy designed to give you bit of extra profit potential, while also capping downside risk. This is accomplished by buying a put option with a strike price at or below the current price of your stock holding, as well as selling (writing) a call option with a strike price above the current stock price.

The put is a cash outlay, as you must pay the premium. The put option caps your downside at whatever the strike price of the put option is.

To cover the cost of the put, sell a call option. For this you will receive a premium. The call option caps your upside on the stock position to the level of the call strike price.

The strategy can be utilized on short-term positions as well as long-term positions. Longer-term traders use LEAPS (Long Term Equity Anticipation Security), which are simply options that can be purchased for distant dates in the future.

Be sure to also read Options 101: American vs. European vs. Exotic.

When to Use a Costless Collar

The strategy is best utilized in a stock that has some upside potential, but the short-term outlook is uncertain. For instance, the price is in an uptrend, but is consolidating (see Figure 2). The price could drop in the short-term, but based on the uptrend you believe you can squeeze a bit more profit when the price starts moving higher again. If it doesn’t move higher, before the expiry of the option, the strategy protects you from further losses below the strike price of the put option.

The options cap risk and profit for a period of time. This is different than a stop loss or profit target order placed directly on the stock position. These orders also limit risk and profit, but once the price touches either of these levels the trade is closed. Not so with options; the stock position remains protected, and potentially able to profit, until either the options are closed out or they expire.

Implementing the Costless Collar

Here’s a real world example using 100 shares of AAPL, which is currently trading at $100.24, and the option premiums in Figure 1 are based on that.

put and call premiums
Figure 1. Put and Call Premiums for Various AAPL LEAPs Based on $100.24 Stock Price – Source: CBOE

These are LEAPS available on the CBOE at the time of the potential trade. First, decide when you want the options to expire – assume we decide April 2015.

Then, to make the strategy costless, go through the available puts and calls and find strike prices that give you some upside, protect your downside and are very similarly priced.

See also the Protective Put Options Strategy Explained.

In this case, we can buy an April 2015 94.29 put for $4.90 (current ask price), costing a total of $490 ($4.90 × 100 shares). We also sell an April 2015 105 call option for $4.95 (current bid price), receiving a total of $495. Since a put and call will rarely be the exact same price, as in theoretical examples, the costless collar strategy may result in a small debit or credit from the trading account. In this case, you make $5 by implementing this options strategy (not including commissions).

Both the put and call have the same expiry (April 2015), which is 6 months away from the current date (October 2014).

Your downside and upside are now capped. Participate in a price rise up to $105, or $4.76 above the current $100.24 price, and eliminate downside below $94.29, or $5.95 below the current price.

costless collar profit and loss
Figure 2. AAPL Daily Chart with Risk and Profit Limits of Costless Collar – Source: FreeStockCharts.com

Get option premium prices for any stock (if available) on the CBOE Options Table page. Input a stock symbol, and select “List all options, Leaps…” if you wish to see options that expire more than several months out.

Costless Collar Considerations

You may face some issues implementing a real-world costless options strategy. It’s rare to find a costless collar that gives significant upside potential while keeping your downside very low. In order for the strategy to be costless, you may only get an extra 5% of upside for example, while risking 7% to 10% (varies) on the downside. In the example above our upside potential was 4.74% ($4.76/$100.24), while the downside was 5.93% ($5.95/$100.24).

A costless collar is also typically aimed at investors, because a short term trader is more likely to just sell the stock if unsure of the position. Therefore, the investor is buying an option that expires several months or more into the future. Unless the stock is very well known and heavily traded, there may not be volume in options several months out. If no one else is trading LEAPS in the stock, it isn’t possible to construct a costless collar.

Be sure to also see the 25 Stocks Day Traders Love.

Use the strategy if you want to exit the stock position eventually, but want to try to make a bit more money in the mean time. If you don’t want to lose your equity position, don’t use this strategy

Compute what your upside and downside would be if you executed a costless collar based on current option premiums. Only make the trade if you are comfortable with capping your upside and risk (and the strike prices you can do this at) and potentially being forced to exit the position if the options are exercised.

The Bottom Line

By buying a put with a strike below the current price, and selling a call above the current price, you create a costless collar options strategy. It caps your risk and profit on a stock holding, so it’s best suited to investors who eventually want to exit a position anyway but want to see if they can get a bit more out of it first. In the real-world, put and call options usually won’t have the same price. This means there may be a small cost or profit made when creating the “costless” collar.


Position Sizing Strategies – Which Position Sizing Strategy Is for You? Equal Risk vs. Equal Dollar

Whether day trading, swing trading or investing, position sizing is one of the most crucial elements for success. Unfortunately, it is usually neglected and gets very little coverage when compared to trade entry/exit methods. There are two common types of position management; one predominantly used by longer-term traders, and the other which short-term traders should adhere to. To effectively trade, control risk and get the most “bang for your buck” out of your trades, it’s important to understand how position sizing works and the best methods for accomplishing the ideal position size.

What Is Position Sizing?

Position sizing is how many shares you take when trading a stock or ETF, or how many contracts you buy when making a futures trade.

Many traders just “wing it,” buying as much as their account will allow, or buying a large position if they feel very confident in the trade, or a small position if they aren’t as confident.

Be sure to also read Do You Know Your Trading Order Types? A Foolproof Guide

These are not effective methods for determining an ideal position size.

Why Is Position Sizing So Important?

For active traders, and even investors who want to avoid the major drawdowns in their accounts that inevitably occur during crashes, position size must be of paramount importance.

Without proper position sizing, it is possible that you could lose a substantial amount of capital on a single trade.

Assume for a moment you have $50,000 with which you trade. You feel confident that stock XYZA, currently priced at $10, is going higher. You decide to buy 3000 shares, costing $30,000. Earnings come out the following week and the stock drops to $9, and proceeds to decline over the following week, finally settling at $5. You admit you were wrong and close out the position, for a loss of $15,000 in a matter of weeks, nearly a third of your trading account.

There are two major problems here. The position size, 3000 shares, is random and not calibrated to the account size. Risk was also not controlled in any way when the trade was placed. Defining how much we are willing to lose is something every trader should do on every trade.

See also Don’t Fret, Salvage Your Losing Position With Options

Equal Dollar Strategy Explained

The equal dollar position sizing strategy is when a specific amount of capital is allocated to each trade. The dollar amount is determined by the trader based on account size and how diversified they wish to be.

Assume a $100,000 investment account. The investor decides they will only take up to $5,000 in any stock trade they make. The investor can therefore buy 20 stocks, investing $5,000 in each.

A more conservative investor, wishing to be more diversified, may buy 40 stocks, only investing $2,500 in each.

Given this scenario, assume our investor wants to invest $2,500 in Braskem S.A. (BAK). The current share price is $12.43. Divide the desired investment amount by the share price to get the position size: $2,500 / $12.43 = 201 shares. Since most shares trade in even 100 shares lots, the investor buys 200 shares, getting very close to the $2,500 investment goal.

All charts courtesy of StockCharts.com

Determining Equal Dollar Position Size on BAK Daily Chart
Figure 1. Determining Equal Dollar Position Size on BAK Daily Chart

A not-so-conservative investor may decide to invest $20,000 in each stock, and only take five positions. For such a non-diversified portfolio, a stop loss strategy is recommended, as discussed below, on each of these trades.

The equal dollar method is mostly used by passive investors, because it is an easy and efficient way to allocate capital.

With this method it is best to invest a small portion of the total account in each stock, achieving some level of diversification. That way, if some stocks go down, hopefully some of the others will rise, offsetting the loss.

A stop loss can also be utilized with this method to control risk within each trade. When buying $2,500 worth of stock, the trader may not wish to risk all that capital should the company fail. A stop loss can therefore be placed below the entry price to close out of the position if a loss becomes too large.

See also The Best Investments of All Time

If an investor has a lot of positions they may choose to simply close out a position if the stock declines by 15%. Therefore, a stop loss order is placed 15% below the entry price. If the stock declines 15%, the trade is closed out and the trader preserves 85% of the capital allocated to that stock. Using the chart above, if the stock was purchased at $12.43, a stop loss is placed 15% below, at the $10.57 level.

Setting Stop Loss with Equal Dollar Position Sizing in BAK
Figure 2. Setting Stop with Equal Dollar Position Sizing in BAK

The stop loss percentage used in this example, which could be called an equal stop loss if applied to all positions, is also typically used by longer-term traders because it eliminates the need to place a stop loss order that is specific to the stock.

A specific stop loss could also be placed on each trade, as shown in the next section, which utilizes the equal dollar method.

Equal Risk Strategy Explained

The equal risk position sizing strategy is typically used by shorter-term traders because it requires the use of a stop loss tailored to the stock.

With this strategy, the trader can use all their capital and take a short-term trade in one stock, but the stop loss prevents them from losing more than a specific percentage of their account. Equal risk also means equal percentage risk. Many traders only risk 1% of their account on any one trade.

Assume Trader Joe has an $80,000 trading account (assume no leverage) and only risks 1% of his account on each trade. This means Joe can risk $800 per trade.

He buys Ford (F) stock at $17.09 and places a stop loss just below the recent low at $16.70. The risk is $0.38 per share (difference between entry price and stop loss price). To figure out how many shares he can take, to make sure he doesn’t loss more than 1% ($800) of his account, he divides the amount he can lose by the risk per share: $800 / $0.38 = 2,105 shares. Round this down to 2,100 shares.

Ideal Position Size Based on Equal Risk on F Daily Chart
Figure 3. Ideal Position Size Based on Equal Risk on F Daily Chart

With the equal risk method it doesn’t matter how much of the capital is allocated to the trade – $35,889 of $80,000 in this case. The focus is on the stop loss, and calculating the ideal position size based on how much we wish to risk (percentage of our account).

See also 4 Ways to Exit a Losing Trade

This method is much more fine-tuned to the individual stock. A trader can put all of their capital into one stock with this method because the risk is controlled to a small portion of the account.

The Bottom Line

Long-term investors will likely find the equal dollar method of position sizing easiest to implement. By investing a small portion of the total account capital in each stock some level of diversification is achieved. Stop losses can be implemented on each position to control risk, either by using a fixed percentage risk or by applying individual stops to each position.

Short-term term traders typically use the equal risk — also called equal percentage risk — position sizing strategy. This is because diversification doesn’t matter as much to short-term traders. The trader wishes to utilize their capital on opportunities, but keep risk controlled to a small percentage of their account while doing it. This method requires placing a stop loss and then calculating the position based on the individual risk of the trade.

Both methods can be utilized by any trader, as can any stop loss strategy. The ultimate goal is to make sure that no single trade creates a large drawdown in the account; this is accomplished by making sure the position size matches the goals of the trader for controlling risk.


Bullish Pennant – Bullish Pennant: How to Identify & Use It

The stock that you’ve been watching suddenly experienced a sharp increase in price, but it started moving sideways following the breakout. How do you know if this is a brief period of consolidation or the start of a bearish reversal? These kinds of situations are very common for active traders.

In this article, we will look at a bullish continuation pattern, known as a bullish pennant, which can help answer these questions and help you identify profitable trades.

What Is a Bullish Pennant?

Bullish pennants are continuation patterns that occur during a strong uptrend. After a strong move higher, the price moves sideways in a pattern that resembles a triangular flag – or pennant. The uptrend continues when the price breaks out from the narrowing price pattern on above-average volume.

There is a psychological underpinning for the bullish pennant: Short-term traders are simply locking in some or all of their profits following a sharp move higher. Since the market still consists of net buyers, the security resumes its uptrend when these short-term traders have sold out of their positions.

Check this article here to know how day trading rules apply to U.S. investors.

Bullish Pennant Diagram

The bullish pennant has several key components:

  • Prior Uptrend: The bullish pennant must be preceded by an uptrend, including a sharp move higher on heavy volume. Often times, this is the first leg of a longer-term trend higher with the pennant being a short pause on the way.
  • Flagpole: The flagpole is a vertical line connecting the first resistance breakout to the high of the pennant.
  • Pennant: The pennant is the symmetrical triangle that begins wide and converges over time until a breakout occurs. While there may not be specific reaction highs and lows, the price action should be contained within the pennant.

Bullish pennants are usually short-term patterns that last one to four weeks. If the duration lasts any longer, the chart pattern is often classified as a symmetrical triangle.

The bullish pennant is also known as a bull flag.

How to Trade Bullish Pennants

Bullish pennants are relatively easy to trade.

Buy signals are generated in the period following a candlestick that closes above the pennants upper trend line. When the breakout occurs, traders often look for heavy volume as confirmation. You can also look at other chart patterns or technical indicators for confirmation.

Stop-loss points are placed at the bottom of the pennant. In addition, some traders use a trailing stop-loss point that’s set equal to the pennant’s height.

Take-profit points are typically set by taking the height of the flagpole and applying it to the points at which the breakout occurred to produce an upper limit.

Learn more about other trading strategies here.

Examples of Bullish Pennants

Let’s take a look at a bullish pennant in Companhia Paranaense de Energy SA (NYSE: ELP) as an example.

Bullish Pennant Chart

In the chart above, the initial breakout occurred on September 17 and lasted until September 24. The stock then experienced a period of consolidation that formed a bullish pennant.

The entry point for the bullish pennant would have been at around $5.80 following the breakout from the pennant formation. The stop-loss is set at the bottom of the pennant at $5.10 and the take-profit is set at around $6.60.

The stock breaks out from pennant formation and reaches the take-profit level before trending sideways for a period of time.

The Bottom Line

Bullish pennants are a continuation pattern that can help you determine if a period of consolidation is a step along the way higher or a potential reversal lower. Using the chart pattern, you can intelligently enter trades complete with take-profit and stop-loss points to limit your risk.

The bullish pennant works best when combined with other forms of technical analysis, including both chart patterns and technical indicators. For example, the on-balance volume (OBV) can help determine the breakdown between buyers and sellers, while the relative strength index (RSI) can show trend strength.


Trend Trading Strategies – Best Trend Trading Setups With Examples

Knowing which stock to trade is only half the battle; picking the right time and identifying the most opportune setups is your next challenge. Trading opportunities, or trade setups, generally fall into four broad categories: continuation, reversal, breakout and range-bound. Each presents opportunities if you are able to identify the setup, and have strategies for capitalizing on it. Below we offer a visual guide for how to take advantage of the most popular technical setups.

Continuation Setups

A continuation trade setup is based on finding an entry point in an existing trend. Trends are where traders are likely to make the most money, so having a few continuation setups in your strategy arsenal is crucial.

Perhaps the most important thing to remember with this setup is that prices never move in a straight line, at least not for long. Instead, a stock uptrend moves in waves – one step higher, half a step back, and so on. Downtrends are no different. The price drops, followed by a rebound and then another drop. Continuation setups attempt to exploit this movement by entering during the pullback stage, and then riding the next wave of the trend to a profit.

Figure 1 shows how a trend may develop. General Electric (GE) is moving higher overall, as the price is making new highs and higher lows. Notice the zigzag pattern – a strong price move higher, followed by a less strong pullback. By entering on the pullback you’re positioned for the next wave higher, but you still need to find an entry point. Please note that all example charts are created using FreeStockCharts.com:

There are a number of tools and indicators you can use to enter a trade when a stock provides a continuation setup.

See Also: Ten Commandments of Futures Trading

GE stock chart continuation setup
Figure 1. General Electric Uptrend – Daily Candlestick Chart

Price Patterns

After a pullback, in order for the uptrend to continue the price must begin to move higher again. Trendlines can often be drawn around the correction, identifying its course; when the price breaks above the trendline it signals the correction is likely over, and the trend is resuming.

In Figure 2, simple trendlines have been added, connecting the high points in several pullbacks. The trendlines provide a frame of reference for the direction of the stock. When the price breaks above one of these trendlines it indicates that the trend may be continuing.

There are always multiple pullbacks, of varying degrees of intensity, during a trend. Active traders may wish to participate in many of them, while longer-term traders may only wish to participate on longer-term opportunities, such as the buy signaled in late November. For this particular entry method, a target is usually placed just beyond the previous high point, and a stop loss is placed below the recent low.

GE continuation setup
Figure 2. General Electric Breaking Pullback Trendlines – Daily Chart

As the price moves higher, the stop can be moved up to just below new price lows that form, locking in a potential profit.

The main problem with this strategy is that the trendline may need to be drawn multiple times before a breakout occurs. In hindsight it is easy to draw a line connecting the high points of the pullback, but in real-time is can be a challenge and takes practice. The upside is that the reward significantly outweighs risk if the trend continues. Therefore, even if a couple losing trades occur before a winner, the strategy can still be profitable.

GE continuation setup
Figure 3. Continuation Trade, Stop and Target Levels – GE Daily Chart

Indicators can be used to help verify price patterns, such as those discussed prior, or can be used on their own. During a trend, an indicator provides clues as to when a pullback is ending, and the trend is resuming.

The RSI is a commonly used indicator, but when a moving average is applied to it, not only can it help confirm trade signals from other strategies, it can also generate its own buy and sell signals.

In Figure 4, a 14-day RSI is shown, along with a moving average (15) of that RSI. When the RSI crosses above the moving average it indicates a buy signal. The buy signals are most powerful in a trending market, as the signal indicates the uptrend is continuing. When the RSI crosses back below the moving average the long trade is exited. These points are marked with arrows and corresponding vertical lines on the chart. When a signal occurs to exit a position, it is also signaling a potential reversal is underway.

Using an indicator can help confirm these types of continuation trades, and signal when a pullback is likely to continue instead of a breakout. Continuation price patterns can also be applied during a downtrend, to indicate when it is continuing.

This strategy is quite simple, and during a trending market can be very profitable as well. Yet if the price becomes choppy the RSI may also get choppy, producing signals that get traders into or out of positions too early. The RSI-moving-average strategy also does not have a specific stop loss, which can lead to large losses if the price changes direction quickly. This can be remedied by incorporating a similar stop loss strategy as discussed in the price pattern section above. After a buy signal, place a stop below the recent low to limit losses.

Indicator Patterns

If trading with the trend is profitable, it is also necessary to be able to spot when a trend is potentially ending, and a new one beginning. Reversal setups are based on price patterns or indicators that signal an uptrend (or downtrend) is over or nearing completion, and the trend is likely to change direction.

Two main ways to spot reversal setups are using price patterns and indicators.

See Also: 50 Blogs Every Serious Trader Should Read

PFE stock chart setup
Figure 4. RSI Trend Following Method – Pfizer (PFE) Daily Chart

Reversal Setups

Price Patterns

There are a number of price patterns that indicate a reversal, with the most popular being the head and shoulders and the wedge. The double and triple top are also popular reversal signals, and have a similar trade setup to the head and shoulders pattern.

The head and shoulders is a reversal setup because it shows the transition of an uptrend to a downtrend. The pattern is created by a price peak (right shoulder), followed by a higher peak (head) and then another lower peak (right shoulder). Since the right shoulder was unable to reach the former peak it indicates the former trend has lost steam.

A “neckline” is drawn connecting the low points after the left shoulder and head (often called “armpits”).If the price drops below the neckline, the pattern is complete and a downtrend is likely underway. Exit longs and/or take a short position. A stop loss is placed above the right shoulder to limit risk, and a target is calculated based on the height of the formation.

In Figure 5, the top of the head in Macy’s (M) is $50.77 and the low of the formation (left armpit in this case) is $45.72, therefore the height of the pattern is $5.05, rounded to $5. This is subtracted from the breakout price–or the price at which the price drops below the neckline–of $48, providing a target of $43.

GE stock chart setup
Figure 5. Head and Shoulders Pattern – Macy’s Daily Chart

A triple top is a very similar pattern to the head and shoulders. It’s traded the same way, except that the three peaks in a triple top all reach very close to the same level, whereas the head and shoulders has a higher peak in the middle. The double top formation is also similar, except there are only two peaks that reach approximately the same level. Exit longs or take short positions if the price breaks below the lows that occur between the peaks. Place a stop above a recent high, and the target is once again calculated by taking the height of the formation and subtracting it from the breakout price.

Head and shoulders are a higher probability pattern than double and triple tops, and typically provide a better risk-to-reward profile.

The allure of these patterns is that they are quite common, and with a little practice a skilled trader can spot many such opportunities. Depending how the formation is shaped, the risk/reward profile of the formation can vary greatly, therefore not all patterns warrant taking a short position, but still provide evidence to exit long positions.

False breakouts occur in any price pattern, therefore it is possible a number of false signals may occur before a valid reversal is found. Using a stop loss helps minimize the risk, and potential losses incurred, on such occasions.

The wedge is another common reversal pattern. A rising wedge is characterized by an overall upward direction, but within a narrowing band. This creates a wedge appearance. It indicates that buyers are becoming less aggressive, and will eventually be overtaken by strong sellers. Figure 6 shows a rising wedge formation in Lowe’s (LOW) stock.

When the price drops below the wedge, it indicates the uptrend has ended and the price will proceed lower. This is a signal to exit long positions, and/or enter a short position. If a short trade is taken, a stop is placed just above the recent high. Wedges do not provide an exact profit target; therefore, one of the indicator methods mentioned previously can be used to exit trades.

LOW stock chart setup
Figure 6. Wedge Reversal – Lowe’s Daily Chart

Wedges are not always easy to spot, and training your eyes to see them takes practice. Like other patterns that are drawn as new price waves develop, the wedge may need to be redrawn. False breakouts can occur, resulting in early profit taking on long positions, or losing trades on short positions. The pattern also doesn’t provide a profit target, but by utilizing an indicator or other price analysis tool already covered, traders can exit the trade when there is evidence the trend may reverse again.

The benefit of the wedge is that once a wedge breaks it often results in a medium- to longer-term trend in the opposite direction. Once that new trend begins, the trader can continue to profit from it by utilizing the trend continuation method described in the former section.

These price patterns also show up at the end of downtrends. When a price breakouts occur to the upside, it signals the downtrend is likely over a new uptrend is underway.

Indicator Patterns

Indicators are another way to spot reversals. Applying a moving average to an RSI can act as both a continuation and reversal signal, as shown in the Continuation Setups section. When the RSI drops below the moving average it signals a correction and a potential reversal.

Another popular indicator, called the MACD, can also be used to spot impending reversals. The MACD provides a context for how forcefully a trend is moving. The MACD moves in waves just as price does, but can alert the trader to potential danger.

If the price is making higher and higher price highs, but the MACD is not moving past its former highs, this is called a divergence. Notice the strong divergence in Apple (AAPL) stock before it fell from its high.

AAPL stock chart setup
Figure 7. Trendline Break Accompanied by MACD Divergence – Apple Daily Chart

The problem with divergence is that it’s not a trade signal by itself. Instead, it provides confirmation to other indicators providing a sell signal, or to a price pattern that indicates a reversal. In Figure 7 the divergence on the MACD gives an early warning of waning buying pressure, and therefore confirms the signal to exit a long trade and/or take a short position when the price breaks below a trendline in the stock.

Divergence can also confirm other indicator signals, such as the buy or sell signals of the RSI method discussed prior.

In a downtrend, MACD divergence occurs when the price makes lower lows, but the MACD doesn’t. This indicates selling pressure is weakening and traders should be on the lookout for a price pattern or indicator that signals the downtrend is over and an uptrend is potentially beginning.

Another trade setup occurs when the price of a stock consolidates. At times, these consolidation patterns will act as continuation patterns, and at other times reversal patterns. Traders who trade breakouts are not necessarily interested in determining or guessing on which direction a breakout will occur (continuation or reversal), they simply seek to trade the breakout when it occurs.

Common consolidation patterns are triangle and ranges. Traders monitor these patterns and watch for the price to break out of the pattern.

In Figure 8, Amdocs (DOX) was moving in an overall uptrend higher, then pulled back and continued to make a number of smaller price swings resulting in a tighter and tighter price range – this is called a triangle pattern. Eventually the price will move out of this consolidation and begin to trend again, although not always necessarily in the direction it was trending before.

Breakout

The chart highlights the basic strategy. When the pattern is noticed, trendlines are drawn around the pattern. When the price breaks out of the pattern, an entry is taken and a stop loss placed on the opposite side of the triangle. The target is attained by taking the width of the triangle and adding to the breakout price. For a downside breakout, the width of the triangle would be subtracted from the breakout price to attain the target.

The major downfall of the strategy is that false breakouts can occur, and the triangle will need to be redrawn. On the flip side, by the time the price breaks out, risk is often much smaller than the potential reward; since the triangle converges over time, risk gets smaller as the price approaches the apex, yet the target is always based off the widest part of the triangle.

Ranges are another common form of consolidation. This is when the price moves in an overall sideways direction, finding support near a certain price area, and resistance at another.

The strategy for trading a range breakout is similar to that of a triangle. Draw the range, and wait for the price to break out of the pattern to signal an entry. In the case of an upside breakout, as shown in Figure 9, the stop loss is placed just below a recent low. For a downside breakout the stop loss is placed just above a recent high.

For an upside breakout the target is attained by adding the height of the range to the breakout price (subtract the height for a downside breakout).

See Also: 25 Stocks Day Traders Love

DOX stock chart setup
Figure 8. Triangle Breakout – Amdocs Daily Chart

Range breakouts can be quite hard to trade in real-time. The price rarely stops at the exact support or resistance level it did before. Notice how many times the price edged past a former high or low in Figure 9. Therefore, trading range breakouts can result in multiple false signals and losing trades. Some false breakouts can be avoided by waiting for a very strong price bar to break the range, such as the large up bar indicated in the Figure 9.

The upside of trading this pattern is that once it does break out, the ensuing move can be quite strong. Generally, the longer the range lasts, the bigger the move following the breakout. The target is a guide, but if the range lasted a long time, the trend may continue well beyond the target.

Stocks are often range bound, as shown in Figure 9. While some traders wait for a breakout, others will trade the range while the price is bouncing back and forth between support and resistance.

Trading simply off price movements in a range can prove difficult. Figure 10 shows a range in Procter and Gamble (PG) stock. Notice how the price, on a number of occasions, either overshoots support or resistance, or falls short of it. Traders waiting at support to go long may get stopped or think a breakout is underway when the price overshoots. Other trades may be waiting at resistance to go short, but never get filled because on a number of occasions the price reverses before reaching the level.

Using a stochastic indicator can help with entering and exiting a range trade. Long trades occur only when the price is in the vicinity of support, and both stochastic lines have been below 20. The entry occurs when the fast stochastic line (yellow in figure 10) crosses back above the 20 line.

Short trades (and exits for longs) occur only when the price is in the vicinity of resistance, and both stochastic lines have been above 80. The short entry occurs when the fast stochastic line crosses back below the 80 line.

The strategy works well when the stock is moving relatively rhythmically, as in Figure 10, and generally captures a good percentage of the range as profit. The downside is that a valid signal may occur right before a breakout, which will result in a loss. The strategy also doesn’t have a specific stop loss strategy.

To remedy this, when a buy order is placed, a stop can be placed below the recent low. When a short trade is placed, a stop can be placed above the recent high. Traders may want to leave a little extra room below and above these levels to accommodate for false breakouts, but doing so does increase the risk of the trade.

SWY stock chart setup
Figure 9. Range Breakout – Safeway (SWY) Daily Chart

Range-Bound

PG stock chart setup
Figure 10. Range with Stochastic Indicator – Procter and Gamble Daily Chart

The Bottom Line

Knowing a number of ways to handle continuation, reversal, breakout and range setups provides you with tools to handle nearly every market condition you’ll face. Keep in mind that these setups are not mutually exclusive; understanding the nature of trends will help you notice when a range is forming, and knowing about breakouts can make you more aware of the implications of a trading within a range. The price action of a stock is always the most critical element of analysis and trading, but when price action is unclear, indicators can help you make a decision.


Vwap Trading – Understanding Volume Weighted Average Price (VWAP)

VWAP is an intra-day calculation used primarily by algorithms and institutional traders to assess where a stock is trading relative to its volume weighted average for the day. Day traders also use VWAP for assessing market direction and filtering trade signals. Before using VWAP, understand how it is calculated, how to interpret it and use it, as well the drawbacks of the indicator.

Calculating VWAP

To understand VWAP, let’s look at its inner workings. VWAP overlays the price data, and shows the average price of the day, weighted for volume.

Institutions often base VWAP on every single tick of data that occurs during the trading day. Calculating VWAP based on other time frames, such as 1-minute or 5-minute price bars is also acceptable, and is how most chart platforms such as FreeStockCharts.com or StockCharts.com compute the indicator.

Calculate VWAP using the following steps:

• Pick what period you’ll use as your input, 1-minute price bars, 5-minute price bars, etc.
• For each bar take the High + Low + Close and divide by 3. This gives you a “typical” price for that period.
• Multiply the typical price of that period by the volume for that period, to get the Weighted Price.
• Keep a running total of the Weighted Price, as well as a running total of volume as new data becomes available (a period ends). These are called Cumulative (or Total) Weighted Price and Cumulative Volume respectively.
• To get the VWAP, divide the Cumulative Weighted Price by Cumulative Volume.

Be sure to also read our Ultimate Guide to Analyzing Trading Volume.

VWAP Uses and Strategies

VWAP starts at the open price, and then moves up or down based on price movement and volume.

VWAP eliminates much of the noise seen in a stock throughout the day, even more so than a moving average would. At the start of the day the VWAP is more sensitive to price moves, but as the day progresses it becomes less so. This is because it’s based on cumulative values, so as these values get larger toward the end of the day, each new piece of data has less and less effect on the VWAP.

All charts courtesy of FreeStockCharts.com

VWAP Applied to Stock Chart
Figure 1. VWAP Applied to 1-Minute Chart of AAPL

When the price is below the plotted VWAP values the trend is likely down, or there is a downward bias to the trading day. Institutions looking to buy will often try to buy when the price is below VWAP, as they are able to accumulate a position at a better than typical (VWAP) price.

Short-term traders usually do the opposite, interpreting the price below the VWAP as bearish, and looking for short positions.

When the price is above the plotted VWAP, the trend is likely up, or there is an upward bias to the trading day. Institutions looking to sell or short will often try to sell when the price is above VWAP, as they are able to accumulate a short position or dump shares at a better price than what has been typical so far in the day (VWAP). Short-term traders usually do the opposite, interpreting the price above the VWAP as bullish, and look for long positions.

VWAP is a guide and a source of price information that reduces market noise. It does not provide entry signals, stop loss levels or target prices.

Figure 2 shows how an institution looking to accumulate a position (buy) or dispose of a position (sell or short) would view its transactions relative to VWAP.

Institutions interpreting VWAP
Figure 2. How Institutions Use VWAP as a Benchmark for Trades on M 1- Minute Chart

Figure 3 shows how retail traders use VWAP in helping them decide whether they should be focused on finding long or short trade opportunities as the day progresses.

Learn more about How to Spot and Trade Trend Reversals.

Retail traders utilizing VWAP
Figure 3. How Retail Traders Utilize VWAP on M 1- Minute Chart

On strong trending days the price will be above or below the VWAP for much of the day. On ranging days the VWAP will run through the middle of the price action, showing the overall sideways direction of the price. This can help retail traders determine what type of strategy they should be utilizing, trending strategies or ranging strategies.

VWAP Limitations

Unlike a moving average, which is commonly used in the development of trading strategies, the VWAP is more of an analysis tool than a trade signal tool. It provides a basic guide for whether there’s an upward or downward bias in price, but the actual VWAP line isn’t likely to provide consistently good trade signals. This is mainly because during strong trending moves the price is unlikely to touch (or even come close to) the VWAP.

Later in the trading day, the “lag” in VWAP becomes significant. This is because so much data is already being computed into the calculation that new data points have very little effect. Therefore, VWAP is of more value at the start of day to retail traders because it is more responsive to price moves. On the flip side, at the end of the day the VWAP will flatten out and be of little use to the retail trader. The end of day VWAP values are more important to the institutional trader though, since the end of the day VWAP value gives a benchmark that the institution can compare their transactions to.

The Bottom Line

VWAP gives the typical price of a stock (so far in the trading day), based on price moves and volume. It’s an intra-day indicator, starting with the first period (based on chart time frame chosen) of the day, and ending with the last. VWAP doesn’t provide trade signals like many other indicators; it’s an analysis and benchmarking tool. As the day progresses the VWAP begins to lag more and more. Therefore, retail traders find it more beneficial early in the trading session, and institutional traders find it more beneficial toward the close.


Gartley Pattern – The Gartley Pattern: How to Trade and Use It

The Gartley pattern is the most commonly used harmonic pattern that predicts a bullish or bearish retracement and continuation.

Harmonic chart patterns were developed by H. M. Gartley in 1932 and published in his book, Profits in the Stock Market. The Gartley pattern, or Gartley 222 pattern, is one of the most popular harmonic patterns to predict a continuation of a prevailing trend. While it’s similar to the AB=CD pattern, the Gartley pattern contains one more leg.

Let’s take a closer look at how to identify and use the Gartley pattern, as well as see an example of its use in the wild.

Click here to learn about the Day Trading Rules applicable to U.S. investors.

What is the Gartley Pattern?

The Gartley chart pattern is a continuation pattern that helps you predict if a price will continue its original trend after a retracement. Depending on its orientation, the pattern can be used to predict either a bullish or bearish continuation. It also appears relatively frequently in price charts, which makes it a relatively useful form of analysis.

Follow our Trading Strategies section to learn more about trading strategies.

Let’s take a look at a diagram of the pattern:

gartley patterns

The Gartley pattern consists of three legs:

  • X-A: The X-A leg is the initial move higher or lower.
  • A-B: The A-B leg is a 61.8% Fibonacci retracement of the X-A leg.
  • B-C: The B-C leg is a 38.2% to 88.6% Fibonacci retracement of the A-B leg.
  • C-D: The C-D leg is a 78.6% retracement of the X-A leg.

These reversals usually don’t fall exactly on key Fibonacci levels, but they should be roughly in the area to qualify the pattern.

How to Use Gartley Patterns

Buy and sell signals are generated when the price reaches Point D, which is a 78.6% retracement of the X-A leg. At that point, there’s a high likelihood that the price will reverse its short-term trend and continue on its long-term trend. Any significant move beyond these levels invalidates the pattern and the position should be exited at a small loss.

Stop-loss points are best placed just below the initial Point X, which leaves relatively little downside compared to the upside potential. Take-profit points vary depending on the situation, but many traders look for a 61.8% retracement of the A-D levels. Other traders look for a move to retest Point A’s levels, which are usually at the prior high or low of the long-term trend. It may be a good idea to take-profit at multiple levels to average out gains.

As with many other forms of technical analysis, Gartley patterns work best in conjunction with other forms of technical analysis, including chart patterns and technical indicators. Long-term trend lines and price channels can be helpful for showing areas of support and resistance, while technical indicators can provide insight into when the price is overbought or oversold.

Example of a Gartley Pattern

Let’s take a look at an example of the Gartley pattern in WTI Crude Oil:

gartley chart bull and bear
Source: TradingView

In this example, a Gartley pattern emerged in the WTI Crude Oil futures market. The A-B leg’s retracement is 62.7% of X-A, which is very close to the 61.8% Fibonacci level. The C-D leg’s retracement is 77.4% of X-A, which is very close to the 78.6% Fibonacci level. Traders could have entered the position near Point D to capitalize on the subsequent rebound.

Traders could have also looked for long-term support trend lines that supported a rebound at Point D. The only major red flag in the above examples was the lack of volume following the reversal, but the strong trend line support and other technical indicators may have been enough to justify a buy signal.

The Bottom Line

The Gartley pattern is one of the most popular harmonic patterns used to predict continuations of the underlying trend. Since it appears relatively frequently, traders often use it as a starting point for further technical analysis. The key is matching up Fibonacci levels and setting the right position management trades (e.g. stop-loss and take-profit points).


Cot Report – The Single Most Important Report for Commodity Traders: COT Explained

Commodity and futures traders use a host of technical tools to help their trading; the COT Report is used by traders to determine the positioning of major players in the futures markets. This weekly report helps confirm trends, spot impending reversals and keep tabs on the overall positioning of “big money” traders. Understanding the COT report, what it covers, how to trade with it, and its limitations are essential for effectively using the weekly COT data.

What Is the COT Report?

The Commitment of Traders (COT) report is released at 3:30 PM EST, usually on Friday (may vary at times due to holidays) and includes data from the previous Tuesday. The COT data included shows the positions of three major groups of traders: Commercial, Non-Commercial (large speculator), and Unreportable (small speculator).

COT disaggregated reports break this down further, into categories of Producer/Merchant/Processor/User, Swap Dealers, Managed Money and Other Reportables. This breakdown shows which group of large traders are doing what. For example, if managed money is increasing their overall long/short position, or decreasing it.

Be sure to also read A Trader’s Guide to Understanding Business Cycles

Palladium COT Report
Figure 1. Palladium COT Report – Source: www.cftc.gov

New reports can be found each week on the U.S. Commodity Futures Trading Commission (CFTC) website, the governing body that collects and releases the data.

The report is available on all futures products. Since options are also tradable on futures, there are reports that also include options positions, called the Disaggregated Futures-and-Options-Combined. While options play a pivotal role in the financial marketplace, for most traders’ purposes the Disaggregated Futures Only report should provide a good idea of how these large traders are positioning themselves.

There is also a long and short format of each report. The long format shows all the information of the short format (see Figure 1), but also groups the data by crop year (where applicable) and shows the percentage of positions held by the largest four and eight traders. The short format should provide most traders with what they need to use the COT report effectively for trading purposes.

Types of Traders Included in COT

There are a number of different trader groups listed on the COT reports.

  • Producer/Merchant/Processor/User is the group that actually produces or uses the futures product. Typically this group will take actually deliver on the future. For example, if producing something they may sell futures to lock in a price for it. If they need a commodity in their business process, they may buy futures to lock in a price on that commodity for when they will need it down the road. This is a group that knows a lot about their specific commodity and can move markets; this group is therefore closely tracked by traders.
  • Swap Dealers primarily use the futures market to hedge risk.
  • Managed Money is a speculative group which doesn’t want to take delivery on futures contracts, they just want to profit from the rise and fall in the prices. This is a very large group, and their actions move inversely to the Producer/Merchant group. Since this group has the power to move markets it is also closely monitored by traders.
  • Other Reportables is large traders that don’t fall under the above three categories.

There is also another group, not directly shown in Figure 1, known as Non-reportable positions. By taking all the open interest (see Futures Quotes: An Introduction) in a futures contract, and then subtracting all reportable positions (see groups above) there will be some open interest left over. These are trades made by small traders, typically speculators, that don’t need to report their positions to the CFTC.

Small speculators are considered to be the most uninformed about the futures market, and therefore some traders use small speculator positioning as a contrary indicator (take positions opposite of the small speculators) or ignore this data altogether.

See also Profiling Wall Street’s Best Contrarian Investors

How to Read the COT Report

The COT Disaggregated Report looks scary at first, but can be broken down into several chunks of key information.

Gold COT Short Report
Figure 2. Gold COT Short Report – Source: www.cftc.gov

In Figure 2, the red box shows the commodity. Since the full report lists multiple futures contracts, you’ll need to scroll through and find the one you are looking for.

The black box at the top shows the date of the data.

The blue boxes highlight each major group. Below each group is “Long : Short.” Continuing to scroll down within the box we see “Positions.” The number on the left is how many contracts are long and on right is how many contracts are short. For example, under the Managed Money category there are 149,260 contracts long and 27,173 short. In other words, the Managed Money group is bullish.

Below the “Positions” is “Changes from July 8, 2014” (or the prior week). This shows how much of a change there was in long and short positions, for that group, from last week to this week.

For example, under the Producer/Merchant group, long positions increased by 1,167 contracts and short positions decreased (-) by 1,1441 contracts.

The green box states total open interest at 408,368.

The bottom two rows give additional information, such as how much of the open interest each groups positions represent. The bottom row shows how many traders are in each group.

How to Trade the COT Report

Reading through the report may provide some insight into how traders are positioned, but the real value is monitoring how these positions change over time. Just knowing that Managed Money has 200,000 contracts long doesn’t tell you anything, unless you can figure out if they are accumulating more or starting to unload contracts over time.

Therefore, to make the COT data useful it needs to tracked, potentially in a spreadsheet, to show how positions are changing over time. Luckily some sites track and chart the data for us, so doing this manually isn’t required.

The changes over time in major trader positioning (commercial and large speculator) are important because trading positioning drives trends. For example, if large speculators (such as Money Managers) are heavily bearish but then begin to decrease their short positions by buying, this trend is likely to persist for some time, and the price will move up accordingly.

Typically, price moves are correlated with what large speculators do, so monitoring their positions can act as a confirmation for trade signals seen in the price action.

Figure 3 shows a price chart of gold along with COT summary data, which just includes Large Speculators, Commercials and Small Speculators. This type of chart should provide all the data needed to confirm trades, although the disaggregated data which breaks down the large groups can also be added to the chart, for example, to see exactly what Managed Money is doing.

Gold Price Chart with COT Data and Disaggregated Data
Figure 3. Gold Price Chart with COT Data and Disaggregated Data – Source: BarChart.com

Notice how the Large Spec positioning is highly correlated to price. As price rises, so does the net long position of large speculators. As the price drops so does the number of long positions Large Speculators carry. This is inverse to Commercials (Comm Spec. on chart), which over this time frame are net short, but as the price drops they tend to buy, decreasing the number of short contracts they hold. When the price rallies they accumulate more of a short position again.

Be sure to also read the Ten Commandments of Futures Trading

These relationships may not always hold true, for example Commercials aren’t always short as shown on the chart (negative numbers on right axis), but large speculators do tend to be highly correlated with price movements, while Commercials are often inversely correlated.

There are a number of ways to use this data for trading purposes.

Also using price analysis, watch for trendline breaks and trend reversals that are confirmed by Large Spec. positioning. In Figure 4 the price is moving lower and Large Spec. long positions are also decreasing. By the time price breaks above the trendline and Large Spec. long positions have already leveled off and started to creep back up. This helped confirm that Large Speculators were on board and starting to accumulate more long positions, pushing the price higher.

A long trade could have been initiated on the trendline line breakout with confirmation from the COT data.

Gold Price Chart with Potential Trades
Figure 4. Gold Price Chart with Potential Trades – Source: BarChart.com

Using historical Large Spec. readings can also be beneficial. Similar to what happens with price, Large Speculators also seem to hit areas of support or resistance in regards to how many contracts they hold. In Figure 4, when Large Speculators get over 100,000 net contracts longs there tends to be a correction (although not necessarily right away). Note that this number will fluctuate over time, and vary by each futures contract. Monitor historical COT levels to see which levels may be relevant in the contract you are interested in.

The price in gold rises after buying it, but eventually the price breaks below the trendline. At this time Large Spec. positions are well above 100,000 contracts long. Since over the last year this level resulted in corrections, when the price breaks below the trendline it provides added evidence that now may be the time to get out of the long … and potentially go short. Shortly after the trendline break, Large Speculator long positions begin to decline (along with price), confirming the decision.

It is also important to look at the overall trend in positioning. While Large Spec. long positions have increased and decreased in Figure 4 there is an overall uptrend as the green line is making higher highs and higher lows on each swing. This shows overall that Large Speculators are accumulating, and therefore expecting the price of the future to rise over the long-term.

COT Report Limitations

The main drawback of the report is that it is always lagging. It is not a real-time report detailing positions now. Between when the data is gathered and when the report is disseminated, large changes in positioning could have already occurred. This is why traders watch for trends in positioning, instead of just focusing on each weekly number.

Like any trading strategy, not every trade will work out. While all the evidence may point to the price going higher because of information in the COT, the price can drop as traders can change their minds relatively quickly and seek to adjust their positioning. Also, correlations between price direction and Large Spec. positioning can break down for periods of time, making the data harder to trade off of using the above methods.

The COT provides confirmation for price action, but volatility can mean the price won’t zoom directly in our favor. Use price analysis for stop loss placement and determining when to exit profitable trades. Price should always be the primary input, and COT data just a confirmation tool.

The Bottom Line

The COT report released by the CFTC each week is a great tool for traders. It shows how large traders—commercial and speculator—have positioned themselves in the market. How positioning levels change over time is more important than a single piece of data, since changes can help with spotting reversals and confirming trends. The COT data is delayed and is not a real-time reflection of current positions (although it is relatively close).

While the report can help traders confirm trades, there is still no guarantee a trade will work out. Traders most closely follow Large Speculators because this group moves the market, or Commercials because their positions move inversely to the Large Speculators.


Scalping Strategies – Introduction to Scalping Strategies

Traders use many different strategies to generate above-market risk-adjusted returns.

Many novice short-term traders forget about the “risk-adjusted” part and gamble on volatile low-priced stocks, but experienced traders know that risk management is just as important as high returns.

Scalping is one of the most common strategies used by short-term retail and institutional traders. Rather than optimizing for a big gain from a single trade, scalping optimizes the win-to-loss ratio across many trades. The process involves quickly booking small profits and losses as they appear in the market.

Check out this article to learn more about scalping.

Pros and Cons of Scalping

Traders should carefully consider the pros and cons of scalping before using the strategy.

The benefits of scalping include:

  • Limited Risk: Scalping strategies are designed to limit the risk of loss from any single trade by creating tight take-profit and stop-loss points. There’s very little market risk.
  • Non-Directional: Scalping is a non-directional strategy that doesn’t require the market to move in a specific direction. You can profit in both up and down markets.
  • Easy to Automate: Scalping strategies are often easy to automate with trading systems since they are usually based on a series of technical criteria that can be computed.

The drawbacks of scalping include:

  • Higher Minimums: Scalping requires higher minimum account values to either comply with pattern day trading rules ($25,000) or generate enough profits to reach your goals.
  • Higher Transaction Costs: Scalping involves placing a greater number of trades than other strategies, which means that transaction costs tend to be much higher.
  • Greater Leverage: Scalping often requires a high amount of leverage to generate enough profit, which makes it very important to control for risk to avoid large losses.

Scalping is best for short-term traders with access to sufficient starting capital. A high level of discipline is also required for scalpers that aren’t using automated trading systems to buy and sell equities, currencies, or futures. And finally, it’s important to backtest and paper trade any untested scalping strategy to ensure it’s the right fit for your goals.

Popular Scalping Strategies

There are countless different trading strategies that can be used for scalping profits.

It’s important to note that these strategies cannot be blindly implemented to scalp profits in any asset; rather, they serve as a starting point to developing a more fine-tuned strategy for a particular asset.

There are several steps to implementing scalping strategies:

  • Define: Determine what technical indicators you plan on using and the settings for them.
  • Backtest: See how the strategy would have performed in the past using historical data.
  • Paper Trade: Paper trade the strategies using your broker and level II quotes.
  • Optimize: Make any necessary improvements to the strategy to improve the risk-adjusted returns.
  • Trade: Trade using the strategy and carefully track the results, while being cognizant of any market-moving news.

To know more about different technical indicators, click here.

Here are two common strategies and examples of their usage:

Moving Average Ribbons

The most basic strategy for scalping involves the use of multiple moving averages. Short-term moving averages are often used to generate buy and sell signals when they cross above or below long-term moving averages. Moving average “ribbons” can be created using a series of equally spaced moving averages – oftentimes, a large number of moving averages.

Moving Average Ribbons

In the chart above, we create a series of moving averages, from the 8-day to the 60-day, and plot them all on the same chart of the S&P 500 SPDR (SPY) to create a moving average ribbon. A long position is entered when all of the moving averages cross above the 60-day and a short position is created when the 8-day crosses below the 14-day moving average. The short-term moving average can also serve as a stop-loss point to limit risk.

Stochastics with Bollinger Bands

The Stochastic Oscillator is a popular momentum indicator that shows the location of the closing price relative to its high and low prices over a given period of time. On the other hand, Bollinger Bands® are used to show volatility over a period of time. These two technical indicators are often combined to identify scalping opportunities over short periods of time.

Stochastics with Bollinger Bands

In the chart above, the Stochastics Oscillator and Bollinger Bands are plotted on a chart of the S&P 500 SPDR (SPY). A buy signal is generated when the price hits the low end of the Bollinger Brand and the stochastics experience a bullish crossover. A sell signal is generated when the price hits the top of the Bollinger Band and the stochastics experience a bearish crossover. The Bollinger Band can also serve as a valuable stop-loss point to limit risk on the trade.

The Bottom Line

Scalping has become one of the most popular short-term trading strategies used by both retail and institutional traders, and for good reason: it’s a relatively low-risk strategy that works in any market conditions. However, when developing a strategy, it’s important to backtest and paper trade it to ensure that it produces the expected results and is the right fit for you.


Pairs Trading – Pairs Trading: How to Trade Pairs

Traders have hundreds of technical tools and price action strategies to help them take advantage of price trends and ranging markets, but pairs trading is something completely different. Pairs trading uses correlations and divergences between two stocks in an attempt to capture a profit. While it isn’t riskless, by understanding how pairs trading works, how you control risk and how you manage profits, it’s a great tool to add to your trading arsenal because the strategy isn’t dependant on market direction.

Pairs Trading 101

Pairs trading is when a simultaneous long position is taken in one stock while a short position is taken in another.

The stocks must be highly correlated, meaning most of the time they move in the same direction. Typically, this is seen in the stocks of companies that are very similar, such as Coca-Cola Bottling Co. (KO) and Pepsico Inc. (PEP), or Ford (F) and General Motors (GM).

Since the stocks of these companies move in a similar fashion due to their similar business—we always must check to make sure they are moving in a similar fashion—when their stocks diverge it presents a trading opportunity. The strategy is to buy the stock that is underperforming and short-sell the one that is outperforming the other. Doing this safely requires some research and risk controls.

See also 25 Stocks Day Traders Love

Pairs Trading Considerations

Before utilizing this strategy we first must see if two stocks are correlated. We want them to move in tandem most of the time; that way, when they diverge from one another, if history holds true, then eventually they will revert back to trading in tandem and a profit can be made.

F (red) and GM (green) Comparison Daily Chart
Figure 1. F (red) and GM (green) Comparison Daily Chart (Percentage Scale) – Source: Freestockcharts.com

Figure 1 shows that over this time frame, Ford and General Motors often move in tandem. When they separated it presented an opportunity to short-sell GM when it was outperforming, and buy Ford when it was underperforming. As long as the stocks eventually come back to trading in tandem then a profit is made. In this case they did.

Overall market direction doesn’t matter. As long as the stocks separate and then come back together a profit is made, even if both stocks drop or both rally but get back in sync by doing it.

That’s the theory, but deciding when to take a pairs trade, how to control risk, and when to take profit is a more precise matter.

Stockcharts.com allows you to plot a chart that shows the ratio of one stock compared to another. Figure 2 shows the share price of Ford divided by the share price of General Motors. The ratio is currently 0.51, meaning Ford is almost exactly half the price of GM.

See also Trend Reversals: How to Spot and How to Trade

F / GM Share Price with 200-day Moving Average
Figure 2. F / GM Share Price with 200-day Moving Average and 200 Day Bollinger Bands (2.5 Standard Deviations) – Source: StockCharts.com

A 200-day period moving average is applied to get a “normal” ratio (currently 0.45). Bollinger Bands are also applied (200 periods and 2.5 standard deviations) to spot times when the ratio has moved significantly away from the norm, offering a trading opportunity.

The next section shows how to pick an entry and get out, but before that, position sizing must be addressed. The stocks are priced differently; according to current data General Motors is about twice as much as Ford. This means we can’t buy the same number of shares in each, we must calibrate each position.

Be sure to also read Don’t Fred, Salvage Your Losing Position with Options

The easiest way to determine position size is to set a fixed dollar amount for each side of the trade, say $10,000. Buy $10,000 worth of one stock and sell $10,000 worth of the other stock. That way the exposure is the same, but the number of shares held in each will be different.

Pairs Trading Example Explained

Consider the trade that occurred in December 2013. Ford declined steeply in value relative to GM, as is shown in both figures 1 and 2.

On December 6, the ratio breaks below 2.5 standard deviations (lower red Bollinger Bands) from the 200-day norm. Ford is falling and GM is rallying; the stocks are diverging. While a trade can be taken at the exact moment the ratio penetrates the 2.5 standard deviation Bollinger Band, it is prudent to wait for both the stock prices and the ratio to start converging (moving back toward normal) again before taking the trade.

See also Analyzing Trading Volume: The Ultimate Guide

In this case, we don’t see the ratio begin to trend back higher until January 2. By waiting for the ratio to begin heading back toward the norm we avoid holding a losing position for longer than we need to (in this case it would have been almost a month), and we can also place a stop below the recent low in our long trade and above the recent high in our short trade.

Therefore, enter trades when the ratio has gone beyond 2.5 standard deviations from the 200-day norm and is starting to move back toward the norm. Exit when the ratio comes within 0.02 points of 200-day norm.

This is how the trade looks on the ratio chart.

F / GM Ratio Pairs Trade Entry and Exit
Figure 3. F / GM Ratio Pairs Trade Entry and Exit – Source: StockCharts.com

Buy Ford near the close on January 2 at $15.44. Place a stop loss below the recent low at $15.10.

Short-sell GM near the close on January 2 at $40.95. Place a stop above the recent high at $41.85.

Pairs Trade with Entries, Stops and Exit
Figure 4. Pairs Trade with Entries, Stops and Exit – Source: FreeStockCharts.com

If each side of the trade is allocated $10,000, then we buy 647 shares of Ford ($10,000 / $15.44) and sell 244 shares of General Motors ($10,000 / $40.95).

Close out trade near the market close on January 24 because the ratio has moved to within 0.02 of the norm (200-day average). Therefore, we can conclude the price relationship has reestablished itself and our reason for entering the trade has now diminished.

GM is closed at $36.83 and Ford at $15.83.

Profit collected is:

General Motors: $40.95 – $36.83 = $4.12 × 244 shares = $1,005.28

Ford: $15.83 – $15.44 = 0.39 × 647 = $252.33

Net Profit: $1,005.28 + $252.33 = $1,257.61

The short trade creates a cash inflow that offsets the outflow of the long position, so there is minimal cash outlay. If calculating the return based on the initial $20,000 in positions though, the return is greater than 6% in less than a month.

Not all pairs trades will work out this well; sometimes only one trade will be profitable and the other a loser, other times both trades may be unprofitable.

The stop losses also contained risk to a small amount of capital, and the profit potential was much greater than the risk with these stops in place.

If either position gets stopped out, exit the other trade as well. With this style of pairs trading you always have two positions or no positions.

Pros and Cons of Pairs Trading

Pros include the strategy being market neutral. Just address the dynamic that is going on between the stocks and little regard or time needs to be committed to study of broader market conditions. The strategy is also quite flexible; shorter term traders can use less of a standard deviation or a shorter time frame (i.e. 30-minute chart) to trigger more trade signals.

Cons include the possibility that a divergence can last much longer than expected, or the prices can simply continue to diverge based on fundamental changes in company structure or performance. This is why a risk limit must be set to avoid catastrophe situations where the two stocks continue to move more and more out of sync. The strategy also goes against traditional trend trading concepts of buying the strongest stocks and selling the weakest – pairs trading does the opposite.

This strategy is also subjective. The price must diverge, and then we wait to take the trades until the prices start to converge again. While this is theoretically a safer approach, it takes skill and practice to develop that timing.

Traders must also consider a stock’s beta. Two similar stocks that have very different betas indicate a discrepancy in volatility. If one stock is much more volatile than the other it could cause issues with the trade. Ideally, pairs trade with stocks that are correlated and have similar betas.

The Bottom Line

Pairs trading involves taking a long and short trade simultaneously in two typically highly correlated stocks with similar volatility. A long position is taken when one stock underperforms by a certain threshold, and a short trade is taken in the outperformer, with the intent that the stocks will eventually revert to the historical norm thus resulting in a profit. If the stocks do revert to being highly correlated, the trade is profitable, but risk controls in the form of stops should be used to avoid situations where stocks continue to diverge. Reversions to the norm can take a long time, so traders must weigh which trades are worth the potential wait and risk, and which aren’t.

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Doji%20candlestick

TRADING STRATEGIESShare

How to Identify & Trade Doji Candlestick Patterns

Justin KuepperFeb 20, 2019

Candlestick patterns provide instant insights into market sentiment. For example, candlesticks with a small real body suggest indecision in the market, whereas candlesticks with a long real body suggest strong directional moves. Candlestick shadows also provide insight into intra-session volatility, which can be critical when looking at the underlying market psychology. Doji patterns are a great example of how these patterns can provide critical insights.

Let’s take a look at how to identify and trade the doji candlestick pattern, as well as an example of the doji patterns in action.

Click here to learn about the Day Trading Rules applicable to U.S. investors.

What Is the Doji Pattern?

The doji candlestick pattern is a cross-, plus- or T-like pattern that indicates indecision in the market. Traders can use the pattern on its own or in combination with other candlestick patterns to identify potential reversals in the prevailing trend.

Doji candlestick patterns

Doji candlestick patterns are very simple to recognize:

  • Very thin or no real body
  • Shadows of any length

The very thin real body suggests that there’s a lot of directional indecision in the market – that is, bulls and bears are fighting over control. Longer shadows usually indicate a larger fight with a lot of volatility, while shorter shadows suggest a quieter market with little volatility. Doji patterns with long shadows are usually the most reliable trading signals.

How to Trade Doji Patterns

Doji patterns are interpreted by varying positions and length of shadows, so traders have given different names to different shadow arrangements.

The most popular doji patterns include:

  • Doji Star: Doji stars indicate indecision in the market with low activity. If it proceeds a gap higher or lower, it can signify a near-term reversal, but in most cases, it represents only the early signs of a reversal.
  • Long-legged Doji: Long-legged doji indicates indecision in the market with high activity. As with the doji star, the pattern works best when it follows a strong directional move, but it usually only represents the early signs of a reversal.
  • Dragonfly Doji: Dragonfly doji appear like the letter “T” and is most reliable when it appears after a significant downtrend. After opening lower, the doji signals that bulls regained control over the price and will likely remain in control of the following session.
  • Gravestone Doji: Gravestone doji appear like an inverse letter “T” and is most reliable when it appears after a significant uptrend. After opening higher, bulls lose control over the price and bears take over throughout the session.

When trading in these patterns, it’s important to take the previous trend and volume into consideration. The most reliable trading signals are generated following a strong previous trend with higher than average volume during the doji session. It’s also a good idea to consider other forms of technical analysis as confirmation, such as trend line support or resistance levels.

Examples of Doji Patterns in Action

Let’s take a look at an example of a dragonfly doji in the SPDR S&P 500 ETF (SPY).

Doji candlestick in action
Source: TradingView

In the above chart, the dragonfly doji is immediately followed by a sharp increase in price as the bulls take over control of the price from the bears. The strong volume just before and on the doji pattern provides a strong signal that a directional move is about to occur. When zooming in, the breakout also occurs from a key trend line resistance level, which further confirms that a bullish move higher is likely to occur.

The Bottom Line

Doji candlestick patterns indicate indecision in the market. Depending on the length of the shadow and other factors, the indecision can translate to an imminent reversal in price or a mere suggestion that a reversal will eventually occur. The key is to look at the prior trend and volume for context, as well as using doji candlestick patterns in conjunction with other forms of technical analysis that can serve as confirmation.


Andrews Pitchfork – Understanding Andrews’ Pitchfork and How to Use It

Andrews’ Pitchfork was developed by the renown educator Dr. Alan H. Andrews using the median line concept that was established by Roger Babson. On September 5, 1929, Mr. Babson famously gave a speech where he proclaimed “… a crash is coming, and it will be terrific” and, of course, Black Tuesday occurred just a month later. Dr. Andrews expanded upon these concepts to create Andrews’ Pitchfork and the rest is history.

In this article, we’ll take a look at Andrews’ Pitchfork, how it’s calculated and drawn, and how it can be used to improve trading performance over time.

Creating Andrews’ Pitchfork

Andrews’ Pitchfork consists of a median line at the center and two parallel trend lines equidistant it, where the outside trend lines represent areas of support and resistance. In Figure 1 below, AAPL remains largely within the bounds of the indicator with the exception of a short false breakdown near the beginning. Traders often look for buying or selling opportunities as the price approaches the ends of these channels.

Andrews' Pitchfork 1
Figure 1 – Andrews’ Pitchfork AAPL – Source: TradingView

The technical indicator is created by selecting three points on a chart:

  1. A beginning point that represents the start of a trend.
  2. A reaction high coming after the beginning point.
  3. A reaction low coming after the beginning point.

The selection of these points is somewhat subjective, but it’s a good idea to experiment with different reaction highs and lows to find what works best. In some cases, traders may want to plot multiple Andrews’ Pitchforks on the same chart to provide an indication of where support or resistance may be strongest. Traders may also look at different timeframes to determine long-term and short-term support and resistance levels for a given security.

Using Andrews’ Pitchfork

Andrews’ Pitchfork is used in many of the same ways as traditional channels, including as support, resistance, and reversal trend lines. In addition to these standard methods, trigger lines can be used to identify additional areas of support and resistance based on a line connecting the first point (“handle”) to the peak at the third point. These are particularly useful when a breakout occurs from the Andrews’ Pitchfork later down the road.

The two most common strategies falling under the S/R umbrella include:

  • Buying the Bounce. Traders may buy when prices hit the bottom of a channel and sell when prices hit the top of the channel to profit from the difference. In these cases, it’s important to wait for confirmation that the price is responding to these levels.
  • Buying the Break. Traders may buy when prices breakout from the top of a channel or sell when prices breakdown from the bottom of the channel. In these cases, it’s important to look for a clean break to avoid false breakouts or breakdowns.

There are many other trading strategies that can also be employed. For instance, an options trader may write call options outside of the channel to collect premiums on an option that’s less likely to be callable. The key value of the indicator is it’s ability to predict when prices are likely to face support and resistance, as well as when a breakout or breakdown occurs, which can be useful in a number of different markets using many different strategies.

Of course, there are some limitations that traders should consider when using the indicator. Selecting the initial three points is a very subjective activity, which means that the trading indicator’s success hinges on experiencing in finding the optimal points. As with any technical indicator, there is always a chance that false breakouts and false breakdowns will occur, which makes it important to use a variety of different tools instead of relying on only a single tool.

Examples of Andrews’ Pitchfork

Andrews’ Pitchfork can be applied to nearly any chart, ranging from stocks to commodities to currencies. Let’s take a look at a couple examples of Andrews’ Pitchfork in action:

Andrews' Pitchfork 2
Figure 2 – Andrews’ Pitchfork SPY – Source: TradingView

In Figure 2, Andrews’ Pitchfork is applied to a 1-hour S&P 500 SPDR ETF (NYSE: SPY) chart. The technical indicator successfully predicts upside resistance at two points and subsequently indicates that a breakout is likely to occur. After breaking through the upper Andrews’ Pitchfork level, the index gaps above the trigger line and a rally higher follows.

Andrews' Pitchfork 3
Figure 3 – Andrews’ Pitchfork EUR/USD – Source: TradingView

In Figure 3, Andrews’ Pitchfork is used to predict resistance in at least three places in the EUR/USD currency pair. The breakdown below the final support resulted in a gap and the prior support turning into a key resistance level. In addition, it’s worth noting that the trigger line was not reached in the brief breakout from the upper trend line, which suggested that the pattern remained in tact and the trend was headed lower.

The Bottom Line

Andrews’ Pitchfork is a great technical indicator for day traders to use when determining areas of support and resistance. While it’s not perfect in every scenario, the indicator provides a good indication of where prices may be headed. The downside is that picking the three points is a largely subjective process that require experience to master. Traders should also be sure to use the indicator as only one piece of the puzzle rather than relying on it exclusively.


Gap Trading – Gap Trading: How to Trade the Gaps

A price gap occurs when there is a difference between the closing price one day and the opening price the following day. Price gaps are important in technical analysis because they show a strong change in value from one day to the next. There are multiple types of gaps, from common gaps, which are generally ignored, to full gaps, which show an important shift in sentiment when sufficiently large.

Gaps are often the result of overnight news, such as earnings or an unexpected company-specific event. Upon understanding the types of gaps, strategies are employed to take advantage of them.

Be sure to also learn about a Short-Squeeze and How to Profit From One.

The Appeal of Gap Trading

screen with tickers and prices

Gaps are highly visual and easy find using a stock screener. Once found, a gap is traded with precise protocols (vary by strategy). This produces a positive trade expectation where the profit potential is greater than the risk. This is the desired outcome of most strategies. Since gaps are associated with a volatile move, the potential gains from trading the aftermath of a gap can be quite large as volatility and emotions continue to run high in the days and weeks that follow.

The gap trading strategy below isn’t time consuming. This is useful for traders who don’t have time to sit in front of their trading screens all day.

Visual Guide to Gaps

There are three main gap types, and three more which have relevance for analytical purposes.

Common Gap is frequent, and not of concern. For most stocks, a common gap is when the open price is within 1% of the prior close. In a volatile stock, a common gap may be up to 3% or 4%. In a “tame” stock, common gaps will be approximately 0.5% of less.

Common gaps don’t show a strong shift in buying or selling pressure, but instead show differences in price that can be reasonably expected from day to day. Volume helps verify if it is a common gap. If there isn’t an increase in volume on the gap, and it is small, it is probably common and insignificant.

Be sure to read our Ultimate Guide to Analyzing Trading Volume.

All charts courtesy of StockCharts.com

common price gaps
Figure 1. Common Price Gaps

Full Gap occurs when the open price is completely outside the price range of the prior day.

A full gap higher is when the open price is above the previous day’s high, and with a full gap lower the open price is below the previous day’s low.

full price gaps
Figure 2. Full Price Gaps

The Partial Gap is when the open is different than the close, but the open is within the price range of the previous day.

A partial gap higher is when the open price is below the previous day’s high, but above the prior close. A partial gap lower is when the open price is above the previous day’s low but below the prior close. Most partial gaps are of little concern.

partial price gaps
Figure 3. Partial Price Gaps

The above types classify the gaps that occur, with full gaps being the most useful for trading purposes, especially when there is a big percentage difference between the prior close and the open price.

These big gaps are further classified as breakawayrunaway and exhaustion. At the time they appear they are essentially the same – a big full gap. It is only when looking at the broader trend and the aftermath of the gap does it become apparent which type of gap it is.

Breakaway gaps occur after a consolidation or chart pattern (such as a triangle or head and shoulders pattern) and signal a strong breakout. Runaway gaps occur during strong trends and show the trend is accelerating. An exhaustion gap occurs near the end of the trend, giving one last strong burst in the trending direction before the trend reverses. Volume on all these gaps is much higher than average.

See also Trend Reversals: How to Spot and How to Trade.

The strategy discussed shortly is most useful when traded following a breakaway gap, such as the one shown in Figure 4.

breakaway price gap
Figure 4. Breakaway Price Gap

Finding Gap Trade Candidates

Any stock that has a price gap of 10% or more is one to monitor closely. Stock screeners such as a the predefined scans on StockCharts.com or the Top Gainers and Top Losers on Finviz.com or Yahoo! Finance will provide a handful of stocks that gapped. See our list of the 10 Best Stock Screeners.

Monitoring gaps in real-time isn’t required for the strategy below. Rather the levels the price gapped from in the past will provide potential trade levels for future trades.

Gap Trading Strategy

Following a significant gap—roughly 10% or more—the price will often, eventually, move back to test the point from which the gap originated. This is referred to as “filling the gap.”

If the gap was higher, the price moves back to test the price on the day prior to the gap higher. This presents an opportunity to go long. A buy order is placed near the close of the day prior to the gap. A target is placed near the recent high, and a stop is placed below support prior to the gap, or several percent below the entry price.

long entry on filled price gap
Figure 5. Long Entry of Filled Price Gap

If the gap was lower, the price often moves back to test the price on the day prior to the gap. This presents an opportunity to go short. A short entry order is placed near the close of the day prior to the gap. A price target is placed near the recent low. A stop is placed above resistance prior to the gap, or several percent above the entry price.

Short Entry on Filled Price Gap
Figure 6. Short Entry on Filled Price Gap

The drawback to this strategy is that the price may not pullback, and instead keep trending. In this case, trend trading strategies can be employed so opportunities aren’t missed. See: Best Trend Trading Setups with Examples.

There is also potential that the price will continue to move right through the entry location, hitting the stop. Waiting for a bullish engulfing pattern on a long trade, or a bearish engulfing pattern on a short trade, could be used to indicate that the price is moving back in the anticipated/trade direction before entry.

The Bottom Line

Gaps occur all the time, although common gaps and partial gaps aren’t usually of importance to traders. Full gaps on the other hand, which move significantly away from the previous close, show a strong shift in investor sentiment. When a price gaps 10% or more, the stock will often “re-test” the area the price originally gapped away from. This presents a trading opportunity. Stocks that have gapped can be recorded and monitored for future trades. Use freely available stock screeners to find stocks that have gapped.


– Don’t Fret, Salvage Your Losing Position With Options

When facing loss, you have multiple ways to deal with it. Many traders don’t’ consider stock options for “repairing” a losing stock position, either because they are unfamiliar with options, or not sure how to use options to repair an equity position. The “Option Repair” strategy is used by equity traders who are facing a loss and want to reduce their break-even price so they can get out of the trade; furthermore, these option positions can typically be attained at little or no cost.

Ways to Deal with a Large Loss

When facing a loss in a stock, the simplest solution is to sell the stock and take the hit. Another possibility is to wait it out, hoping the stock will eventually get back to your purchase price. Some traders choose to “double down,” buying more stock and creating a lower average purchase price. While this reduces the break-even point it also increases risk if the stock price continues to drop; this is not to mention that they are coughing up more cash to purchase more stock.

The Option Repair strategy is another alternative. Say you purchased 200 shares of Apple (AAPL) at $600 in 2012, then you watched it drop below $400 in 2013. In early 2014 the stock is trading at $523, and you have decided you just want out, but you don’t want to take the $15,400 loss ($120,000 – $104,600). If you can break-even on the trade, you will be happy, and if you can reduce the break-even price without dishing out more capital, even better! That’s exactly what the Option Repair Strategy does.

Option Repair Setup

When facing a loss in a stock, the simplest solution is to sell the stock and take the hit. Another possibility is to wait it out, hoping the stock will eventually get back to your purchase price. Some traders choose to “double down,” buying more stock and creating a lower average purchase price. While this reduces the break-even point it also increases risk if the stock price continues to drop; this is not to mention that they are coughing up more cash to purchase more stock.

The Option Repair strategy is another alternative. Say you purchased 200 shares of Apple (AAPL) at $600 in 2012, then you watched it drop below $400 in 2013. In early 2014 the stock is trading at $523, and you have decided you just want out, but you don’t want to take the $15,400 loss ($120,000 – $104,600). If you can break-even on the trade, you will be happy, and if you can reduce the break-even price without dishing out more capital, even better! That’s exactly what the Option Repair Strategy does.

Option Repair Example

Assume the prior scenario: You purchased 200 shares of Apple (AAPL) at $600. The stock now trades at $523, near the start of April 2014. If you can break-even, you want out, and are willing to give up any profit over and above your break-even price.

Step 1. Calculate the difference between your stock purchase price and the current price, divide it by two, and then add the number to the current stock price. This is the strike price (approximate) where you will sell two calls for each 100 shares you own.

  • In this case, $600-$523=$77. Divide this by 2, and then add it to the current price. So $38.50 + $523 = $561.50. Round this down to $560 (nearest Apple strike price). This is the price you are going sell four call options at (two for each 100 shares).
  • This is also your new break-even price. If the stock price is at $560 when your options expire, your stock loss is eliminated (or very close).

Step 2. Buy one Call for each 100 shares you own, at or near the current market price.

  • In this case, the current price is $523. Round this to $525 (nearest Apple strike price). This is the strike for buying 2 calls (1 for each 100 shares).

Step 3. Choose an expiry. If the price has to cover a lot of distance to reach your new break-even, choose an expiry several months out. If the price doesn’t need to cover much distance, you can choose a shorter expiry.

  • In this case, the price needs to move up $38.50. So assume we choose an expiry two to three months away (If it’s April, expiry is in June). All charts were made with FreeStockCharts.com.
This is the first figure in the article
Figure 1. Key Levels for Option Repair (Apple, Daily Chart)

Step 4. Calculate how much the options cost. Buying the calls (one for each 100 shares) is your cash outlay. Selling the calls (two for each 100 shares) is your income. The source for the following two charts is the BOE.

Figure 2. Apple June Call Options, $525 Strike
Figure 2. Apple June Call Options, $525 Strike
Figure 3. Apple June Call Options, $560 Strike
Figure 3. Apple June Call Options, $560 Strike
  • In this case, the option we buy (near current price) is $19.95, and we need to buy two because we have 200 shares. Total cost: $19.95 × 200 = $3990.
  • The options we sell are priced at $7.78, and we sell four because we have 200 shares. Total income: $7.78 × 400 = $3112
  • Total cost is $3990 – $3112 = $878. This is an additional cash outlay.
  • If the options you are sell are worth more than the options you buy, you pocket some cash on the transaction.

The bigger the loss on the stock position, the more likely it is that attaining the options will cost you money (like above). The smaller the stock position loss, the more likely it is that the option position will cost you nothing or may even generate a small amount of cash inflow [see also Ten Commandments of Futures Trading].

Scenarios

If the stock continues to decline, the options expire worthless, and you’ll still be holding a losing stock. For many positions, the options positions won’t cost you anything, so you are no worse off than if you just held the stock. If the options did cost you something, as in the example above, then you will have lost slightly more by instituting the Option Repair strategy.

If the price rises above where you bought the call, then your loss will be reduced. If the price rises to your new break-even price, then your stock loss will be eliminated. In the example above, if Apple rises to $560 the loss will be erased (or very close to it).

This is because the calls you wrote will expire worthless (unless the price goes above $560). But the 2 calls you bought are now worth $560-$525=$35 × 200 = $7000. The loss on your stock position is nearly the same. You purchased at $600 and the stock is now at $560, a loss of $8000. Instead of losing $8000, your loss is reduced to $1000 ($8000-$7000), plus the cost of options if applicable. This is essentially a rounding error, based on the available strike prices. Alter when you purchase the options, or the strike prices, to completely reduce the loss.

If the price continues above the new break-even price ($560 in the example above), you have the same scenario as the prior. You will have broken even, although in this case there is a “rounding error,” as often happens in the real-world, so you lose $1000 regardless of how high the stock price rises.

Stock at ExpirationGain/Loss on Stock (200 shares)Value of 2 Bought Calls ($525)Value of 4 Sold Calls ($560Net Gain/Loss
$400-$40000$0$0-$40000
$450-$30000$0$0-$30000
$500-$20000$0$0-$20000
$550-$10000$5000$0-$5000
$575-$5000$10000-$6000-$1000
$600$0$15000-$16000-$1000
$650$10000$25000-$36000-$1000

You always have the choice to close out your options positions at any time. Since option prices are always changing, you’ll need to price out what it costs to sell your bought call, and buy back the options you sold.

Final Considerations

Commissions have not been included, as they are not typically a material cost when applying this strategy once in a while.

Strike prices are not available for every price the stock passes through, which means you may not totally reduce your loss, but typically you can get quite close. Sometimes you’ll pay for the option positions; other times you’ll receive cash flow from the options, which can also be used to reduce the stock loss position.

The Bottom Line

The Option Repair strategy typically doesn’t leave you worse off when compared to just holding a losing position. Whether the stock rises or falls, often you will end up better (reduced loss, or small gain), or with a similar loss than if you had not implement the Option Repair strategy.

If you decide to utilize the strategy, be sure to do the math and see how you will fare under different stock price scenarios. By slightly adjusting the options used, you may be able to completely eliminate your stock loss, and possibly even collect some cash flow on the sale of the options.


– What Is Elliott Wave Theory?

Ralph Nelson Elliott was a professional working in various accounting and business roles until he contracted an illness in Central America, which led to an unwanted retirement at 58 years old. With a significant amount of time on his hands, Mr. Elliott began studying 75 years of stock market behavior in the early 1900s to identify yearly, monthly, weekly, daily, hourly, or minute price patterns.

By late-1934, Mr. Elliott had developed a theory that he called Wave Theory and presented it to Charles J. Collins of Investment Counsel, Inc. in Detroit. Mr. Elliott finally managed to convince Mr. Collins that the theory was useful in March of 1935 with a contrarian call that the Dow Jones Industrial Average was at a bottom. The 13-month correction ended the next day and the market moved sharply higher.

The Wave Principle was published in August of 1938 as a collaboration between Mr. Elliott and Mr. Collins. Over the subsequent years, the Wave Theory was refined to include principles from the Fibonacci ratio, and Mr. Elliott eventually published Nature’s Law – The Secret of the Universe. Elliott waves are now ubiquitous among market technicians that use the technique in their decision-making.

Elliott Waves 101

The Elliott Wave Principle is a detailed description of how groups of people behave, according to Elliott Wave International. Unlike many other trading systems, Elliott waves seek to identify probable rather than certain moves in a given direction. Traders must assess the individual probability of each situation given other technical and fundamental factors that might be at play.

In practice, market technicians using Elliott waves look for specific patterns in a stock price. Impulse waves are price movements with the larger trend, which can be broken down into five subwaves. On the other hand, corrective waves are price movements against the larger trend, which can be broken down into three subwaves. These patterns combine into five- and three-wave structures.

Elliot Wave Pattern

Fibonacci ratios are used to effectively qualify various waves. For example, an impulse wave’s subsequent corrective wave might be a correction in Fibonacci proportions of 38%, 50%, or 62%. Similarly, impulse waves after corrective waves might rise in relation to Fibonacci proportions. Most popular charting platforms offer Fibonacci retracement, projections, fans, and other tools.

Advanced Rules

Elliott wave practitioners use a variety of other rules and guidelines to help ensure that they are correctly identifying patterns. While the three rules are widely considered to be requirements for a valid wave, the additional guidelines are tendencies that may not occur all of the time. Elliott wave analysis tends to be subjective and traders must learn to identify patterns over time.

The three rules include:

  • The second wave cannot retrace more than 100% of the first wave.
  • The third wave can never be the shortest of the three impulse waves.
  • The fourth wave can never overlap the first wave.

Three additional guidelines include:

  • When the third wave is the longest impulse wave, the fifth wave will approximately equal the first wave.
  • The second and fourth waves will alternate. For instance, if the second wave is a sharp correction, the fourth wave will be a flat correction, and vice versa.
  • Corrections usually end up in the area of a prior fourth wave low after a five-impulse wave advance.

Since Elliott waves are fractal in nature, the patterns repeat themselves as a trader zooms in from long time periods to short time periods. Market technicians refer to these various levels of waves by a combination of letters and numbers.

Elliot Wave Levels

Example: Yahoo Inc.

Elliott waves are best explained by looking at a real-life example, since actual prices are much less pretty than the theory. In these cases, it’s important to look at long-term tops and bottoms rather than short-term price volatility that can be random by many accounts. These tops and bottoms can be further confirmed using technical indicators as will be explored in the following section.

See Also: 50 Blogs Every Serious Trader Should Read

Yahoo Elliott Wave
Figure 2

Yahoo Inc.’s price action in mid-2013 through mid-2014 showed a clear Elliott wave pattern over time. After the first impulse wave, the correction wave moved to the Fibonacci level of 50% before the second impulse wave began. The second correction wave again moved 38.2% lower, which represents another key Fibonacci level, before the third impulse wave moved to highs in early 2014.

In this case, traders could have used Elliott waves to enhance their odds of a successful trade over time. The fifth wave could have signaled a long-term reversal and a top that could have avoided the subsequent losses from the downturn. Buying at the key Fibonacci levels could have also enhanced profits during the five waves higher by enhancing the timing of the trades to optimize profits.

Of course, Elliott waves are most useful when looking at multiple timeframes with multiple Elliott waves within those time frames. For example, the end of the C wave above signifies the beginning of a new bullish or bearish Elliott wave. Looking at longer timeframes and larger patterns can help discern the overall trend and help make it easier to see where prices are headed over the subsequent patterns.

Risks & Considerations

Elliott waves are best used as a single part of a market technician’s toolbox instead of as a solo prediction technique. For instance, an Elliott wave predicting a rebound might be much more powerful in the context of a MACD crossover, low RSI reading, and potential ascending triangle breakout, while an Elliott wave contradicting various other technical indicators might not be as reliable.

Zooming in on the Yahoo Inc. example above, there are several other technical indicators that seem to confirm what’s happening as seen in Figure 3 below. The overbought RSI reading above 70 suggested a possible reversal, while the bearish MACD crossover confirmed it after the fact. Conversely, the bullish MACD crossover confirmed the rebound from the Fibonacci support level.

See Also: 25 Stocks Day Traders Love

Yahoo Technical Indicators
Figure 3

There are several things traders should keep in mind when using the technique:

  • Multiple Timeframes. Traders should look for Elliott waves in multiple timeframes in order to ensure that they are not trading against long-term trends when buying into short-term trends.
  • Seek Confirmation. Traders should look for confirmations of Elliott wave patterns by looking at other technical indicators, like RSI or MACD, as well as chart patterns, like ascending triangles or wedges.

See Also: Best Trend Trading Setups With Examples

Bottom Line

  • Elliott waves were theorized in the 1930s by R.N. Elliott and have since been embraced by many market technicians around the world.
  • Elliott waves are based on principles of market psychology and present themselves as fractal patterns consisting of impulse and correction waves.
  • There are many different rules and guidelines that traders should follow when using Elliott waves, but the practice remains very subjective.
  • Traders can increase their odds of success by combining Elliott wave theory with other technical indicators and chart patterns.


Covered Call – Covered Call Options Strategy Explained

An option is a great tool even for an investor. The covered call option strategy is commonly used by traders and investors who are holding stock, but seek an income stream from that investment. Before implementing a covered call options strategy the trader or investor should know what a covered call is, how the strategy works, when and why to implement it as well as the pros and cons of the strategy.

Covered Call Option Strategy

A call option is an agreement that provides the right, but not the obligation, to buy a stock at a specific “strike price.” Someone who buys a call option is hoping the stock price will rise above the strike price, in which case their option becomes more valuable and they make a profit. For this potential, the call buyer pays a “premium.”

This is where the covered call strategy comes in. If you own 100 shares of XYXYZ you can write a call option on that stock, with a strike price that’s above the current share price. For this you’ll receive a premium/income (from the buyer of the option).

Be sure to also read about the 3 Ways to Exit a Profitable Trade.

When writing a call, your profit (on the call) is limited to the premium received. Since you own the stock your risk on the written call option is limited. The shares you own are still susceptible to decline.

Assume XYXYZ is trading at $50, and you decide to write a covered call option on the stock with a strike price of $52. The option premium is $1, so you receive $100 ($1 × 100 shares). If the price does nothing and the stock price is below $52 when the option expires you keep the stock, and you made $100 on the option premium.

If the stock price is above $52 at expiry, you give up your shares because the option buyer has the right to purchase your shares from you at $52. This is actually a favorable outcome, since you profited up to the $52 on the shares (up from $50 when you wrote the option) and you made $100 on the option, effectively netting $53 per share.

If the price of the stock drops, the option offsets your total loss on the stock by $100.

The graph below shows how this works. Profit potential is the Y axis while the price of the stock is the X axis. As the price drops, so does the profit, but it’s offset by the premium received. The premium increases profit if the stock doesn’t move, and the profit potential plateaus if the price moves above the strike price.

Profit Loss Graph for Covered Call Strategy
Figure 1. Profit Loss Graph for Covered Call Strategy, Source: Adapted from CBOE.com

The Covered Call Strategy – When and Why

The strategy is used for different reasons and at different times.

If a stock isn’t going up or down, you can get some income out of it by writing covered calls.

The stock may be a low volatility dividend-paying stock, but you want to increase your income from the stock by writing calls options. Careful here though, if you really like the stock you don’t want to have it called away if the stock price goes above the strike price.

If a stock you own has had a nice run higher, and you want to take profits, writing a covered call is one way to do it. If the price keeps going above the strike price your stock will be called away (you don’t own it anymore, the call buyer does) and you have the premium as a bonus. If the stock starts to drop you can sell it, keeping the premium as a bonus. In this case be sure to close the option trade, if it hasn’t already expired, at the same time you sell the stock. If you don’t, you’re “naked,” and if the stock price sky rockets you no longer have the shares to give to the call buyer. This means you’ll need to buy them at market price resulting in a big cost/loss.

Learn about How to Profit in a Sideways Market.

If the stock is dropping and you think it could drop further, sell it. Don’t write covered calls on it. The premium received from the options won’t be enough to offset the price drop of plummeting stock.

Covered Call Trading Example

Consider the following example using Macy’s (M) stock. The price was trending higher but has now leveled off, ranging between $55 and $63. The price is currently $57.64. You decide to write a covered call on the 100 shares you own of M, with a strike price at $62.50 and an expiry three and half months into the future (it’s the start of November and you choose a February expiry).

If the price falls, the premium received helps offset your losses, and you can always sell the shares and close your written call for a small profit (since the price has dropped the price you pay to buy/offset your call should be lower than what someone paid you for it).

Current options prices are available from the Chicago Board Options Exchange.

option premiums chart
Figure 2. Option Premiums for M Call Options, Source: CBOE.com

Someone is willing to buy this option at $1.46; since there’s no volume you’ll want to sell to this buyer and take the $1.46 (premiums will constantly fluctuate as the price of the stock fluctuates).

If the price rises above $62.50 you keep the option premium and get out near the top of the range. You get $62.50 for your shares plus the $1.46 premium, which means you effectively netted $63.96 on your shares. You give up gains if the stock continues to rise though, and if the stock plummets the premium only offsets $146 of the loss.

covered call trade example chart
Figure 3. Profit/Loss Chart, Source: FreeStockCharts.com

Covered Call Pros and Cons

Options trades incur commissions, which will slightly reduce the premium received. Commissions aren’t factored into the above scenarios. Also, as the premium chart above shows, there’s isn’t always volume in options. That means it may be impossible to actually establish the option position exactly how you’d like.

See also 4 Ways to Exit a Losing Trade.

A covered call is one of the simplest option strategies; it provides additional income, but caps your gain. If you really want maintain a position in a stock, then covered calls may not be for you, since your stock may be called away.

Options are flexible in that you can close them at any time, realizing a profit loss on the option position only. You don’t need to give up your stock. If you hold the option till expiry, you’ll have profited the entire premium if the price is below the strike price, or you’ll give up your stock if the price is above the strike.

The ideal scenario is when you get to keep the stock, the stock doesn’t really move, and you get the premium income. Unfortunately, in low volatility stocks the premium is usually very small, so the income potential is also very small.

The Bottom Line

A covered call strategy isn’t one you have to use, but it should be in your trading tool belt. The covered call provides a bump in income, while helping reduce some downside risk. For this you give up profit potential if the stock skyrockets. This shouldn’t be a major concern though, especially if you’re seeking an exit anyway. If you decide to sell your stock, close the option position as well, as a written call with no stock means you’re exposed to potentially large losses.


Price Action Market Trap – 7 Psychological Traps Every Trader Must Face

There are enemies we know about in trading, such as bogus information, outlandish promises of wealth, and financial risk. Once aware of these threats, we can take steps to monitor outside information and protect ourselves. Yet some of the greatest risks we face as traders are from within. The market may be blamed, but it is how we react in response to the market that caused the huge trading loss or missed opportunity. Here are seven psychological traps that are prevalent in trading; becoming aware of them is the first step toward improving, and the next step involves creating a plan to overcome these traps in real-time.

Exposure Bias

businessman with too much information

Exposure bias is when we form an opinion based on the most readily available information, without checking to see if the information is correct. A news anchor may make a witty financial comment that goes viral, and in turn becomes “common knowledge.” Traders then act on this information believing they are doing a good thing, yet the original source of the information may have been inaccurate. Just because you hear something often, doesn’t mean it is true.

Because so much news is available—we are overexposed to it—a trader may believe they need more and more information to be an effective trader. This is an exposure bias. Nothing dictates that more information will make you a better trader. In fact, protecting yourself from the many biases inherent in the comments of others may actually makes you a better trader, because your trades will only be based on your own convictions, strategy and research.

Confirmation Bias

Confirmation bias is the tendency to draw a conclusion first, and then rationalize the decision after. Humans have a natural tendency to do this. Instead of testing out a market strategy and spending several months in a demo account to make sure it is profitable, most traders jump right in, assuming the strategy works, betting real money on it. They made the conclusion before getting the facts. No matter what happens, the trader can rationalize the choice; the strategy works and they are genius, or the strategy fails and they have the excuse that the strategy wasn’t tested.

The only way out of this trap is to keep an open mind when first exposed to something new. Attempt to verify the information before acting on it. Seek evidence that confirms and denies your suspicions, and then draw a conclusion based on all the evidence.

Trend Chasing

As humans, we have a tendency to extrapolate what is happening right now into the future. If the price of a stock is sky rocketing, our decisions tend to be based on the idea that it will continue to sky rocket. Taking a step back will of course reveal that stocks always move in a trend-pullback-trend-pullback fashion. Yet in the moment, traders often forget this and end up chasing the price.

While prices may continue to run in one direction for some time, trading requires rules that dictate when to get in and when to get out. By always chasing the price these rules are likely to be violated.

There is a reason funds are required to disclose “Past performance is not indicative of future results.” Conditions change, and chasing trends is a sure way to get caught when they do. Establish rules for when to get in, and if you miss your entry point, don’t chase the price. Another opportunity always comes along.

Overconfidence

Confidence in what you are doing is a requirement for traders; without it you can become easily rattled by see-sawing markets. Overconfidence is a killer though.

Believing so strongly in a trade that you ignore contrary factors, or are willing to risk everything on a trade you believe in, is how overconfidence presents itself in the markets. You can be confident and still admit you are wrong. The overconfident person refuses to admit they are wrong and ends up paying the price. Usually they hold losing trades too long, believing they are smarter than the market and the price will eventually make them whole. They may also hold winners too long, letting it turn into a loss because it didn’t give them the profit they expected.

Remain open to new information, even if it goes against your beliefs about a position. Ideally, follow a plan that establishes when you will get into a position, what you will risk, and when you will get out. This way, overconfidence won’t affect you, because you have a plan for how you will trade, which isn’t based on emotion.

Loss Aversion

man with his head down

Loss aversion is the tendency to do whatever it takes to avoid a loss. Losses are painful, so we stay in toxic relationships to avoid the pain of leaving, and we stay in losing trades to avoid the pain of accepting the loss. The irony is that in both these cases the damage has already been done, we just haven’t accepted the loss yet. Usually these situations only get worse, and if it becomes a pattern the trading account is likely to be drained. Even if we avoid a couple of big losses by hanging on, and the price comes back to produce a profit, if we do this repeatedly eventually one of those trades is going to keep going against us until it is too late to salvage.

The ideal way to handle the situation is to set a risk limit on each trade. Once the price reaches that risk limit exit the trade … and never deviate from the rule.

Paradox of Choice

Choice is good, right? Maybe not as good as we think. Too many choices can actually lead to confusion and can make it difficult to come to a conclusion. Stock traders frequently experience this. There are so many stocks with big moves each day that you can drive yourself crazy trying to keep up with them all. Trying to follow too many stocks can actually lead to reduced performance because the more time you spend examining your choices the more likely it is you will miss trades or make trading errors; your focus is not on trading, it is on your choices.

Limit your universe of choices. Set criteria for what you will trade, and then only trade a couple stocks each week that meet the criteria. Alternatively, only trade one very active stock all the time. It is less stressful and with a defined number of trading choices it will be easier to monitor and find trading opportunities.

“Popular Prescription” Bias

A popular prescription, as it applies to knowledge, is a concise phrase—often a quote—that sounds great but holds little usable information. Traders latch on to these phrases because they are easy to remember. The problem is that the phrase is general in nature, and not specifically usable by the trader. An example is “The trend is your friend.” It sounds like sage advice, until you begin to question what it means. In order to have relevance you must determine how you will define a trend, and you still need to answer the question of how will enter and exit that trend?

Trading is a calculated endeavor, which requires more than simply remembering a few one-liners. Monitor what you hear, and if sounds good, dig deeper into how you can actually apply the advice. “The trend is your friend” isn’t usable information, but digging deeper and putting in some work to fill in the holes could lead to a good trend-following strategy.

The Bottom Line

The external world bombards us with information in the form of news reports and price changes. It is easy to point the finger at these external events and blame them for our trading mishaps, but it is our own psychology that allows us to fall victim in the first place. These psychological traps represent some of the “devils within” that need to be understood, addressed and marginalized in order to really succeed as a trader. Take a hard look and spot the biases you are most prone to. Then, create a plan for how you will address these issues. Accept the bias and follow your plan to reduce the power these psychological traps have over your trading and life.


Options Trading Strategies – How to Profit in a Sideways Market: Short Strangle Explained

Utilizing a short strangle means you aren’t relegated to the sidelines when the stock market isn’t trending, or a stock you are interested in isn’t moving. Sideways markets present opportunities for astute traders, especially when incorporating options. Option strategies allow traders to potentially profit from all sorts of trading conditions, including sideways markets, if their prediction ends up being right. Here’s how to use the short strangle options strategy to profit from a sideways market.

Why Sideways Markets Are Risky

Trending trading is where many traders place their focus because the trend provides a directional bias and profitable edge. As long as the trend persists the trader makes money. Trends can reverse though, or may come to a halt for extended periods of time as the price moves sideways, moving within a band of support and resistance.

These sideways times typically cause traders to wonder about the trend. They enter and exit positions but the stock doesn’t really move. In other words, for most traders a sideways market is a scary place full of uncertainty and risk depending on which way the price eventually price breaks out, and when that will occur.

For a trader with options strategy knowledge, a sideways market can present an opportunity.

Be sure to also read What are Stock Options.

What’s a Short Strangle?

A short strangle options strategy is the simultaneous selling of both a put and a call option. Both options are sold out of the money, preferably a decent distance away from the current underlying stock price. For example, if a stock is stuck near $40 and barely moving, a put option is sold at $38, for example, and a call option sold at $42.

The options seller receives premiums for both the call and put. If the price stays between $38 and $42 (called strike prices), in this example, then both options expire worthless and the short strangle seller gets to keep the premium received.

The short strangle is designed to make money during a sideways market. If the market breaks out though, and moves above $42 or below $38, then the short strangle faces potentially large losses depending on how far the price runs.

While losses can get large when holding a short strangle position, an option seller can close out their position at any time to reduce damage. Just like a stop loss can be placed on a stock position, if the price breaks above or below $42 or $38 respectively the seller has the ability to close out the option positions, giving up the premiums, and taking a small loss.

See also 7 Options Trading Mistakes Beginners Can Avoid

Who Should Use the Short Strangle

It makes sense to use a short strangle during times of low volatility, or potential low volatility. If you believe a stock or other asset is going to move sideways at least until the options sold (a put and a call) expire, then utilizing this strategy makes sense. It’s a way to profit even when the profit potential is very small or non-existent in the underlying stock.

Short-term traders can utilize the strategy as well as longer-term traders. The longer the time till expiry the greater the premium received, but that also leaves more time for the trade to go sour. The shorter the time till expiry typically the smaller the premium but there is less time for the trade to sour. There obviously is a trade off here.

Due to the high risk if the underlying stock moves beyond either of the strike prices, this strategy is recommended for advanced options traders, or at minimum someone who is very disciplined and capable of cutting the loss on losing trades very quickly.

Risks and Rewards

To understand the risks, profit potential and how to execute a short strangle, here’s a real example using Istar Financial (STAR) as the underlying stock, and using end of day quotes for the options from the Chicago Board Options Exchange (CBOE.com).

On August 18, 2014 the price of STAR closed at $15.01. The high of the current range is $15.19, therefore a call could be sold at $16 (above the high of the range). The low of the range is $13.79, therefore a put could be sold at $13.00 (below the low of the range). Both the call and the put are outside the current price. As long as the price stays between $16 and $13 the trade will be profitable.

Istar Financial (STAR) in Range
Figure 1. Istar Financial (STAR) in Range – Source: FreeStockCharts.com

October $16 calls sold for $0.50, while $13 puts are selling for $0.25

The premiums represent the premium received for each share sold. Assume the trader sells 500 shares worth of options on each the put and call.

The amount received equals: 500 x $0.50 = $250 for the calls, and 500 x $0.25 = $125 for the puts for a total of $375 (less commissions).

If at the October expiry the price is between $16 and $13 the option short strangle seller gets to keep the $375.

If at the October expiry the price is above $16, or below $13 they face an approximate $500 loss for each dollar the price moves beyond these thresholds.

For example, if the price is at $18 when the options expire, the trader faces a loss of $2 per share on the call option. Holding 500 shares worth of call options, the seller is required to make good on this transaction, which requires dishing up $1000. The trader received $375 initially so the loss on the trade is $1000 – $375 = $625.

If the price is at $12 when the option expires the faces a loss of $1 per share on the put option. Holding 500 shares worth of put options, the trader faces a loss of $500. $375 was received initially so the actual loss is ($500) + $375 = ($125). Figures may vary slightly based on the actual market value of options just prior to expiry.

Remember though, as an option seller you can close out the position at any time. If the price is breaking out of the range, it is possible to cut losses before expiry, and possibly even pocket a small portion of the premium before it is completely lost or the loss becomes larger.

The Bottom Line

The short strangle options strategy is used in sideways markets, and involves selling an out of the money call and put. The option seller receives the premium for the option sales, and if the price is between the two strike prices at expiry the traders keeps the premium. The risk comes in when the price moves above or below the call or put strike price respectively. This can result in large losses, therefore the strategy works in sideways markets, but doesn’t fair well in trending markets. The short strangle seller can exit at any time before expiry to lock in part of the premium, or cut their losses.


How To Identify Trend Reversal – Trend Reversals: How To Spot and How To trade

Price is the ultimate indicator and tells us when trend reversals are occurring. By spotting trend reversals we can potentially get in early on the next major price wave. Using price as the primary input for our decisions, there are two methods for trading trend reversals. One involves a slowdown in the trend followed by a trendline break. The other requires a sharp move against the trend and then a pullback.

Spotting Trend Reversals

Before spotting trend reversals, we need to be able to spot trends. An uptrend is when the price is making overall higher swing highs and higher swing lows.

A downtrend is when the price is making overall lower swing highs and lower swing lows.

“Overall” in this case applies to the time frame being watched. A stock price is constantly wiggling up and down, but as long as significant lows and highs are moving higher, it is an uptrend. All charts created using StockCharts.com

Figure 1. Downtrend Reversal and Uptrend
Figure 1. Downtrend Reversal and Uptrend

In Figure 1 the stock is in a downtrend on the left because the price is making progress lower—lower lows and lower highs.
In March there is a transition to an uptrend. Following a major low in February, the price rallies beyond the former high seen in January. That strong move higher was enough to erase the decline seen between January and early February. That indicates a potential change in direction, but we need one more piece of evidence.

After the move higher in March the price barely pulls back and then starts to move higher again. The pullback therefore created a higher low. With a higher-high and a higher-low the downtrend is at the very least in trouble, and an uptrend is likely underway. More higher-highs and higher-lows confirm the new uptrend.

The transition to a downtrend is similar. The price will be making higher highs and higher lows. It then makes a lower low, followed by a lower high on the pullback (up), indicating the uptrend is at minimum in trouble and a downtrend is likely underway.

The sequence for the reversal isn’t always the same. Following a downtrend the price may not make a higher high to spark the reversal. Instead, the price makes a higher low. The higher low indicates the trend may be in trouble. When the price starts to moves higher again, it signals the downtrend is quite likely reversing.

Be sure to read our Top 21 Trading Rules for Beginners: A Visual Guide

Figure 2. Downtrend and Uptrend Reversals
Figure 2. Downtrend and Uptrend Reversals

Figure 2 shows this transition from downtrend to uptrend. The price is making lower highs, but then makes a higher low indicating selling pressure is slowing. When the price rallies following the higher low it shows the downtrend is likely reversed.

A short-term uptrend reversal also occurs near the top of figure 2. The price makes a lower high followed by another move lower indicating the uptrend has lost steam. This is a short-term reversal because the overall trend could still be up; the major low near $38 in April is higher than the major low at $36 in December. Over the long-term the price is still making progress higher.

Applying stops and entry points to these methods make them viable for trading reversals.

Trading Trend Reversals

Trading a trend reversal requires an entry point and a stop loss to limit risk in case the reversal doesn’t materialize.

Downtrends are reversed by the price either making a higher high followed by a higher low, or a higher low followed by another move higher.

Uptrends are reversed by the price either making a lower low followed by a lower high, or a lower high followed by another move lower.

Figure 3 shows the price making a strong move higher, which recovers the ground lost during the prior wave of the downtrend. This strong up-move indicates the downtrend is in trouble. Following this strong move wait for a pullback (lower), and assuming that pullback makes a higher low, buy when the price breaks above the trendline of the pullback. Place a stop just below the recent low.

Figure 3. Downtrend Reversal via Higher High with Entry and Stop
Figure 3. Downtrend Reversal via Higher High with Entry and Stop

The same concept would apply if it was an uptrend being reversed. A sharp down move is strong enough to erase the progress of the last uptrend wave. This indicates the uptrend is in danger. Wait for a pullback higher; as long as that pullback makes a lower higher, sell short when the price breaks below the pullback trendline. Place a stop just above the recent high.

Sometimes the trend weakens before it reverses. When this occurs we apply a similar strategy.

Figure 4 shows an initial downtrend which is followed by a higher low. The higher low indicates the downtrend is in trouble. Wait for the next pullback, and then buy when the price breaks above the downward sloping trendline of that pullback. Place a stop just below the recent low. This will typically keep risk very small, relative to the potential profit should an uptrend develop.

Figure 4. Downtrend Reversal via Higher Low with Entry and Stop
Figure 4. Downtrend Reversal via Higher Low with Entry and Stop

The same concept applies to an uptrend reversal. The price is making higher highs and higher lows, but then it makes a lower high indicating the uptrend may be in trouble. Wait for a pullback (up) and sell short when the price breaks below the pullback trendline. Place a stop just above the recent high.

Target Price

A trend reversal signals a major change in direction, potentially over the long-term. Therefore a specific target is not provided. Active traders may wish to exit a portion of their position at multiples of their risk.

For example, if you buy 500 shares and your stop is $2 below your entry price, look to exit some of your position at a profit of 2x your risk, then 3x risk or 5x your risk (decide on several multiples and then stick to them). Therefore, targets would be placed $4, $6 and $10 from your entry price.

This method provides defined exits, but also compensates you well for the risk you are taking should the price continue trending in your direction.

Another option for less active traders is to hold the trade until a signal in the opposite direction occurs. A signal in the opposite direction indicates the trend you are participating in is likely over. This exit method is less active, but requires continual monitoring.

See also 25 Stocks Day Traders Love

The Bottom Line

Downtrends are reversed by the price either making a higher high followed by a higher low, or a higher low followed by another move higher. Uptrends are reversed by the price either making a lower low followed by a lower high, or a lower high followed by another move lower. We can trade these reversals by entering when the price breaks the pullback trendline. This usually keeps risk small compared to the reward potential of participating in the new trend. The signals won’t always work out, and the trend may not reverse even though the signal is there. This is why it is important to make more on winning trades than on losing trades—that way even if we are right less than 50% of the time we’ll still make a profit.


– A Trader’s Guide to Scalping

Traders are often classified based on their trading frequency into various categories, such as day traders, swing traders, or position traders. Scalping is a common strategy used by day traders in order to realize small profits from temporary distortions in the financial markets. By mitigating risk ahead of everything else, the strategy works to produce stable risk-adjusted returns.

In this article, we’ll take a look at what scalping is, why it’s appealing, the mechanics of the trade, and other important considerations.

What Is Scalping?

Scalpers aim to profit from the difference between the bid and ask prices, sometimes in the role of a market maker or specialist. By making hundreds of short-term trades per day, these traders can accumulate larger profits over time even though the profit from each trade is relatively low. The positions are also only held for seconds or minutes, which limits the risk associated with each trade.

Often times, scalpers use tape reading in order to time their trades and maximize their profits. Tape reading involves using time and sales data to determine when and where to place trades. For example, a trader might notice blocks of stock being purchased in increments every day and then decide to buy ahead of the purchase and sell into the purchase to realize a small profit each time.

Be sure to also read about What is Swing Trading?

Longer-term scalpers may implement different strategies designed to take advantage of short-term technical tendencies. For example, a trader might always buy a stock as it breaks out from an ascending triangle pattern on higher-than-average volume and automatically sell after a 3% move higher. These dynamics are the opposite of “let your profits run” strategies, which are typical among technical traders.

Why Is Scalping Appealing?

trading sideways market

Scalping is appealing to many traders due to its straightforward approach that applies in nearly any market environment. Since scalping opportunities may come about anytime, some traders also find these strategies useful as a supplement to a different trading style that they use more regularly. For example, position traders may use scalping strategies during choppy sideways markets.

Some key advantages to scalping include:

  • Market Neutral. Scalping doesn’t rely on strong trends or directional movements, which means that traders can profit in nearly any market environment and avoid waiting on the sidelines.
  • Limited Risk. Scalping involves buying and selling during the same day – and often within seconds or minutes – which limits downside risk from catastrophic events that occur overnight.
  • Easier Moves. Scalpers target small price movements that occur with a greater frequency than larger trade setups, which means that consistent profits can be earned over time rather than waiting for a rare move.
  • Simple Trades. Scalping strategies are generally very simple and involve specific rules for entry and exit, which removes a lot of the subjective decision-making from the trading process.

See also the 7 Psychological Traps Every Trader Must Face

Mechanics of the Scalp Trade

Scalpers make from ten to hundreds of trades per day using a variety of different tools designed to spot opportunities depending on their preferred strategy. A primary scalper probably uses a direct access broker while looking at one-minute charts, level two quotes, total view, and time/sales data for their preferred set of equities in order to determine high-probability entry points.

A trader using scalping as a supplemental strategy may decide to utilize a so-called “umbrella” strategy to first identify long-term trends and then look for shorter-term trades in the same direction as scalping opportunities. For example, a trader may decide to only make short-term buys if a short-term moving average is trending above a long-term moving average for a given equity.

Learn more about High Frequency Trading

In general, scalpers can be classified as market makers that try to capitalize on the bid/ask spread, bulk buyers that purchase a large number of shares and sell them for a gain on very small price movements, and technical scalpers that enter a trade based on a technical signal and close the position as soon as the first exit signal is detected with a 1:1 risk/reward ratio.

Risks & Other Considerations

Scalping may help reduce many risk factors, making them attractive to short-term traders, but there are still several important risks to consider. After all, if scalping was capable of generating risk-free profits, the markets would eventually eliminate any potential profit over time! Investors should keep these considerations in mind before embarking on a scalping strategy in order to avoid sudden losses.

Some key risks associated with scalping include:

  • Slippage. Scalping involves profiting from small price movements, which means that it’s important to get accurate quoted prices. Even a little slippage can result in quick losses on frequent trades.
  • Discipline. Scalping requires fast entry and exit from trading positions with very small margins for error, given the tiny profit margins. After all, a single large loss could eliminate literally thousands of small profits.

The Bottom Line

Scalping can be a very profitable trading strategy for both pure scalpers and those using the strategy as a supplemental option. That said, traders should be very disciplined and experienced with using short-term trading tools like one-minute charges, level two quotes, and similar tools. Scalping may also require a lot of practice in order to master and generate high risk-adjusted returns.


Dividend Capture Strategy – Dividend Capture Strategy Explained

Many investors are drawn to dividend stocks because they provide a steady stream of income to supplement retirement income or simply provide some extra cash on the side. For public companies, paying out a portion of their net income as a dividend helps attract longer term investors and generally helps stabilize their stock price. Dividend stocks tend to be strong performers during economic downturns when cash is king.

For active traders, dividends present a unique opportunity to generate a profit from a source other than capital gains realized from buying and selling stocks. While investors may hold dividend stocks for the long-term, active traders look to buy these stocks just in time to receive a dividend payment and then turn around and sell them.

Be sure to also read our Beginner’s Guide to Sector Rotation.

In this article, we’ll take a look at the dividend capture strategy and how active traders can use it to profit from dividends over the short-term.

The Dividend Capture Strategy 101

man pointing to rising graph

The dividend capture strategy focuses on quickly capturing dividends without holding onto a security for a long period of time. In simple terms, the strategy is executed by purchasing a dividend-paying stock prior to its ex-dividend date in order to secure the payout and then selling it the next day or after the stock bounces back. The idea is to generate a greater profit from the dividend yield than the loss incurred by buying and selling the stock.

There are four key dates that traders must know to execute the strategy:

  • Declaration Date – The day that a company announces its next dividend payout date, which is usually done via a press release, conference call, or other medium.
  • Ex-Dividend Date – The day that new buyers are NOT entitled to collect the next dividend payout, which results in a reduced share price reflecting that fact.
  • Holder of Record Date– The day that a trader must be registered as a shareholder to collect the dividend payout, which is usually two days after the ex-dividend date.
  • Payment Date – The day that the dividend should be deposited into the trader’s brokerage account and the profit is realized.

Let’s take a look at a quick example:

Suppose that a trader finds a stock that’s trading at $10.00 per share with a $0.25 quarterly dividend and purchases the stock just before the ex-dividend date. On the ex-dividend date, the stock briefly falls to $9.75 per share to reflect the dividend payment, but quickly recovers to $10.00 per share as traders look to maintain the key resistance level. The trader holds onto the stock until the day after the holder-of-record date and then sells the stock or $10.00 per share after collecting the $0.25 per share dividend – yielding a 2.5% profit on the trade.

Does the Dividend Capture Strategy Work?

There is a lot of debate within the financial community about whether or not dividend capture strategies are effective. Since the strategy amounts to a form of arbitrage, academics believe that the market will act quickly to close the gap before traders can capitalize on the opportunity. The old adage “there is no free lunch” seems to confirm the belief that a “free” profit would ever be left in the market without everyone taking advantage of it. In reality, the truth lies somewhere in-between fiction and reality.

The dividend capture strategy can be effective in certain scenarios. As the example above highlighted, the $10.00 price level was a key support level that the market has defended over time, which means that the temporary drop below was only likely to be temporary. These are the opportunities where the odds may favor the strategy’s success. In cases where there’s no technical support, traders may have a tougher time profiting from the strategy, while the movement could even trigger a bearish breakdown in some cases.

Finding Trade Candidates

man searching on computer

The dividend capture strategy takes advantage of companies issuing dividends, which means that potential opportunities are simply dividend-paying stocks. In general, traders can identify these opportunities by tracking companies that have upcoming ex-dividend dates and then analyzing those opportunities on an individual basis to determine the strategy’s viability in the context of technical support and resistance levels.

There are many online resources for traders to identify stocks with upcoming ex-dividend dates and even analyze the profitability of the dividend capture strategy, including:

  • Dividend.com Screener – Dividend.com’s Dividend Stock Screener provides advanced tools that let traders quickly screen for stocks with upcoming ex-dividend dates that meet a variety of different criteria, including things like dividend yields.
  • TheStreet.com Calendar – TheStreet.com’s Dividend Calendar provides a simple calendar view of all stocks with upcoming ex-dividend dates. Traders can use the calendar as a starting point for their research of potential opportunities.

After identifying stocks with upcoming ex-dividend dates, the next step is determining the viability of a dividend capture strategy. The most important elements to watch for are key technical support and resistance levels, as well as any risks that may be involved with holding the stock for the requisite period before being entitled to the dividend. In addition to those concerns, traders should consider the commissions and tax consequences in order to ensure that the strategy is capable of generating a profit after all expenses are deducted.

Learn more about Day Trading and the 50 Blogs Every Serious Trader Should Read.

Hedging with Covered Call Options

Covered call options provide a great way for traders to hedge dividend capture strategy positions in order to improve the odds of a successful trade. By selling the right to acquire the stock on or before a certain date, traders can generate an immediate income from the option’s premium to offset any potential losses as the position is being held. The strike price of the call option caps the position’s upside potential, but if the dividend is the primary reason for the trade, the potential upside isn’t a major concern for the trader.

In general, the position should be established about a week before the ex-dividend date by selling/writing call options that are set to expire within 10 business days of the ex-dividend date with an in-the-money strike price that’s roughly equal to the dividend’s value. The basic premise behind the trade is that the covered call option will be exercised just before the ex-dividend date and the trader will receive the premium – roughly equivalent to the dividend payout. If the stock doesn’t reach the strike price, the trader still collects the dividend.

See also: How to Profit in a Sideways Market.

Risks & Limitations

There are many important risks associated with the dividend capture strategy that traders should carefully consider before committing any capital:

  • Tax Consequences – Qualified dividends are taxed at anywhere between 0% and 15% depending on an investor’s tax status. Unfortunately, short-term dividends don’t meet the requirements to be considered “qualified”, which means that they may be taxed at regular income rates of 30% or higher depending on the trader’s income.
  • Transaction Costs – Traders must account for the cost of the transaction when determining the profitability of a dividend capture. In many cases, traders may be paying upwards of $5.00 to place a buy and sell order, which means that the amount must be subtracted from the projected profit to come up with an accurate number.
  • Risk Exposure – Buying any stock entails the risk of downside movement and the same is true when using dividend captures. As a rule, traders should carefully consider the technical and fundamental merits of a stock before buying to capture a dividend and place appropriate stop-loss orders to limit their risk.

The Bottom Line

The dividend capture strategy involves purchasing a dividend-paying stock shortly before its ex-dividend date in order to capture the dividend and then selling it shortly thereafter. While the strategy sounds simple in theory, there are many important considerations that must be made to ensure that it’s profitable. Traders that are considering trading ex-dividend should carefully analyze each opportunity, ensure the proper protection is in place, and consider all of the tax consequences. But in the end, the strategy is a useful addition to any trader’s collection of trading strategies.


Rounding Top Pattern – What Is a Rounded Top and Bottom?

Most traders use technical analysis to find short-term opportunities in hourly or daily charts, but some indicators and patterns are designed to work on weekly or monthly timeframes.

Investors use these forms of technical analysis to identify long-term trends, while short-term traders can use them for insights into the bigger picture. For example, a short-term trader may only place short-term trades in the direction of the long-term trend.

In this article, we will look at how to identify and use rounded tops and bottoms, as well as explore some real-life examples of the pattern in action.

Don’t forget to check out other trading strategies here.

What Is the Rounded Top & Bottom?

The rounded top is a long-term bearish reversal pattern that signals the end of an uptrend and the possible start of a downtrend. Conversely, the rounded bottom is a long-term bullish reversal pattern that signals the end of a downtrend and the possible start of an uptrend. Unlike sharp V-like price movements, rounded tops and bottoms have a U-like appearance and occur over the course of several weeks or months.

There are five stages to rounded top and bottoms:

  • Previous Trend: Reversal patterns require a previous trend to reverse, and rounded tops and bottoms are no different. Rounded tops should be preceded by an uptrend and rounded bottoms should be preceded by a downtrend.
  • First Leg: The first leg of rounded tops and bottoms are a continuation of the previous trend toward a tipping point. If the move occurs very rapidly, the pattern should be classified as a single, double or triple top or bottom.
  • Tipping Point: The tipping point can be more V-like than U-like, but it shouldn’t be too sharp and should take several weeks to form.
  • Second Leg: The second leg higher or lower from the tipping point should occur over roughly the same amount of time as the first leg.
  • Breakout or Breakdown: The rounded top or bottom pattern is confirmed when the price breaks above or below the neckline of the pattern. As with other breakouts, this level becomes a key support or resistance level moving forward.

Rounded tops and bottoms perform best with U-shaped volume, where volume falls as the pattern reaches a tipping point and accelerates as the reversal picks up steam.

Trading Rounded Tops & Bottoms

Traders use rounded tops and bottoms in the same way as many other longer-term reversal patterns, such as the head and shoulders pattern.

Buy (or sell) signals occur when the price breaks out from the neckline. For example, a trader might initiate a long position after the price breaks out from the neckline of a rounded bottom or initiate a short position after the price breaks down from the neckline of a rounded top.

Stop-loss points are typically placed below the neckline of the rounded bottom pattern or above the neckline of a rounded top pattern. If there’s a sustained move below the neckline, the pattern is invalidated and it’s a good idea to exit the position at a small loss.

Take-profit points are calculated by measuring the distance between the top or bottom of the pattern and neckline, and then applying that distance to the neckline in the other direction. In some cases, traders may lock in profits on the way up or down using Fibonacci extensions from the neckline or other technical indicators.

Learn more about the different day trading rules that apply to U.S. investors here.

Examples of Rounded Tops & Bottoms

Let’s take a look at an example of a rounded top pattern in the AUD/CAD currency pair:

rounded top trading pattern

In this example, the AUD/CAD produced a rounded top over the course of a week or two. The neckline was formed by connecting a prior high with trend line support that formed near the bottom of the rounded top pattern. Stop-loss points could have been placed just above the neckline, while the take-profit point was calculated by computing the distance between the neckline and rounded top (~789 pips) and subtracting that number from the neckline price.


– Merger Arbitrage Trading Strategy Explained

Mergers and acquisitions often produce spectacular short-term returns after they’re announced. By attempting to predict these events or capitalizing on price differences between the buyer and seller’s stock, merger arbitrage strategies enable traders to capitalize on these price movements. Traders looking to add to their arsenal of strategies may want to take a closer look at these strategies.

In this article, we’ll take a look at merger arbitrage, why it’s used, mechanics of the trade, and some important risks to consider.

What Is Merger Arbitrage?

Mergers and acquisitions—otherwise known as M&A—occur when a company purchases another company. Often times, companies make acquisitions in order to grow their revenue or diversify into different businesses. Most acquisitions also take advantage of synergies between the buyer and seller’s businesses, such as economies of scale dynamics that can immediately improve profitability.

Merger arbitrage strategies are designed to profit from these M&A transactions and they come in various forms:

  • Pure Merger Arbitrage – Traders buy the target and short the acquirer in order to profit from the difference between the acquisition price (in either cash or stock) and the market price assigned to the target.
  • Speculative Merger Arbitrage – Traders buy potential targets in order to profit from an upcoming merger announcement without knowing for certain that such an announcement will ever materialize.

In general, large institutional traders use pure merger arbitrage as a way to generate relatively risk-free profits, while smaller traders use speculative merger arbitrage as a way to identify relatively low-risk, high-reward opportunities. Pure merger arbitrage may require significant leverage to be truly profitable, while speculative merger arbitrage often makes use of leverage for diversification.

See our Quiz: Did Facebook Buy It?

Why Use Merger Arbitrage?

merger arbitrage explained

Merger arbitrage strategies have a number of unique benefits compared to traditional trading strategies. In particular, traders can use the strategy in nearly any market condition, which makes it a nice alternative to have on-hand. The strategy’s unique risk-reward profile may also make it compelling to many different types of traders looking to balance out their portfolio risk levels.

The core benefits of merger arbitrage include:

  • Low-Risk. Pure merger arbitrage involves relatively low risk since an acquisition has already been consummated, although the potential profit is limited to the difference between the market and acquisition price.
  • High-Reward. Speculative merger arbitrage involves significant potential upside if an M&A announcement is made, although there’s no guarantee that such an announcement will ever be made.
  • Market Neutral. Merger arbitrage strategies are market neutral since they involve a long and short position, which means that a trader’s exposure to the overall market is relatively limited compared to other strategies.

See also The Beginner’s Guide to Pairs Trading

Mechanics of Merger Arbitrage

The mechanics of merger arbitrage strategies depend on the type of strategy being implemented. In general, merger arbitrage involves betting on the price differences between the buyer and target stocks, which means that the position will involve the purchase of the target and the short selling of the buyer to maintain a market neutral position that eliminates larger industry or macro risks.

Pure merger arbitrage strategies:

  • Identify existing M&A opportunities with a focus on large percentage spreads between the proposed purchase price and the target stock price.
  • Analyze potential reasons for the spread between the two, including the possibility that the merger will fall through and be unsuccessful.
  • Purchase stock in the target company and short stock in the acquirer in order to profit from the gap in a market neutral way.
  • Monitor the trade over time for any changes that could impact the odds of success and adjust the trade accordingly.

Speculative merger arbitrage strategies:

  • Identify potential M&A targets by looking for stocks trading below book value, having unused leverage, or operating within consolidating industries.
  • Analyze similar transactions in the industry to determine a likely buyout multiple and use that to calculate a target price for the stock.
  • Purchase the stock or use stock options to buy a levered position and optionally short-sell larger potential acquirers in the industry.
  • Monitor the trade over time for any changes that could impact the odds of success and adjust the trade accordingly.
COV Stock Chart
COV Stock Chart After Buyout (Source: StockCharts.com)

Risk Factors to Consider

Merger arbitrage strategies are designed to mitigate many types of risks, but there are still many important considerations for traders. Most traders should consider using merger arbitrage as only one of a set of strategies in their arsenal instead of using it exclusively, although many institutional investors still use pure merger arbitrage strategies to capture small low-risk movements.

Be sure to also check out the 50 Blogs Every Serious Trader Should Read.

Some important risks to consider include:

  • Event Risk. The largest risk for pure merger arbitrage is the merger falling through and becoming unsuccessful, which can result in rapid steep losses.
  • Inverse Risk. Merger arbitrage removes macro risk factors, but some dynamics could lead to a buyer’s stock appreciating and hurting a short.
  • Liquidity Risk. Mergers tend to reduce trading in a stock once the price rises, which means that it could be difficult to enter or exit a position.

The Bottom Line

Merger arbitrage strategies are an excellent addition to any trader’s arsenal, given their market neutral approach applicable in any conditions. Before placing any trades, traders should be aware of the many nuances and risks associated with the strategy, including event, inverse, and liquidity risk.


Price Action Trading – Price Action: How to Use Price Action to Analyze Stocks

Multiple tools exist for analyzing stocks (or any other market), and while no single tool is perfect, analyzing price action is the purest form of analysis since ultimately price is what creates profits and losses. Two keys to analyzing price action are speed and size; these relate to how fast a price wave is moving (speed) and how much distance a price wave covers (size). Using just these factors much can be determined about whether a trend is likely to continue, is slowing down, or is likely to reverse.

Analyzing Price Action: Trends

Prices move in trends, creating impulse waves and corrections. Impulse waves are the larger waves moving in the overall trend direction, while corrections are smaller waves that move against the trend direction. The impulse waves being larger than the corrections is what allows a trend to make progress.

These concepts even apply to ranges. When the corrections are the same size as the impulse waves, the price is ranging.

Charts courtesy of FreeStockCharts.com.

Impulse and Corrective Waves Form Trends and Ranges
Figure 1. Impulse and Corrective Waves Form Trends and Ranges – BSX Daily Chart

Traders typically focus on trading trends since they offer the most profit potential. It then becomes a question of how to analyze trends in order to determine if it is a good time to enter a trade, stay in a trade, or get out. Determining the speed and size of impulses and corrections aids in this regard.

Analyzing Price Action: Size

When analyzing price action there are no absolutes; current price waves must always be considered in the context of (relative to) other price waves around it.

When there’s a large price wave in the trending direction it typically confirms the trend. When pullbacks are relatively small, compared to the impulse waves in the trending direction, this also confirms the trend.

A larger corrective wave against the trend (as big or bigger than the impulse moves) indicates a reversal, or at least that a deep pullback is likely underway.

Using Size of Price Waves to Determine Trend Strength
Figure 2. Comparing the Size of Price Waves to Determine Trend Strength – BSX Daily Chart

If the impulse waves of the trend are continually getting smaller, then the trend is losing momentum. This will typically result in divergence on technical indicators such as the MACD or RSI. It may regain momentum, but right now it is showing signs that the trend is weakening. This occurs in figure 2. in March and April, before the trend has a deeper correction and then ultimately moves into a range.

Analyzing Price Action: Speed

The speed of a price wave isn’t as important as the size, but is used in conjunction with size to further analyze the price action.

Speed is how fast the price covers a distance. It is not absolute, but rather is always relative to prior waves. Some stocks always move quickly, while other stocks always move slowly, but if a “quick stock” moves quicker or slower than normal, that’s important information.

Fast movements are noteworthy and show that traders have a strong interest, relative to price moves that are slow. When the price moves slowly there is no urgency; quick price moves show urgency.

Therefore, small pullbacks that are also slow moving (hesitant) confirm the current trend direction. Large and fast price moves in the trending direction confirm the trend is healthy because it shows traders are eager to jump in on the current trend.

A price move that is both large and moving quickly confirms the trend more so than a price move that is only large, or only fast. In figure 2., the impulse wave in April decreases not only in size, but it also takes longer (slower) for the price to move higher. This doesn’t guarantee that the price will reverse, but it is a strong warning sign that the trend is slowing down and is therefore more likely to reverse because buyers are no longer as eager to buy the stock.

A large and fast price move (relative to prior price waves) in the opposite direction of the trend is a strong indication that the trend is reversing, and the direction of the new large and fast move will be the new trending direction.

Large and Fast Moves Reversing Stock Trend
Figure 3. Large and Fast Moves in Opposite Direction Often Reverse the Trend – TWTR Daily Chart

The One Exception

Typically, large and fast price moves in the trending direction confirm the trend. One exception is when an extremely large and fast price move occurs, much bigger and faster than the price waves around it. This can often mean rampant speculation has taken over, and the extremely strong move actually indicates an end to the trend, not a continuation. This is common in commodity markets, such as the massive surges in silver and gold in 2011 which ended those multi-year bull markets.

Currency markets, individual stocks, and stock indexes—like the 2000 “dot.com” peak— also see such moves. Buyers or sellers plow in with such ferocity that they completely exhaust themselves and there is no one left to continue pushing the price in that direction—a reversal is imminent.

How to Trade with Size and Speed

Analyzing price action in this manner is not a strategy. It does not tell you where to enter or where to place stop-losses or target orders. Instead, it is used in conjunction with a strategy to let you know in which direction you should be trading, and when you should pass on a trade if conditions look unfavorable.

If price action confirms the trend is up and strong, then favor strategies which give you buy signals. If price action indicates the uptrend has reversed, then favor strategies which give sell/short-sell signals. If price action indicates the price is an a range, use range-trading strategies.

The size and speed concepts can be applied to all time frames. Therefore, while analysis is conducted on daily charts in the examples above, the same analysis could be done on one-minute or weekly charts. Being aware of the size and speed of price moves on different time frames will give you a more complete picture of trends, ranges and potential reversals.

The Bottom Line

Analyzing price action doesn’t require indicators, it is simply identifying impulse and corrective waves based on how large the waves are and how quickly they move. The size of a price wave is most important. Large price waves help confirm the trend, while a large wave in the opposite direction indicates a reversal (on that time frame). Speed is used in conjunction with size to help gain additional insight on whether the trend is accelerating or slowing down. Extreme moves may indicate a reversal.


Best Trading Indicators – Technical Indicators: How to Use On-Chart Technical Indicators

Technical indicators are some of the most important quantitative tools used by active traders.

Unlike chart patterns, trend lines and other subjectives tools, technical indicators provide numeric data that can be used to make trade decisions. Some traders even use these indicators to create fully automated trading systems!

In this article, we will look at different types of technical indicators and how you can build them into trading strategies.

Four Types of Technical Indicators

There are thousands of different technical indicators developed over the years. While they’re all computed using a security’s price and volume, they can be combined in many different ways to draw many different conclusions about future price movements.

It helps to break down technical indicators into various categories in order to better understand how to use them.

The four major types of indicators include:

  • Trend Indicators – Trend indicators are designed to show the trend or direction of the security. For example, is a stock trending higher, lower or sideways? Examples of trend indicators include moving averages, moving average convergence-divergence (MACD) and average directional index (ADI).
  • Momentum Indicators – Momentum indicators measure the speed at which a security’s price is moving in a given direction. For example, is a stock’s uptrend strong or weak? Examples of momentum indicators include the relative strength index (RSI), stochastics, and the commodity channel index (CCI).
  • Volatility Indicators – Volatility indicators show how volatile a security is at a given point in time. For example, how much might a stock drop over the next week or two? Examples of volatility indicators include Bollinger Bands, envelopes, and average true range (ATR).
  • Volume Indicators – Volume indicators show the volume behind a security’s price movement and serve as a confirmation. For example, is the volume following a breakout strong enough for it to hold key support levels? Examples of volume indicators include on balance volume (OBV), Chaikin Money Flow and the Force Index.

To learn more about technical indicators, check out our Trading Indicators section that dives deeper into specific technical indicators and how to use them.

How to Use Charting Techniques of Technical Indicators

There may be thousands of different technical indicators, but adding a lot of indicators to a chart can quickly lead to chaos – especially if you don’t understand them. It’s better to focus on just a handful of useful indicators that you take the time to clearly understand. One such messy chart setup is shown below.

SPY Stock Trading Indicators
Source: StockCharts.com

The most common approach is to select one or two types of technical indicator and use them to create a well-rounded trading strategy. For example, you may look for MACD convergences or divergences (trend) for trade entries, look at on-balance volume for confirmation (volume) and then set stop-loss or take-profit points based on Bollinger Band levels (volatility).

There are a few key points to remember when combining technical indicators:

  • Trend indicators are most useful for determining the direction of a trade (e.g. a long or short trade).
  • Momentum indicators are helpful for determining if a trend is likely to continue or if a reversal is coming soon.
  • Volatility indicators are great for setting stop-loss and take-profit points, as well as avoiding getting stopped out.
  • Volume indicators are best used as confirmation for other technical indicators.

If you’re trading currencies or futures contracts, you may also want to consider following economic indicators. These are quantitative indicators, but they’re based on economic readings (e.g. GDP or inflation) rather than the price of a security.

Effective Use of Using Technical Indicators

Let’s take a look at a few examples of technical indicator combinations and how they can be used in practice.

1. RSI, MACD & Moving Averages

Many traders use moving averages and the MACD to identify trend reversals, along with the RSI to show when a trend is losing steam. In the example below, buy signals are generated when the price is nearing a key moving average and the MACD is crossing over. Meanwhile sell signals are generated when the RSI approaches overbought levels, suggesting the trend is likely to end.

SPY Stock Indicators

2. Envelopes & Stochastics with Trendlines

Moving average envelopes are a great way to show support and resistance levels. They also work great with stochastics to generate buy and sell signals. In the example below, buy signals are generated when stochastics reach oversold levels and the price hits the bottom of the envelope and sell signals are generated when the price hits the top of the envelope and stochastics reach overbought levels.

XOM Stock Indicators

The Bottom Line

Technical indicators are arguably the most important tools for active traders since they provide a quantitative measure of trend direction, momentum, volatility or volume. By understanding how they work and combining them, you can create powerful trading systems that can help increase risk-adjusted returns over time.


– Sector Rotation: What You Need to Know About Sector Rotation

Most investors are familiar with the cyclical nature of the markets. While everyone loves a good bull market, they inevitably come crashing down to reality. The good news is that the cyclical nature of the financial markets makes them somewhat predictable.

Those cognizant of where in the cycle the market stands can position their portfolios to take advantage of where the market is headed.

In this article, we’ll take a look at sector rotation and how it can be used to predict which asset classes are best positioned based on market cycles.

Be sure to also read A Trader’s Guide to Understanding Business Cycles.

What Is Sector Rotation?

business cycle graphic

Sector rotation is simply an investment strategy designed to profit from the movement of money from one industrial sector to another. While the concept originally stemmed from a theory developed by the National Bureau of Economic Research (“NBER”) relating to economic cycles dating back to the 1850s, the concept has evolved over time with the help of both academics and financial professionals.

According to NBER, there have been 11 business cycles between 1945 and 2009 with an average length of about 69 months. The average expansion has lasted 58.4 months, while the average contraction has lasted 11.1 months, which explains why the financial markets have trended higher over the long run. Of course, the level of profitability depends on where in the cycle investments were made.

Be sure to see our profiles of Wall Street’s Best Contrarian Investors.

Defining Economic Cycles

The first step to implementing sector rotation is to understand so-called business cycles or market cycles. According to NBER, there are five stages of a cycle, which include three stages of expansion and two stages of recession. These five stages occur between four key periods that mark turning points investors should consider, including the trough, expansion, peak, and recession.

NBER's Sector Rotation
Source: National Bureau of Economic Research

Industry Selection

Determining what phase the economy is in at any given point requires a top-down approach involving monetary policy, interest rates, commodity prices, and other economic factors. For instance, low interest rates with rising inflation could be a sign that the economy is beginning to recover in Stage I, while high interest rates and deflation could be a sign of an upcoming recession in Stage IV.

Learn more about Economic Indicator Types: Leading vs. Lagging vs. Coincident.

Sector Rotation Industries
Source: Standard & Poor’s Guide to Sector Investing 1995

The easiest way to gain exposure to specific industries is using sector exchange traded funds (“ETFs”), which provide instant exposure to a diversified group of companies in a given industry. Using ETFs, investors don’t have to worry about constructing a diversified portfolio within a specific industry, while the strategy minimizes the transaction costs associated with moving in and out of stocks.

Important Considerations

The sector rotation strategy has a number of caveats that traders should carefully consider before implementing it. For example, the strategy involves correctly interpreting large macroeconomic movements, which is difficult even for trained economists that exclusively study such things. Traders should keep these factors in mind and ultimately consider whether the strategy is right for them.

Some key tips to keep in mind include:

  • Interventions – Governments often intervene in economies in order to try and limit inflation or jumpstart growth, while the increase in unconventional monetary policies could disturb future economic cycles.
  • Timing – Often, those implementing sector rotation strategies are early to the party, which means that the beginning can be rough. Traders should be prepared to weather the storm.
  • Industry Factors – Some economic events affect entire industries rather than just individual companies. For instance, the tech sector may usually do great during growth, but changes in patent law could cause a decline.

Be sure to also see the Illustrated History of Every S&P 500 Bear Market.

The Bottom Line

The sector rotation strategy involves looking at economic cycles to determine what industries are best positioned to profit. While these techniques are backed by solid research dating back to the 1850s, past performance is never a guarantee of future results, especially with the escalation in unconventional monetary policy. Investors should also be sure to consider the other risks discussed in the text above before making an allocation.


– Download the Global Trading Times Cheat Sheet

For active traders, knowing when markets across the globe operate is essential. To help keep track of the markets, we’ve created a simple, easy-to-use Global Trading Times “cheat sheet”, which lists trading hours for every major stock and futures exchange in the world.

Download the Global Trading Times Cheat Sheet

Global Trading Times Cheat Sheet


Contrarian Trading Strategy – Fading Strategies: A Contrarian Way to Profit

Most active traders have been told at some point that, “the trend is your friend” and “don’t try to catch a falling knife”.

Contrarian strategies may seem to contradict this advice, but in reality, they’re just different ways of profiting from the same trends. They work on the assumption that prices fluctuate randomly around a prevailing trend and that prices deviating far from the trend tend to reverse and revert back.

The most common contrarian strategy to capture these mean-reversion opportunities is known as ‘fading.’

What is the Fading Strategy?

Fading strategies involve placing trades against the prevailing trend to profit from a reversal. For example, if a stock’s price is unusually high, a trader might take a short position with the expectation that it will go back down. Or, a trader may place a long trade if a stock’s price is unusually low.

Click here to learn more about the scalping strategy.

The fading strategy hinges on three assumptions:

  • The price is overbought (or oversold).
  • Early buyers (or sellers) are ready to take profits.
  • Current holders (or short sellers) may be at risk.

Overbought or oversold conditions are often identified using technical indicators, such as the Relative Strength Index (RSI). Momentum may show early signs of shifting as early buyers (or sellers) take profit off the table. And these trends may force current holders (or shorts) to rethink their positions.

These conditions are often exacerbated by a specific tipping point, such as an earnings announcement. A bullish earnings announcement may lead to a knee-jerk reaction on the part of other traders to buy the stock, but at some point, this reaction is over-extended and a mean-reversion takes place.

Here’s an example of a fading strategy in action:

Fading strategy image

In the above example, Snap shares experience a significant decline that leads to oversold RSI levels. Volume starts to decline after reaching a peak, suggesting that a trend change may be near. The following session’s price then opens higher, which points to a potential short-term bullish trend change.

How to Use the Strategy

Most fading strategies can be executed in three steps.

Step 1: Identify Overbought or Oversold Conditions

The first step is identifying overbought or oversold conditions using technical indicators or chart patterns.

Some of the most popular technical indicators to use include:

  • Stochastics
  • Relative Strength Index (RSI)
  • Swenlin Trading Oscillator (STO)

Want to know the correct combination of technical indicators? Click here

These are oscillators where overbought or oversold conditions are indicated by a reading above or below a certain level. For example, the RSI is overbought above 70.0 and oversold below 30.0, which can help traders identify fading opportunities.

Traders may also use chart patterns, such as candlesticks, or simply rely on their own intuition when watching price action.

Step 2: Watch for Early Signs of Capitulation

The second step is watching for early signs of capitulation or a change in the short-term trend.

There are several signs to watch for:

  • Technical indicators start to lose steam or move away from their extreme overbought or oversold levels.
  • Volume in the direction of the trend decreases and/or volume in the opposite direction increases.
  • Bearish candlestick patterns start to appear or key support or resistance levels are breached.

It’s important to identify these early signs to maximize the profitability of the trade and avoid missing a move.

Step 3: Enter into the Trade with Stro-Loss and Take-Profit

The third step is entering into the position and setting the appropriate stop-loss and take-profit points.

Limit orders are almost always used to place trades to avoid any slippage or other issues, particularly in less liquid assets.

Stop-loss points are often placed above or below key support or resistance levels. But take-profit points may be more dependent on a reversion to some kind of mean, such as a moving average or indicator reading, rather than a set price level.

Important Risks to Consider

Fading strategies can be very risky since they’re going against the prevailing trend.

It’s usually a good idea to use stop-loss and take-profit points to control the risk-reward of the trade. Although it’s important to leave enough room to avoid getting prematurely stopped out from an otherwise profitable trade.

The Bottom Line

Fading strategies are commonly used by short-term active traders to capitalize on short-term reversions to the mean along a prevailing trend.


Forex Exit Indicator – How To Exit A Losing Trade

Anyone who participates in the financial markets is faced with the regular occurrence of managing losing trades. Finding a balance between minimizing risk and also allowing the market enough room to move in your favor can be a tricky situation. Traders are commonly told to “cut losses quickly,” but unfortunately that isn’t a strategy that is easily applied in the real world – everyone views “quickly” differently. In that light, here are four methods you can consider when looking to exit your next losing trade.

“Cutting Losses Early”

Traders shouldn’t arbitrarily decide to cut their losses, because that isn’t a testable strategy; instead, they should have a plan to manage their risk. Outline how much money you are willing to risk before placing a trade, and how you will bail out of a trade if it turns sour, so you know exactly when to cut your losses.

Since everyone trades differently, it’s important to come up with a plan for cutting losses based on your own trading style, account size, and position size. The goal is to allow the asset enough wiggle room to move in your favor, but if a certain size loss develops (or specific conditions), you get out and seek other opportunities [see also 25 Stocks Day Traders Love]

Stop Loss

A stop loss is an order placed with your broker to get you out of a losing trade if the stock hits a certain price level.

The stop level should be at a price that keeps your loss manageable—based on account size and risk tolerance—but is also at a level that lets you know you were wrong about your expectations for the stock.

Stop losses are appealing not only because they manage risk, but because they also allow traders to make risk/reward assessments on their trades. If you are willing to risk up to $100, but expect to make $300 if your expectations materialize (and both possibilities are equally likely), that is a good risk/reward trade off (See also 3 Ways to Exit a Profitable Trade). All charts created with FreeStockCharts.com.

Potential Stop Loss Scenario
Figure 1: Potential Stop Loss Scenario – Apple (AAPL) Daily Chart

Assume you entered a long position in Apple stock after seeing a bottoming pattern and then a strong run higher. You enter on a price pullback, and place a stop loss below a recent swing low. As long as the price makes overall progress higher—higher highs and higher lows—your stop loss isn’t in danger of being hit. But if the price reverts to a downtrend, your risk is managed.

Stop losses are placed at a specific price level in your trading platform, or with your broker, when you enter a trade.

The draw-back to stop losses is that the price may hit your stop loss only to continue moving in the direction you expected. Also, a stop loss does not guarantee that will you will be able to get out at the price specified by the stop loss order. If there is no liquidity, the stop loss will fill at the next available price. In volatile conditions, you may take a larger loss than expected even with a stop loss. Despite these drawbacks, having a capital safeguard in place is better than no safeguard.

Trailing Stop

A trailing stop moves as the stock moves in your favor. If you set a trailing stop on a long position, and the stock price rises, the trailing stop will also rise to reduce risk or lock in a profit. During strong trends, the trailing stop allows you to capture large gains, all while controlling risk.

There are different types of trailing stops. The simplest is the manual trailing stop. This is where you progressively move your stop level based on recent price action.

Figure 2 revisits the trade scenario from Figure 1, and utilizes a manual trailing stop to lock in a profit as the price rises. The trade is eventually stopped out when the price reaches the trailing stop level.

Figure 2Manual Trailing Stop
Figure 2. Manual Trailing Stop – Apple (AAPL) Daily Chart

Many of today’s trading platforms also allow you to enter an automatic trailing stop. Assume you enter a stock at $50, and place a stop loss at $49 ($1 difference). If you set this as a tailing stop, the stop will always stay $1 behind the most recent high price since your purchase. If the stock price goes to $52, your stop will move to $51. If the price goes to $55, your stop will go to $54. It only moves higher (for long positions), so if the price drops to $54 after reaching $55, your trailing stop will get you out of the trade at $54.

The drawbacks of trailing stops are the same as traditional stop loss orders.

Breach of Support Levels

Trades are often predicated on a stock’s historical price action. Whether it is a trend or a sharp move higher, price support can be used to exit a losing trade (in a downtrend, use resistance). During an uptrend, if price breaks a support it indicates the trend may be in trouble, and therefore, many traders use a breach of support to exit a long trade.

Support can be either horizontal—such as a price area that has caused the price to bounce off of it on several occasions—or it can be diagonal, such as a trendline.

If you are long and the price is holding above a support level—a price level where buyers have stepped in with regularity—it confirms your trade. If the price breaks below support, those buyers are no longer eager to buy the stock, and this warns of further price declines. Therefore, when support breaks, many traders will exit in an effort to cut their losses.

Support Breach in International Business Machines
Figure 3. Support Breach in International Business Machines (IBM), Daily Chart

For more than a year, the price area between $183 and $181.50 held as support, with no significant breaks below it. In October 2013, the price closed significantly below it. This could have been used as an exit to cut the loss on a long position.

The problem with support areas/levels is that they can change. The price might bounce off $184 one time and $183 the next. Therefore, use areas, and preferably closing prices to help isolate support breaches.

Indicators

Many traders use indicators to get into positions, so it follows that they can also be used to get out. When an indicator you use provides a sell signal, it may be time to get out of that losing trade, as further price declines could be developing.

Figure 4 shows a popular indicator called the MACD. When it is above zero it helps confirm an uptrend, and if it drops below zero a downtrend may be developing. Many seasoned traders tend to combine indicator sell signals with other evidence provided by price movements to cut losses.

Indicator Sell Signal in AT&T
Figure 4. Indicator Sell Signal in AT&T (T), Daily Chart

The one downside of indicators is that they just tell you when to get in and out; they don’t control the precise amount of money you have at risk, like a stop loss or trailing stop does. You could experience a much larger loss than desired before an indicator gives you the signal to get out. Therefore, combine indicators with the other exit methods to control risk and get out when the tides turn against you.

The Bottom Line

All of the methods highlighted above can be used in conjunction with one another to exit losing trades. For example, place trailing stops at new support levels as they form. Indicators can also be used to compile evidence about your trade. Stop loss levels and trailing stop levels can be aligned with indicators so the stop loss is triggered when the indicator is about to provide a sell signal. It is important to control risk, not only for peace of mind and trading longevity, but also to calculate risk/reward scenarios. The same tools and methods profiled here can be used to control risk on short positions as well.


Keep Trading Simple – Anatomy of a Trade: These 4 Steps Keep Trading Simple

With so many indicators and forms of analysis, taking trades may seem overwhelming – there’s always conflicting information and varying viewpoints. But there is a simple trading strategy.

Break every trade down into four parts, and only focus on one part at a time. Here are the four steps that form the anatomy of every trade. Keep your focus on these for simple trading.

1. The Setup

This setup is what’s needed for a trade to potentially occur. There are thousands of trade setups, ideally you should only trade one or two if you want to keep your trading simple. Assume for a moment you use a moving average (MA) crossover strategy. You buy when a 50-period MA crosses above a 200-period MA from below (this is not an endorsement of this method, just an example). For other trade setups see the Trading Strategies section.

When the 50-period is above the 200-period MA, there is no possible trade setup. You do nothing. When the 50-period moves below the 200-period you now have a potential trade setup you’ll want to watch for. If the MAs are far apart, the setup is still a ways away and of no concern. When the 50-period approaches the 200-period, be on high alert, as a trade is potentially setting up.

Having a setup lets you know when you should be trading and when you shouldn’t. No setup, no trading. If a setup is forming, proceed to next step.

2. Establish Your Exits

You have a trade setup forming. Your next step is to determine if you should take the trade, if it “triggers” (step three).

A trade requires an exit. How will you exit this trade? Consider the possibility of the trade being a loser or a winner … you need an exit in either case. Once you’ve established this, if you’re comfortable with taking the trade, then you can trade the setup if your trade trigger occurs (next step).

With an MA crossover strategy the exits can be quite simple. Whether the trade is profitable or unprofitable, exit when the 50-day MA moves back below 200-day. Unfortunately this type of exit creates large risk, since the price can fall a long way before sell signal is given.

To offset this problem with the strategy, you may choose to exit profitable trades when the 50-day crosses below the 200-day MA, but also input a stop loss to protect capital in the case of a losing trade. Determine exactly where you will place this stop loss, and confirm to yourself that you won’t exit a profitable trade until the 50-day MA crosses below the 200-day MA. Your exits are now determined.

Learn about the 4 Ways to Exit a Losing Trade.

Charts courtesy of StockCharts.com.

trading exit chart example
Figure 1. Establishing Exits on a Trade, Before It’s Taken

For advanced traders, also consider whether you’ll allow yourself to alter your exit method once in a trade. What you decide here determines what you will do; think it through and then stick to what you decide during the trade.

During this stage, also consider your position size and the percentage of your account you’re willing to risk on the trade. While you don’t know your exact entry price yet, you can estimate it, and use the estimated entry point along with your stop loss to determine your risk. Too much risk? Avoid the trade. If you can risk more, don’t alter the parameters of the trade, instead, increase your position size. For more on determining position size and risk, see Which Position Sizing Strategy Is for You?

Once you’ve established how you will exit (based on your strategy), and you are comfortable to proceed with the trade—should it “trigger”—move to the next step.

3. The Trade Trigger

A trade setup isn’t a signal to enter a trade. The setup just lets you know a trade could happen.

Actually entering a trade requires a “trigger.” With the MA crossover method, the trigger may be “Enter a trade on the day the 50-period crosses above the 200-period.” As soon as that occurs, you enter a trade. That very precise event triggers you into action. Before this you simply wait.

trade trigger chart example
Figure 2. Using a Trade Trigger to Enter a Trade

Trade triggers vary by strategy, but it should be something precise, and relatively rare, which tells you now is the time to act and get into a trade. The trade trigger is something used on every trade (for a particular strategy); it doesn’t change based on the whims of the trader.

4. Trade Management

Once in the trade, your only goal is to manage the trade as laid out in step two. Place stop loss orders and take profits as dictated in step two.

Once in the trade, no new decisions are made. How you will manage this trade has been determined in advance. This relieves a lot of psychological pressure, because you have a plan, and all you need to do is follow it. This is done on every single trade.

Bringing It Together

You only need to focus on one thing at a time:

  1. No trade setup, no trade. You don’t even need to watch the market. Set an alert that will notify you when a trade setup is starting to form.
  2. Once a trade setup is forming your only job is to assess if you want to trade it, and how you will trade it – establish your position size, and how you will exit the trade (win or loss).
  3. Based on step two, if all the qualities of the trade are acceptable, take the trade if it triggers. If it doesn’t trigger, there is no trade.
  4. Once the trade is in place, your only job is to manage the trade as specified in step two.

The Bottom Line

Each trade is composed of four parts: Setup, Exits/Risk/Profit, Trade Trigger and Trade Management. At any one time you only need to think about the elements related to the stage of the trade you are in. Most of the time, this means doing nothing. Trading is as much about knowing when not to trade as it is about actually trading. Once in a trade, follow the plan you laid out in prior steps. This helps avoid making impulsive and emotional decisions when real money is on the line. Trade only one or two strategies, and know them very well. This four step process keeps you focused on what needs to be done for simple trading.


Finviz Relative Strength – Find the Strongest Stocks and How to Trade Them

Relative Strength is an important term in trading. It shows which stock (or other asset) is performing better than its peers. Relative strength shouldn’t be confused with the Relative Strength Index, which is a technical indicator.

By monitoring relative strength, a trader can always be trading the best stocks in the strongest sectors, which are likely to produce bigger and more trending moves than a randomly picked stock. Relative strength is not fixed though; what’s relatively strong this month may not be strong next month. Therefore, relative strength trading is especially beneficial to day traders and swing traders who can easily jump from one stock to another when the relative strength strategy calls for it.

Learn more about Swing Trading.

Use Stock Screeners To Find Relatively Strong Stocks

Finviz.com and StockCharts.com both have stock screeners to show which sectors are strongest (and weakest).

On Finviz, click on the “Groups” tab to see how sectors are performing over various time frames. Then jump to the Screener and select the group you want to view. Filter for stocks which have at least 500K in trading volume. View the results by “Performance,” and sort the list by Performance (Week) or Performance (Month) to see top and bottom ranked stocks.

finding strongest stocks
Figure 1. Finding the Strongest Stocks in a Sector – Finviz.com

Pick up to three of these stocks, near the top of the list (strongest) if day trading. These are stocks you’ll look for buy signals in (discussed shortly).

If swing trading, pick up to six (or more) stocks to watch for buy signals in.

Buying works best when the overall market (S&P 500) is in an overall uptrend on the timeframe being traded.

If the S&P 500 is in a downtrend, focus on short selling stocks in the weakest sectors. Look for the weakest sectors, sort by performance and select a few of the weakest stocks on the list. Monitor these stocks for sell signals.

On StockCharts.com, click “Sector Summary” on the homepage. This will produce a sector list; view performance based on the last week or month. Click on the sector to see the top industries within that sector. Click on an industry to see top stocks within the industry. Select several candidates to watch for buy signals in. If looking to go short, pick the weakest sector, weakest industries and the weakest stocks within them.

finding weakest stocks
Figure 2. Finding Weakest Stocks in a Sector – StockCharts.com

Trading Relatively Strong Stocks

Assuming the overall market trend is up, buy stocks which are relatively strong. These stocks already have a lot of buying interest in them. Looking for opportunities in these stocks is a simpler task than trying to analyze all stocks and figure which ones may have buying interest in the future.

Use these three tenants to trade relatively strong stocks:

  1. Watch for a pullback in the S&P 500. Your stock should not pull back as much, relatively speaking.
  2. If the stock starts to rise again after a pullback, buy it. A “trade trigger” will help define an exact entry. Enter long when the price rallies above the high of the most recent pullback bars(preferably these should be small, showing the selling momentum has slowed).
  3. Only trade on the long side if the stock continues to show relative strength (stock continues to make higher highs and higher lows relative to the S&P 500 index). If relative strength disappears, quit trading the stock and find a relatively strong stock.

The following charts show how this works. Figure 3 shows how a stock is analyzed for strength, relative to the S&P 500, or in this case the S&P 500 ETF (SPY). This process determines if the stock is relatively strong or not, and whether you want to be trading it. On this time frame MSI is as strong, or stronger, than the S&P 500 so trading the long side is favorable. At the far right, there is an indication relative strength may be waning.

relative strength on a price chart
Figure 3. Determining Relative Strength Using a Price Chart – FreeStockCharts.com

Figure 4 shows one way long trades could be established in this relatively strong stock, based on the three tenants discussed above.

Trading with Relative Strength
Figure 4. Trading with Relative Strength – FreeStockCharts.com

This trading strategy doesn’t have a defined method for taking profits. It’s suggested profits are taken at a fixed reward:risk ratio. For example, if risking $0.50 on a trade (difference between entry price and stop loss order) placed a target $1 or $1.50 above the entry price. This equates to a 2:1 or 3:1 reward to risk on the trade. This means you won’t trade all the signals on figure 4, since you may still be in a prior trade when a new signal develops.

Learn about the difference between using a Fixed Profit Target vs. Letting Your Profits Run.

Figure 4 shows all valid entries based on the method. The target chosen should not be obstructed by major support or resistance levels. Traders can also implement a trailing stop on positions in an attempt to capture bigger gains when the price trends strongly after an entry.

Pros and Cons of This Trading Strategy

The benefit of this method is that you’re always trading in stocks which are strongly biased in the direction you are trading. These stocks are rising strongly and you’re buying along with it. This means little research and nice potential returns as long as the stock stays relatively strong. The approach can be actively traded on a 1, 5 or 15 minute chart, or search for stocks which are stronger over a longer period of time and take trade signals on a 4-hour or daily chart.

The downside is there is no guarantee what is strong today will be strong tomorrow, or even later today. Relative strength traders must be nimble, dropping one stock in favor of another. This means constantly monitoring the market for which stocks are currently strongest, and also monitoring the stocks you’re trading to make sure they stay relatively strong. While research time is minimal, traders do need to spend time monitoring market conditions and updating their list of potential trade candidates.

The Bottom Line

Relative strength is comparing one asset or stock to its peers. Typically a stock is compared to the S&P 500, as this index is a broad benchmark of performance. The process for selecting relatively strong stocks also assures the stock selected is one of the strongest performers within its sector. Trading a relatively strong stock still requires a strategy, even though the stock is directionally biased in the direction we want to trade. One strategy is to watch for a break above the small bars often created during pullbacks. Use stop loss orders to control risk, and trade the stock as long as it continues to remain relatively strong.


Profit Target – Fixed Profit Target or “Let Profits Run?”

There are two very common approaches in trading: taking profits at a fixed target, or letting profits run (a trailing stop type approach). Both have merits and drawbacks.

Whether you decide to use a fixed profit target or let profits run, the most important thing is to actually use some sort of exit strategy. Breaking down what these methods are, along with their pros and cons, will help you choose the method that works best for your trading style, time frame and personality.

Be sure to also read about the 3 Ways to Exit a Profitable Trade.

Why the Exit Is Important, Yet Underappreciated

Many people spend loads of time searching for ideal entries, but it’s the exit that determines risk and profit. The entry is important, yet it’s only one piece of the trading puzzle (in addition to the exit, also consider position size).

You may get a great entry point, but if you can’t lock in profit the entry was wasted. An exit strategy attempts to remedy this. It dictates when the trader will take profit, forcing the trader to exit when an asset displays a specific set of conditions. Two common exit strategies are the fixed target approach, and the rather vague “let profits run” approach.

How to Use a Fixed Target

A fixed target takes profit at a specific price, determined at the outset of the trade based on the market conditions present at that time.

While the fixed target is an exit strategy, how it’s applied varies from trader to trader. If you buy a stock, you could place a fixed profit target right below an established technical resistance level. If you short-sell a stock you could place a fixed profit target right above an established support level. This approach is common when range trading or trading trend channels: buying near the bottom and selling near the top.

Be sure to also read our Beginner’s Guide to Trend Trading.

Charts courtesy of StockCharts.com.

Trading with Fixed Targets
Figure 1. Using Fixed Targets Based on Support/Resistance

Another fixed target method is the risk/reward approach. Many traders only take trades where they can make two, three, four (or more) times as much on their winning trades as they lose on their losers. When entering a trade a stop loss is placed. The distance between the entry and stop loss price determines the risk; assume it is $1 (per share).

If the trader uses a 5:1 reward to risk ratio, then a target is placed $5 from the entry point. If the target is hit, the trader makes $5; if the stop loss is hit the trader loses $1. With this approach the trader must ask “Is this target likely to get hit?” Using the support/resistance method mentioned prior helps traders determine this.

The benefit of the fixed target approach is that you’re going to lock in some profit on a regular basis. It is also useful for active traders, who don’t mind jumping in and out of the market, booking a profit (or loss) and then moving on to another trade. The downside is that you’re going to have very few “big” winners. You’re hitting singles and doubles consistently, but home runs are rare.

How to “Let Profits Run”

Letting profits run isn’t really a trading strategy until an actual exit method is implemented. How long do you let it run for? How do you know when it is no longer “running?” The easiest way to answer these questions is with a trailing stop. A trailing stop is an order that will get you out of a trade. If you own a stock, a trailing stop will rise as the price of the stock rises. Since the stock will eventually stop rising and reverse, the trailing stop locks in a profit. The amount of profit is determined by how far the price rose before reversing course and hitting the trailing stop order.

A trailing stop is implemented in a number of ways. One way is to set a stop loss, and set the order as a trailing stop. This is a “hands off approach” as the stop loss will move on its own with the price, not requiring you to manually move the stop. If a trailing stop is set to $1 (can be any amount) below the entry price, the trailing stop will always be $1 behind the highest price point reached. Once the stock falls $1 from the highest point the trailing stop will exit the trade for you.

Another approach is to use an indicator, such as a moving average or Chandelier Exits. Since these indicators move with the price, but trail behind, they can act as a trailing stop. If you’re long, the trade is held until the price drops below the indicator; when this occurs, exit the trade. This approach tends to work well in strongly trending markets, but poorly in sideways markets.

Learn more about How to Profit in a Sideways Market.

Trading with trailing stop
Figure 2. Using Indicators as a Trailing Stop

A manual trailing stop can also be implemented. If long a stock, each time the stock makes a new swing low, the stop loss is manually raised to just below the new swing low. That way, if the stock makes a lower swing low—a potential reversal signal—the trade will be stopped out (see: 3 Ways to Exit a Profitable Trade).

The benefit of the let profits run approach is that when a big trend develops, you stand to make a lot. When strong trends are present this strategy is useful for traders who don’t want to be active. Unfortunately, when the market is choppy, this method can result in lots of trades because the price keeps reversing and closing you out of the trade. With this approach, you will eventually a hit a few home runs (big winning trades) but when a strong trend isn’t present you are going to take lots of small losses and profits.

Which Trading Strategy Suits You?

Based on the Pros and cons of each strategy, one likely appeals to you more than the other. Both strategies take work. With the ‘let profits run’ method you must adjust your stop price as the price moves in your favor (this can be automated in many cases). Also, trades that fail to trend will be stopped out quickly, meaning another trade needs to be found.

Profit target traders may be in and out of the market more often, but are booking profits (and losses) likely on a more regular basis. Letting profits run can be psychologically difficult, as some profit is always given up at the end of the move. Profit targets may get a trader out right near the end of the move, but sometimes the trader leaves a lot of money on the table by taking profits.

There is no right or wrong here. Which one are you most comfortable with? Pick one and stick with it. Also consider using both: place a fixed target, and as the price is moving towards it, implement a trailing stop.

The Bottom Line

One strategy isn’t necessarily better than the other. Ultimately, which strategy is better is the one that works for the individual. Letting profits run could mean more losing trades waiting for that big winner, but the winners can be huge when they come. Fixed targets are based on the tendency of the market being traded, therefore, the win-rate is typically higher so profits are booked more often. Under this strategy though there are almost never “home run” trades.

All in all, establishing an exit method is key to successful trading. Find and implement a method, and stick to it.


Event Driven Strategy – Event-Driven Trading Strategy 101

There are a number of different strategies that active traders use to profit in the financial markets, ranging from various forms of technical analysis to trading based on Level II quotes and order books. While many of these strategies rely on technical factors that predict price changes, traders may also want to consider the impact of fundamental events that can have a dramatic impact on prices over the near-term instead of just the long-term.

In this article, we’ll take a look at event-driven trading strategies and how they can be used by active traders to improve their trading performance.

Be sure to also see our Guide to Position Trading.

What Is Event-Driven Trading?

man looking at multiple monitors

An event-driven strategy involves placing trades based on market-moving events, ranging from earnings announcements to natural disasters. Since volatility tends to increase during these times, active traders have an opportunity to generate a higher profit than they would otherwise be able to in range-bound markets. This volatility can be measured in a number of different ways, ranging from beta coefficients to daily volume versus average daily volume.

After identifying potentially volatile situations, traders must determine the direction of any future price movement and the best strategy to capitalize on that movement. These factors are largely determined by looking at various technical indicators, chart patterns, or other forms of technical analysis. For instance, a breakout due to favorable earnings could coincide with an ascending triangle pattern, which often predicts a specific price target.

See also Trend Reversals: How to Spot and How to Trade.

Common Market-Moving Events

Stock prices reflect a constant stream of new information and changing investor expectations of what the future holds. While a lot of this information is relatively benign in nature, such as weekly job reports or financial commentary, there are many events that are capable of dramatically moving the market for a given stock or index. Recognizing these events is the first step in capitalizing on the resulting price volatility.

Some common micro-level events to watch include:

  • Earnings Releases – Corporate earnings tend to move markets when they come in above or below the market’s expectations, which means that it’s important for active traders to understand the expected figures beforehand.
  • Mergers & Acquisitions – M&A tends to produce dramatic increases or decreases in share prices depending on the terms of the deal, while creating an opportunity for arbitrage strategies between the buyer and seller.
  • Spin-Offs – Spin-offs tend to see an initial decline in share price as institutional investors who received shares sell off their stake to comply with regulatory requirements or other rules, thereby creating opportunities for traders.

See our Guide to Merger Arbitrage Trading.

Macro-level events to watch include:

  • Natural Disasters – Natural disasters can spark dramatic movements in the equity markets, especially in certain sectors that are exposed. For instance, a hurricane in the Gulf of Mexico could hurt oil companies with rigs in the region.
  • Politics – Political issues can have a dramatic impact on some equities, especially in parts of the world where policies can change dramatically. A new regime in an emerging market, for instance, can have a big impact on the country’s ETFs.
  • Monetary Policy – Central bank monetary policy changes can have a big impact on broad equity indexes, since interest rates directly influence portfolio allocations, which means that these events are important for traders to monitor closely.

See also A Brief History of Penny Stock Chaos.

Event-Driven Strategies

There are many different ways to capitalize on event-driven volatility in individual securities or entire indexes. While some traders may decide to simply purchase a stock after a market-moving event occurs, others may choose to use options or other derivatives to leverage their exposure to the market and capitalize on the opportunity in a different way. The best strategies depend largely on a trader’s knowledge and risk tolerance.

Let’s take a look at an example of a possible event-driven strategy:

Trading an Event-Driven Breakout
Figure 1 – Trading a Breakout – Source: TradingView

In Figure 1 above, Egalet Corporation (EGLT) experiences a breakout due to favorable top-line results in one of its clinical trials. A trader implementing an event-driven strategy may have taken notice of the positive clinical trial results and purchased the stock after it broke above the descending trend line resistance. After making the purchase and holding the stock into the second day, the trader might lock in profits by setting a stop-loss just below support levels at around $7.50 and set up a take-profit price target at the psychologically important $10.00 level that also happens to be a historic resistance level.

Now, let’s look at an example of the opposite scenario where a trader may enter into a short position to take advantage of an adverse event:

Trading an Event-Driven Breakout
Figure 2 – Trading a Breakdown – Source: TradingView

In Figure 2 above, Uroplasty Inc. (UPI) breaks down below the prior low and psychologically-important $2.00 support level after being downgraded by Roth Capital analysts. An event-driven trader may decide to enter into a short position following the breakdown below $2.00 and set up a price target at long-term prior lows of around $0.30 or perhaps at the psychologically-important $1.00 price level where they would then buy back the shares and profit from the trade.

Learn about the 7 Psychological Traps Every Trader Must Face.

Risks & Limitations

Event-driven trading represents a great way to profit from increasing volatility, but the strategy isn’t without any risks. Given the increased volatility, there’s a risk that the security could recover just as quickly as it fell or vice versa. These dynamics are particularly prone to occur in events that may be reversed, such as a merger that falls through or an analyst note that turns out to be based on faulty information following revelations in a new 10-Q filing.

Some important risks and limitations to consider include:

  • Volatility – Volatility is a double-edged sword in that any potential increase in upside is accompanied by a potential increase in downside risk, which makes it important for a trader to fully understand the event and set up tight risk controls.
  • Whipsaw – Some trading events may cause whipsaw price action that can trigger stop-loss points before a trading thesis can materialize, which means that traders should keep loose stop-loss points to permit some volatility to occur.
  • Knowledge – Many market moving events are quite involved, which makes it hard to fully interpret and digest the information. For instance, clinical trial results may be hard to instantly decipher as good or bad before the price moves substantially.

The Bottom Line

Event-driven trading strategies provide a great way to capitalize on increasing price volatility, but there are many risks and limitations to consider. When developing and executing these strategies, it’s important for traders to set up tight risk controls while providing enough room for the volatile situation to play out in the market. In the end, event-driven trading strategies provide a valuable arrow in the quiver of any active trader.


Backtesting Platform – Backtesting Tools and Tips

Backtesting is an essential practice for anyone looking to develop automated trading systems. Using historical prices for multiple securities, traders can optimize the profitability and enhance the durability of their “trading systems”:http://traderhq.com/10-relics-only-traders-appreciate. There are many tools available to assist in the process of developing and backtesting trading systems across many different markets, including both equities and forex markets.

In this article, we’ll take a look at what backtesting entails, some essential resources, and limitations to keep in mind before trading with real capital.

What Is Backtesting?

Trading systems consist of computer programs that automate the process of buying and selling securities based on a set of rules. By applying the rules to historical prices, traders can evaluate the profitability and risk associated with their trading systems without putting any real capital at risk. The process of applying a trading system to historical prices is known as backtesting that trading system.

For example, suppose that a trader devises a trading system that generates a buy signal when the 10-day moving average crosses above the 50-day moving average and a sell signal when the 10-day moving average crosses below the 50-day moving average. By applying these rules to historical prices, traders can see how much they could have generated and the volatility risks taken in the process [see also Ultimate Guide to Bollinger Bands].

Some key data points that traders might find useful from backtesting include:

  • Profit/Loss – Traders can determine the overall profit or loss over a period of time expressed as a percentage of initial capital, which provides a rough guide of how profitable the trading system might be when pushed live.
  • Max Drawdown Traders can determine the maximum loss of initial capital that a trading system generates over a period of time, which is useful when considering margin requirements and other leverage-related concerns.
  • Sharpe Ratio Traders can determine a trading system’s Sharpe Ratio, which provides a great indicator of overall risk-adjusted returns.

How to Backtest

Backtesting can be accomplished manually, but complex trading systems can make the process quite daunting. Using a variety of different software programs, traders can input their trading system’s rules and automatically backtest the strategy against a wide range of historical timeframes and securities. Many software programs also report detailed risk and profitability analyses (as seen above).

The most popular integrated broker and backtesting platform is TradeStation and its Portfolio Maestro®. While TradeStation’s brokerage clients have access to the platform for free (if they meet certain criteria), the software platform is available to the general public for $59.95 per month. The platform enables portfolio-level backtesting, analytics, optimization, and performance reporting.

TradeStation Portfolio Maestro® - Source: TradeStation
Figure 1 – TradeStation Portfolio Maestro® – Source: TradeStation

Wealth-Lab is another option that has both free and premium options. With both a drag-and-drop strategy wizard and the ability to use complex scripting language, the software platform caters to both novice and professional traders. Pre-made strategies and multi-system backtesting provide additional options designed to help improve trading systems and implement profitable strategies.

Wealth Lab – Source: Wealth-Lab.com
Figure 2 – Wealth Lab – Source: Wealth-Lab.com

QuantConnect is a relatively new option that provides free backtesting software for quantitative traders. Based on the C# programming language, traders using the software should have a good understanding of basic programming concepts in order to interact with the extensive API. The company itself seeks to invest in profitable algorithms and share the profits as a means of generating revenue.

QuantConnect – Source: QuantConnect.com
Figure 3 – QuantConnect – Source: QuantConnect.com

In the end, these three backtesting software solutions are just a few of many options available to traders. Many software programs are available free of charge – at least for a trial period – while others are either paid or bundled with brokerages. While most platforms require some knowledge of programming, others are designed with drag-and-drop tools designed to make trading system development easy.

Backtesting Limitations

Traders should be aware of the many limitations associated with backtesting trading systems before using these tools. By failing to account for these limitations, losses can quickly add up in cases of frequent and/or automated trading. A great way to avoid these problems is to extensively test trading systems using paper money and live data and then using small amounts of real money with live data.

Some of the key limitations to consider include:

  • Prediction Risk – Past performance does not necessarily correlate with future performance, since the financial markets are extremely dynamic. In fact, competitive edges regularly pass quickly when discovered.
  • Curve Fitting – Optimizing past performance can result in highly-specific trading strategies that are “curve fitted” to the past and unlikely to be broad enough to perform well in the future, especially with unexpected events.
  • Data Resolution – Depending on the frequency of trading, some backtesting data may only provide one-minute or one-day resolution rather than up-to-the second data seen in live real-time trading environments.
  • Slippage – Many trading systems fail to account for random factors like slippage in order pricing, which can result in large changes to the profitability and risk profiles of trading systems.

Of course, there are many other possible limitations that should be considered when developing and backtesting trading systems. Traders can avoid many of these problems by ensuring they are using a solid platform that provides granular data, accounting for slippage in cases where it’s relevant, and being careful to not refine a trading system so much that it becomes “curve fitted” to historical results.

The Bottom Line

Traders looking to automate or make trades based on a set of rules should always backtest their strategies before applying them in the live market. By simulating historical market activity, traders can ensure that live trading won’t yield any nasty surprises in terms of unexpected trading behavior. However, backtesting isn’t perfect that there are many limitations that traders should consider as well.


– The Golden Cross: How to Identify and Use It

Traders rely on many different technical indicators to inform their decisions. Moving averages are one of the most common technical indicators since they help smooth out market noise and make it easier to see important trends. They also provide a way to generate quantitative trading signals.

In this article, we will take a look at the Golden Cross chart pattern, best practices for using it, and a real life example of the chart pattern.

What Is the Golden Cross?

The Golden Cross is a bullish chart pattern, based on the moving average crossover strategy, whereby a short-term moving average crosses above a long-term moving average.

Learn more about moving average trading strategies here.

There are three stages to the chart pattern:

  • There is a previous downtrend that is starting to lose momentum, setting the stage for a reversal.
  • The trend reversal occurs when the short-term moving average crosses above the long-term moving average.
  • There is an uptrend following the trend reversal and the moving averages become key support levels.

The greater the distance between the two moving averages, the more powerful the trading signal. If the price is in a strong downtrend and quickly reverses higher, the short-term moving average has a greater velocity and the trading signal is more reliable than less extreme situations.

The opposite of the Golden Cross is the Death Cross, whereby the short-term moving average crosses below the long-term moving average and signals a new prolonged downtrend.

How to Trade the Golden Cross

The Golden Cross is a very versatile chart pattern, but there are some parameters that can ensure accuracy.

Curious about learning how day trading rules might impact you? Click here to learn more.

Find the Right Security

The Golden Cross uses moving averages, which are lagging technical indicators. It works best when identifying changes in strongly trending, rather than range-bound, markets. In other words, you shouldn’t use a Golden Cross if there are frequent crossovers since there’s a low signal-to-noise ratio.

Here’s an example of a situation where the market is too choppy:

Golden cross not applicable

In this example, there is no well-defined downtrend prior to the Golden Cross chart pattern. The sideways price action is too choppy to generate reliable trading signals and the Golden Cross strategy shouldn’t be applied in this situation. We will take a look at a more ideal situation later.

Select the Type & Duration

The simple moving average, or SMA, is the most common type of moving average used in the Golden Cross, but there are several other options to consider depending on the situation.

The most popular types of moving averages include:

  • Simple Moving Average: The SMA calculates the simple average price over a given timeframe.
  • Exponential Moving Average: The EMA is similar to the SMA but places an emphasis on more recent prices.
  • Volume Weighted Moving Average: The VWMA is similar to the SMA but places an emphasis on prices with higher volume.

The 200-period and 50-period moving averages are the most common periods used to calculate a Golden Cross, but you can adjust the time frame of the moving average depending on your needs. For example, a day trader may prefer a 5-minute and 15-minute moving average to identify intraday trading opportunities.

Manage the Trade

The Golden Cross generates a buy signal when the short-term moving average crosses above the long-term moving average. At that point, you would typically purchase the underlying security and use the moving averages as new levels of support for the subsequent trend higher.

Often times, traders use the long-term moving average as an initial stop-loss for the position and the short-term moving average as a kind of trailing stop-loss or take-profit point. You can also use other forms of technical analysis to set these stop-loss and take-profit points, however.

Examples of the Golden Cross

Let’s take a look at an example of a Golden Cross in the wild.

The following chart shows a Golden Cross in Fortis Inc. (NYSE: FTS) using the 50-day and 200-day moving averages:

Golden cross applicable

In the example, you can see that there was a prior downtrend between mid-September and mid-October before the Golden Cross occurred in late-October. The reversal was followed by a significant uptrend throughout mid-November – even after the short-term increase immediately following the signal.

The trader may have purchased the stock immediately following the Golden Cross and set the stop-loss at the 200-day moving average. Once the stock broke out higher, the trader could have switched to the 50-day moving average as a moving take-profit target and as a way to eventually lock in profits.

The Bottom Line

The Golden Cross is one of the most popular chart patterns for both long-term investors and short-term traders given its ease of use and versatility. In fact, moving average crossover strategies are one of the most common quantitative trading strategies – they’re a battle-tested option.


Cup And Handle Pattern – Cup and Handle Patter: How to Trade with It

Chart patterns are frequently used by traders to identify potential opportunities. While they aren’t as quantitative as technical indicators, they’re a visual way to trade at a glance and can be easily combined with other forms of technical analysis to provide actionable ideas.

In this article, we will take a look at how to identify and use the cup and handle pattern.

What Is a Cup and Handle Pattern?

The cup and handle pattern was introduced by William O’Neil in his 1988 book, How to Make Money in Stocks. The continuation pattern is formed when the price forms a rounded bottom, known as the “cup,” followed by sideways movement, known as the “handle.” A breakout from the handle’s trading range marks a continuation of the previous trend higher.

Learn about other chart patterns and trading strategies in our Education section.

Cup and handle illustration

The pattern can be identified with these rules:

  • Prior Trend: There should be a prior trend higher since the cup and handle is a bullish continuation pattern as opposed to a reversal pattern.
  • Cup: The cup should resemble a “U” rather than a “V” with roughly equal highs on each side of the cup. However, the price doesn’t necessarily need to uniformly follow the bottom of the “U” shape.
  • Handle: The handle should form on the right side of the cup and often comes in the form of a “flag” or “pennant” that slopes downward. But in some cases, the handle can be a sideways price channel or even an ascending triangle.
  • Breakout: The breakout should occur on higher-than-average volume to confirm the continuation pattern. Traders may also use other forms of technical analysis to confirm the breakout, such as a spike in the relative strength index.

How to Use the Cup and Handle Pattern

The cup and handle pattern, like most chart patterns, is relatively subjective in its interpretation.

In general, traders should look for a cup depth that’s no more than one-third of the previous advance and lasts between one and six months. The handle typically lasts between one and four weeks or about one-quarter of the cup’s duration. That said, day traders may use the pattern on much smaller timescales.

Learn how day trading rules apply to U.S. investors.

The price target for the cup and handle pattern can be calculated by measuring the distance from the right peak of the cup to the bottom of the cup and adding that number to the breakout price point. Traders should also take into account other trend lines and resistance levels.

Stop-loss orders are often placed below the lowest point of the handle or below the most recent move lower. In other cases, traders may set a stop-loss at a certain percentage drawdown from the right side of the cup or below a trend line drawn along the right slope of the cup.

Traders should always use the cup and handle pattern in conjunction with other forms of technical analysis. For example, many traders pair the cup and handle pattern with Fibonacci levels to help set the ideal price targets, as well as place intelligent stop-loss points.

Examples of Cup and Handle in Action

Let’s take a look at the cup and handle pattern example in CIGNA Corp.’s (NYSE: CI) chart in 2018.

Cup and handle example
Source: StockCharts.com

The cup was formed between February and August when CIGNA’s stock moved lower. The close of the gap from early March signaled the start of the handle. In this case, the stop-loss could be set at around $180.00 below the bottom of the handle.

The price target is equal to the difference between the low of $165.00 and the right peak of $180.00 – or $15.00 – applied to the breakout point of $190.00 – or $205.00. In early October, the price target was hit for a quick eight-percent profit in about 15 days.

Keep abreast of the latest developments by following our News section.

The Bottom Line

The cup and handle pattern is a great way to identify instances where a trend is poised to continue following a brief correction. Often, the pattern works best when used in conjunction with other forms of technical analysis, including technical indicators and other chart patterns.


Chart Pattern – How to Spot and Interpret the Three-Drive Chart Pattern

Traders rely on a combination of technical indicators and chart patterns to base their decisions on. While chart patterns are more qualitative than technical indicators, they can offer powerful insights into the market’s psychology at any given point in time, making them valuable tools for traders.

The three-drive chart pattern is a reversal pattern that consists of three legs, called “drives”, and two corrections. It’s often considered to be an ancestor of the Elliott Wave pattern, which uses a more complex series of “waves” or “drives” to predict long-term price behaviors.

Click here to learn how day trading rules affect U.S. investors.

Let’s take a closer look at how to identify the three-drive chart pattern and use the insights to profit.

How to Recognize the Pattern

The three-drive pattern is characterized by a series of three higher highs or lower lows that culminate in a reversal of the prior trend. Each move higher or lower is measured using the Fibonacci retracement and extension levels of 0.618 and 1.272, or in percentage terms, 61.8% and 127.2%.

three drives chart

The following rules can help identify the pattern:

  • Correction A should be a 61.8% retracement of drive 1.
  • Correction B should be a 61.8% retracement of drive 2.
  • Drive 2 should be a 1.272 extension of correction A.
  • Drive 3 should be a 1.272 extension of correction B.

In some cases, the definition of the three-drive pattern may be stretched to include different Fibonacci retracement or extension levels, such as a 1.618 or 161.8% extension instead of a 1.272 or 127.2% extension. The chart pattern may even be used without Fibonacci levels, but it may be less accurate.

Traders should also look at the volume behind each of the drives higher or lower. If the volume is higher during drives than during corrections, traders can be more confident in an eventual capitulation and trend change after the final drive.

From a psychological standpoint, the three-drive pattern shows three final attempts at pushing the price higher or lower before capitulation occurs and the trend reverses.

How to Use the Pattern

The three-drive chart pattern is designed to detect reversals of an existing trend, enabling traders to either profit from the trend change or exit any existing positions. For example, a bearish reversal could lead trend traders to exit their positions or short traders to enter new positions to profit from the reversal of the trend over time.

Trade signals are generated when the three-drive pattern is complete at drive 3, but many traders set limit orders at the 1.272 extension following correction B to avoid missing out on the reversal. By setting the price slightly above the exact reversal point, you can increase the odds of a successful fill, although there’s a greater risk of downside.

Stop-loss levels are typically set just above or below the reversal point. If the price continues to rise or decline, the market or limit order can be quickly exited as soon as the chart pattern breaks down. It’s important to set the stop-loss sufficiently far away from the reversal point to avoid being stopped out of an otherwise successful trade from volatility.

Take-profit points are usually set at the beginning of the chart pattern where drive 1 began. However, if the trend shows signs of continuing, traders may hold the position even longer and use the beginning of drive 1 as a new stop-loss point to lock in profits along the way.

As with most forms of technical analysis, it’s a good idea to seek confirmation using other chart patterns and technical indicators. For example, a relative strength index reading in neutral territory (e.g. ~50) could make a trader second-guess a reversal prediction, whereas an extreme RSI reading could be a confirmation that a reversal is likely to occur.

Visit our Trader University section to learn about other technical indicators and chart patterns that can improve your trading success.

The Bottom Line

Traders use many different technical indicators and chart patterns to identify opportunities. The three-drive chart pattern is a great tool for discovering potential reversals, particularly when used in combination with Fibonacci levels. Traders may want to add three-drive patterns to their technical toolbox to improve their success.


– Bear Call Spread Options Strategy Explained

Stock options provide traders with a great way to speculate on future price direction in a way that generates very specific risk-to-reward profiles. While bullish traders could simply purchase a stock outright, stock options enable them to build leveraged positions that involve limited losses. Spread strategies, in particular, provide a very specific maximum loss and maximum profit for each trade.

In this article, we’ll take a look the bear call spread strategy and how it can be used to speculate on a decline in an underlying stock’s price.

Be sure to read our introductory article Options 101: American vs. European vs. Exotic.

What Is a Bear Call Spread?

Bear Call Spread Diagram
Source: TheOptionsGuide.com

A bear call spread—also known as a credit call spread—is a bearish options strategy that creates a net cash inflow at the onset. By purchasing a long call option and writing a short call option at a lower strike price, the strategy generates an immediate income with a limited gain and loss profile. The limited-risk, limited-reward strategy is ideal in situations where traders are cautiously pessimistic.

The strategies key prices to remember include:

  • Maximum Gain – The maximum gain occurs when the stock price falls below both call option strike prices, which results in both options expiring worthless and the initial credit encompassing the profit.
  • Maximum Loss – The maximum loss occurs when the stock price moves above the higher strike price, which results in a loss equal to the difference between the two strike prices minus the net credit received.
  • Breakeven Point – The breakeven point occurs when the stock price is above the lower strike price by the amount of the initial credit received, which would result in the long call expiring worthless and the short evening out.

Bear Call Spread Example

Suppose that a trader believes that a stock will fall after its earnings announcement, but he or she isn’t confident enough to short the stock outright or use simple put options. By simultaneously buying an SEP 50 call for $100 and selling an SEP 45 call for $300, the trader establishes a bear call spread and receives a net $200 credit for entering the trade – the difference between the two premiums.

See also Understanding a Short-Squeeze and How to Profit From One

If the stock falls to $44.00 at expiration, as expected following a poor earnings announcement, both options will expire worthless and the trader will keep the entire $200 net credit received at the onset as a profit. If the stock rises to $52.00 instead, both calls expire in the money and the trader will have to buy back the spread for $500, which translates to a $300 loss after the $200 credit.

Bear Call Spread Dynamics

The bear call spread strategy is ideal in situations where traders are cautiously pessimistic given its limits on profit and loss potential, but there are many different ways to make the strategy profitable in different situations.

For example, traders can enter a more aggressive bear call spread by expanding the difference between the two strike prices. These dynamics will increase the initial credit received and thereby the maximum profit potential, although the stock price must move down to a greater degree in order to realize that profit, which introduces more risk on the part of the position as a whole.

The Bottom Line

The bear call spread strategy is a bearish strategy that’s optimal for traders predicting a moderate decline in price. With its controlled profit and loss profile, traders know exactly how much they can gain or lose on the trade, which sets it apart from riskier strategies like naked puts or short selling. The other key benefit is that the credit is realized upfront and can be reinvested in other trades.


– Understanding Pivot Points and How to Trade Them

Pivot points are support and resistance levels that technical analysts use to pinpoint potential reversals in price over time. While the levels were originally used by floor traders to set key levels to watch during the day, technical analysts have expanded upon the concepts to develop at least five different types of pivot points used in the modern day. The rich history of pivot points has made them a widely followed indicator.

In this article, we’ll take a look at several popular types of pivot points, how they are calculated, and how they can be used by traders to improve performance.

Be sure to also read our Trader’s Guide to Tops and Bottoms.

Pivot Points and Variations

The original pivot point was a relatively simple concept – the average of the high, low, and close price for a given period was a crucial level for the following period. Working off of this figure, additional areas of support and resistance could be identified.

A move below the pivot point was a bearish signal, while a move upon the pivot point was a bullish signal. Traders would then watch the support and resistance levels for additional insights.

Pivot Point Example
SPY Pivot Points – Source: StockCharts.com

The original pivot point support and resistance is calculated as follows:

  • Pivot Point = (High + Low + Close) / 3
  • Support (S1) = (Pivot Point x 2) – High
  • Support (S2) = P – (High – Low)
  • Resistance (R1) = (Pivot Point x 2) – Low
  • Resistance (R2) = P + (High – Low)

Over time, technical analysts have taken these basic concepts to develop new variations of the pivot point that incorporate other forms of analysis. Fibonacci Pivot Points, for instance, incorporate the golden ratio to attempt to make more accurate predictions. For example, the Support (S1) in that case is equal to P – (0.382 x (High – Low)) and Support (S2) is equal to P – (0.618 x (High – Low)), where 0.382 and 0.618 are variations of the golden ratio.

Be sure to also see our Ultimate Guide to Fibonacci Trading

Demark Pivot Points introduce additional complexity by making the calculations contingent upon the opening price relative to the closing price for the period. In addition to these changes, the Demark style is unique in that it only has one support and resistance level rather than two or more like many other styles. Trader should experiment with these various styles in order to find an option that works best for them and/or a particular security being analyzed.

Profiting from Pivot Points

There are many different ways to use pivot points to enhance trading performance, since they simply identify areas of support or resistance. At their core, pivot points set the tone for price action in a given security by establishing when it’s trading higher or lower than a key level set by the previous period. A stock trading above its pivot point could be considered bullish, while a stock trading below its pivot point could be considered bearish.

The support and resistance levels identified by pivot points can also be interpreted as key levels for traders to watch. For example, a trader may buy a stock that breaks out from its pivot point on high volume and put in a take-profit order when it reaches R1 resistance. Traders may also set stop-loss points for a position just below support levels in order to avoid losses if a stock begins to move significantly lower following an adverse event.

A final consideration when using pivot points is timeframes. Since pivot points can be calculated across any timeframe, it’s important for traders to look at more than just a single timeframe during their analysis. A 15-minute chart may show one key pivot point level, but a 1-day chart may show something entirely different. In addition, different equities may respond to different pivot points in different ways, which makes it important to look deeper.

The Bottom Line

Pivot points are a very useful form of technical analysis that were initially used by floor traders to set important price levels to watch during the day. Over time, the same concept has split into a variety of different techniques involving the same premise. Traders use these pivot points to identify potential areas of support and resistance and, combined with other forms of technical analysis, these insights can help improve trading performance over time.


– Range Trading: How to Trade Range Markets

Price ranges occur in all markets, and on all time frames, making range trading a popular trading method. Price ranges occur when there’s indecision on the part of buyers and sellers, and neither group is able to push the price of an asset beyond a certain high and low point. These high and low points are called resistance and support, respectively. Range traders capitalize on the repeating pattern of the price moving back and forth between support and resistance. Doing so requires identifying trading ranges, knowing what indicators aid in trade selection, and where to place stop loss orders and targets on trades.

Defining Trading Ranges

A range occurs when the price has bounced off the same support area at least twice, and the same resistance area at least twice. This will create two high points and two low points. The two highs or two lows don’t need to stop and reverse at the exact same level—that is rare—but they should be relatively close to one another. Many traders look for the price to reach resistance and support at least three times before calling it a range.

See also How to Read a Stock Chart: 10 Things Every Trader Should Know

The two low points are connected by a horizontal line, and same with the highs. This visually defines the range. The more time the price reaches the high and low points, the stronger the range is, and usually the stronger the eventual breakout.

View support and resistance as areas or zones, not a single price. As mentioned, all the highs (or lows) are unlikely to be at the exact same price, so the difference between the highs creates a resistance zone. The same goes for the lows points, creating a support zone.

Charts courtesy of StockCharts.com.

stock market trading range
Figure 1. Trading Range on PLAB Daily Chart

This is typical of most ranges – some price swings don’t reach the prior highs or lows, while other swing will overshoot. When the price breaks well beyond the established range, only to move back into the range, that’s called a false breakout.

The range trader’s goal is to enter short positions near the resistance zone, and enter long positions near the support zone. They are anticipating the range will continue and produce a profit, but also need to guard against false breakouts and actual breakouts.

Trading ranges are also called and channels and rectangles. The term channel should not be confused with “trend channel” which is when the price is moving between support and resistance (lines) but at an upward or downward angle.

See our guide to Trend Reversals: How to Spot and How to Trade

Range Trading Indicators

Traders use indicators to “time” their entries into range trades. The most commonly used range trading indicators are oscillators, including the Stochastic and Commodity Channel Index (CCI) and RSI.

These indicators are useful for range trading, not only because they show when the price is near the high or low of the price range, but also provide trade signals for entries and exits.

range trading with indicators
Figure 2. Trading Range with Slow Stochastic and CCI on PLAB Daily Chart

Range Trading Strategy

The indicators are used to form a range trading strategy. There are numerous oscillators, pick one and adapt it to using the following method.

For the CCI, most of the time the indicator is between +100 and -100, so a move above +100 or -100 is noteworthy. In order to get a trade signal, we must consider the stock price and the CCI indicator.

When the price is within, or near, the resistance zone, the CCI will likely also be above +100. If it is, when the CCI falls back below +100, initiate a short position. Place a stop above the most recent swing high in price. Place a target for the trade just above the support zone.

When the price is within, or near, the support zone, the CCI will likely also be below -100. If it is, when the CCI rallies back above -100, initiate a long position. Place a stop below the most recent swing low in price. Place a target just below the resistance zone.

Figure 3 shows three short trades and two long trades. The price must be near the support or resistance zone in order to confirm a CCI trade signal. Price and the CCI (or other oscillator) must be used in conjunction with one another.

range trading with cci indicator
Figure 3. Range Trades in PLAB using CCI Signals

Range Trading Pros and Cons

A range that lasts can produce multiple winning trades before it eventually gives way to a breakout. Certain stocks and markets have ranged for years. Even markets and stocks that commonly trend typically range for periods of time, so having a range trading strategy for such times can pay off.

The problem is these long lasting ranges don’t come along very often, and when they do you can be assured every other range trader is trading it too, in a similar way. Therefore, long-term ranges can get “crowded,” resulting in choppier trading with lots of false breakouts, usually resulting in losses.

Not all ranges are worth trading either. While a range may be well defined, if it’s too narrow the potential profit may not be worth the risk and paying commissions.

Trends are what non-range traders chase. Arguable trends have more profit potential because they can run indefinitely—your potential is unknown, and can be very large (or not). Range traders are usually only trying to capture the approximate size of the range, so theoretically profit is capped at the width of the range. Ultimately though, it comes down the individual trader, and how they implement their range or trend trading strategy. Some will do better trading ranges, while others will always want to ride trends.

For more insights on trends, consider our guide Trend Trading 101.

The Bottom Line

Trading ranges occur when the price of an asset is moving between horizontal support and resistance levels. Look to profit from the recurring pattern of the range by shorting when the price is in, or the near, the resistance zone and the CCI drops below +100. Buy when the price is in, or near, the support zone and the CCI rallies above -100. Place a stop just outside the recent swing high or low respectively. Targets go just in front of the opposite zone.

When ranges last, they can provide many great trading opportunities, but profit potential is capped. Also, as the charts show, ranges are prone to choppy trading (not reaching or overshooting your established support/resistance zones) which can result in losses or missed targets. Such things are inevitable; make sure the range is big enough to reward you handsomely for the range trades that do work out.


– 130/30 Strategy Explained

Many hedge funds use long-short strategies in order to profit in both rising and falling equity markets. By maintaining both short and long positions, investors can reduce market risk within their portfolios and increase risk-adjusted returns. Short position gains in falling markets help offset losses in long positions and vice-versa, while a tendency to hold overvalued shorts and undervalued longs creates alpha.

In this article, we’ll take a look at the so-called 130/30 strategy, which is designed to create an optimal long-short portfolio and realize many of these benefits.

What Is the 130/30 Strategy?

The 130/30 strategy involves short-selling stocks up to 30% of a portfolio’s total value that the trader believes will underperform the market and then using the proceeds to take a long position in stocks the trader believes will outperform the market. For example, a trader might invest 100% of a portfolio in the S&P 500 and short-sell the bottom ranked stocks and reinvest the 30% for a 130% exposure.

Be sure to read Understanding a Short-Squeeze and How to Profit From One.

Let’s take a look at a quick example of this process:

  1. A fund raises $1 million and buys $1 million worth of securities, making it a basic run-of-the-mill 100% long-only fund.
  2. The fund borrows $300,000 worth of securities and sells them with the agreement to repurchase later, giving it a 30% short position.
  3. The $300,000 in proceeds from the short sale are used to buy $300,000 worth of additional long securities, making the fund 130% long.
  4. The end result is a fund that has $1.3 million (130%) in long securities and $300,000 (30%) in short securities, making it a 130/30 fund.

Since many 130/30 traders invest in large-cap equities or indexes, the strategy can be considered a core asset rather than an alternative asset in most cases. The difference between traditional hedge fund and 130/30 strategies is that the latter is managed against specific benchmark indexes that underlie the portfolio rather than speculating on specific securities as many hedge funds try to do.

According to some studies, the 130/30 structure captures about 90% of the benefits of leverage, while eliminating many of the risks. Those skeptical of 130/30 funds call the idea more of a marketing gimmick than a proven strategy, pointing out that many traditional long-only funds have outperformed their 130/30 counterparts over time (it should be noted that 130/30 became popular circa 2007, however).

Be sure to also see the Best Investments of All Time.

Benefits of the 130/30 Strategy

profiting from 130/30 strategy

The major benefit of the 130/30 strategy is the ability to profit from the bottom quartile of equities. Whereas a long-only investor would simply ignore these stocks, traders using the 130/30 strategy have the flexibility to profit from their decline. Even modestly outperforming long-only investors can produce substantial compounding benefits for traders using the 130/30 strategy over time.

A second major benefit is being able to profit during bear markets, since short positions gain value as an equity declines. While long-only investors must wait on the sidelines for a market recovery, those using the 130/30 strategy can hedge their portfolio against a market decline and even profit in some cases. These dynamics can improve overall risk-adjusted returns over time.

After all, Wall Street’s prime brokerage business has been largely powered by the growth of hedge funds, partly due to their profitability using short positions. Short selling and the leverage it employs may be a double-edge sword, but competent managers employing tried-and-true strategies may be able to generate consistent alpha over time, just as many hedge funds have managed to do.

Who Should Use the 130/30 Strategy?

Many traders can benefit from the 130/30 strategy given its unique neutral market exposure and relatively risk-free nature compared to traditional short selling. In some ways, the 130/30 strategy provides Main Street investors with a way to access strategies that have been the hallmark of hedge funds – which have been limited to high net worth individuals due to their riskier nature.

Some market participants that could benefit include:

  • Long-Only Investors. Investors seeking to increase diversification and return potential by expanding into short selling without the traditional risks associated with short-only or short-heavy strategies.
  • Foundational Investors. Investors looking to build exposure to a diverse number of large-cap U.S. companies may benefit from exploring the 130/30 strategy as an alternative to simply purchasing low-fee funds.
  • Tax Advantaged Accounts. Investors that don’t want to incur current year taxes on frequent trading—typical for 130/30 strategies—may want to consider avoiding the strategy to save money.

Some popular mutual funds and ETFs utilizing the strategy include:

Fund NameTicker SymbolAssets ($M)Expense Ratio (%)
ProShares Credit Suisse 130/30 ETFCSM$373.97M0.95%
Wilshire Large Cap Core 130/30 FundWLTTX$204.61.61%

Risks and Other Considerations

The majority of 130/30 funds became popular during 2007, just before the credit crisis made short selling enormously difficult and expensive. Since then, the number of 130/30 funds has thinned out significantly and the remaining funds have been struggling to recover from the crisis. Traders and investors should carefully consider their risks before making any investment decisions.

Be sure to check out the Top 50 Twitter Accounts Traders Should Follow.

Some key risks and considerations include:

  • Limited Track Record. Most 130/30 funds have a very limited track record, since most of them began back in 2007. The majority of funds that began then also ended up folding due to the 2008 economic crisis.
  • Efficient Market Hypothesis. Many long-only investors believe that minimizing fees represents the only way to generate long-term alpha, proven by the fact that most fund managers underperform the major indexes.
  • Leverage Increases Risk. The use of leverage increases volatility in most cases, which leads to a higher beta-coefficient and greater risk. These levels of volatility are important for investors to consider.
  • Higher Fees & Turnover. Most 130/30 funds use active investment strategies, which means that they tend to have higher turnover (bad for tax purposes) and greater expense ratios than index mutual funds.

The Bottom Line

So-called 130/30 funds have had a rough start since they became popular in 2007, but the survivors from that time provide traders and investors with a unique opportunity. By taking both long and short positions, the funds act similar to hedge funds in their ability to generate leveraged returns and protect against downside risk, but choosing the right manager remains more important than ever.


– Protective Put Options Strategy Explained

Successful investors are just as concerned with managing risk as they are with maximizing returns. After all, the primary goal for investors should be maximizing risk-adjusted returns rather than total returns. Stock options provide a great way to help manage risk with their tremendous flexibility and controllable costs. In particular, protective puts are widely used to help limit downside risk.

In this article, we’ll take a look at the protective put options strategy, dynamics of the trade, and some important risks to consider.

Be sure to also read Options 101: American vs. European vs. Exotic.

What Is a Protective Put?

Protective Put diagrame
Source: The Options Guide

Protective puts are simply long put options backed by shares of the underlying stock. While setting a price floor in the event that the underlying stock falls, the options strategy permits investors to retain unlimited upside potential. The only catch is the premium paid for the long put option, which adds to the cost basis of the aggregate stock and option position in a given security.

For example, suppose that an investor purchases 100 shares of ACME at 100.00 per share. The investor decides to limit his or her downside by simultaneously purchasing a long put option with an 80.00 strike price and a 5.00 premium. If the stock falls to 70.00, the investors can still sell the position for 80.00, although the cost basis for the entire trade is now 105.00 per share.

If you’re sitting on a losing trade, be sure to also read Don’t Fret, Salvage Your Losing Position with Options.

If the stock rises significantly, the investor can sell the put option to recoup some of the premium paid, although the option trade will still result in a loss. The option will eventually expire, however, requiring the investor to either give up the downside protection or purchase a new long put option to regain protection. When near-term options are sold to purchase long-term options, it’s known as rolling out the trade.

Example Usage

Suppose that an investor owns 100 shares of AAPL at $100.00 in January. After hearing about some potential production issues, he or she decides to enter into a protective put by purchasing a put option that expires in April with a 100.00 strike and a premium of $400.00. The option insures the long stock position against a possible crash, setting a floor at $100.00 per share.

Now, let’s take a look at three possible scenarios:

  • Apple Falls from $100 to $50. At $50.00, the long stock position will suffer a loss of ($100.00 – $50.00) x 100 = $5,000, but the option position will have an intrinsic value of $5,000 and could be sold for that amount. Including the $400 option premium, the net loss would be $5,000 – $5,000 + $400 = $400.
  • Apple Rises from $100 to $150. At $150.00, the long stock position will gain ($150.00- $100.00) x 100 = $5,000. Excluding the $400 premium paid for the put option, the investor’s net profit would be $5,000 – $400 = $4,600.

In essence, the protective put strategy capped the investor’s losses at $400, while leaving unlimited room for upside potential. The doubling of Apple’s stock to $200 per share would still be offset by only a $400 premium paid for the put option. On the downside, Apple’s stock could sink to $5.00 per share and the investor would still only lose $400 in the premium paid for the put option.

See also 4 Ways to Exit a Losing Trade.

Risks and Considerations

A protective puts is one of the most conservative options strategies available, since investors know exactly how much they could lose at the onset. As a result, there are very few risks associated with using the protective put strategy, although there are a few important considerations to take into account:

  • Commissions – The calculations in the example above didn’t account for the cost of commissions. While these figures are usually minimal, they can add up over time and should be carefully considered.
  • Breakeven – Protective puts raise the bar for a stock position’s returns in order to achieve profitability. Investors using longer term protective puts may experience higher breakeven points for profitability.

The Bottom Line

Protective puts are a great way to protect an existing stock position against downside without sacrificing much in the way of upside. While the strategy is rather straightforward, investors should carefully consider the breakeven dynamics and ensure that the upside they are sacrificing is acceptable given the risk of decline. Properly used, the strategy provides a great addition to any investor’s toolbox.


Quad Witching – What is Quad Witching?

Quadruple witching refers to the third Friday of March, June, September, and December, when stock index futures, stock index options, single stock options and single stock futures expire at the same time. Traders must offset, close, rollout or deliver on their positions, which creates above-average volume and volatility during the last hour – or witching hour.

For example, more than 10 billion shares traded hands on Friday, September 21, 2018, which is about 65 percent higher than the three-month average. The prior quadruple witching on June 15 similarly saw a 75 percent increase in trading volume to 3.5 billion shares. Despite the large amount of volume and volatility during these sessions, the S&P 500 was little changed in both cases – the event is temporary in nature.

Let’s take a closer look at the quadruple witching phenomena, how it impacts investors, and what it means for your portfolio.

Check out our News section to keep up with market-moving events like quadruple witching.

Quadruple Witching 101

The origins of “witching” are unknown. Some experts suggest that it may have originated from the three witches in Shakespeare’s Macbeth. Others believe that it may simply refer to “witchcraft” in the sense that the high level of volume and volatility can seem surreal at times.

The “quadruple” prefix stems from the fact that there are four different types of contracts expiring at the same time: Stock index futures, stock index options, single stock futures and single stock options. As you might guess, “double witching” and “triple witching” refer to two and three contracts expiring at the same time, respectively.

Quadruple witching occurs on the third Friday of March, June, September and December when all four contracts expire at the same time. Equity volume and volatility tend to be much higher than double or triple witching days, but any witching sessions still have above-average volume and volatility compared to average market sessions.

The last hour of trading on a quadruple witching day is known as the “witching hour” – a time when most of the volatility and volume occurs.

What Happens During This Time?

Quadruple witching is characterized by wide-scale portfolio rebalancing ahead of and following contract expirations.

Traders holding in-the-money options experience automatic transactions between buyers and sellers. For instance, a call option is usually written against stock in the seller’s portfolio. If the option expires in-the-money, this stock is called away at the strike price and sent to the buyer.

In some cases, traders may want to avoid assignment and roll-out their contracts. A futures trader holding S&P 500 E-mini contracts that are in-the-money may rollout the contract to the next month to avoid delivery. Traders may also close out these contracts by settling the difference with the buyer.

Arbitrageurs take advantage of pricing discrepancies that arise when large blocks of contracts influence the price. Since these movements are driven by temporary supply and demand rather than fundamental change, there may be an opportunity to purchase stock at a discount or sell stock at a premium.

Learn more about other trading strategies by visiting our education section.

How Does It Impact Traders?

The impact of quadruple witching depends on the individual trader and their portfolio.

Quadruple witching primarily impacts the equity market, but the volatility can spill over into other markets. For example, an unexpected change in U.S. trade policy could cause a sudden market decline and trigger unexpected losses in stock index futures – and that could prompt investors to sell assets in other markets to cover those losses.

Long-term investors don’t have to worry about quadruple witching since there is very little long-term impact. The temporary volatility is evened out by arbitrageurs and the long-term price trends remain intact. As a result, investors usually tune out the news and focus on their long-term goals rather than watching the short-term volatility.

Short-term traders should be cognizant of the above-average volatility, which can prematurely trigger stop-loss orders. In addition, there may be short-term arbitrage opportunities in some markets to consider, although institutional investors tend to capitalize on these most efficiently.

The Bottom Line

Quadruple witching refers to the simultaneous expiration of stock index options and futures, as well as single stock options and futures, on the third Friday of March, June, September and December. These days are characterized by above-average volume and volatility that can impact short-term traders.


Etf Pairs Trading – Search Results Web results How to Use a Pairs Trading Strategy with ETFs

One of the most basic tenets of investing with which every trader is familiar is to buy low and sell high. This simple foundation is the basis upon which nearly every type of stock trade is built. But it’s not as easy to execute in the real world as it sounds.

Buying low and selling high requires that you know when an asset is actually underpriced or overpriced. Accurately guessing which direction an asset will go – whether it’s up or down – can be difficult thanks to the volatility inherent in the financial markets and the unpredictability of traders themselves.

One method traders use to hedge their bets, and eliminate uncertainty regarding asset price direction, is pairs trading. The method is based on finding two assets that are highly correlated with each other; whichever direction one asset moves in, the other will follow suit. One example is the relationship between the Dow Jones Industrial Average and the S&P 500 Index. These indexes generally move together, making them highly correlated. In pairs trading, investors look for arbitrage opportunities when prices begin to diverge, presenting an opportunity for profit without needing to know in which direction the assets are headed.

Pairs traders buy the lower priced asset while simultaneously selling the higher priced asset. Eventually, whatever caused the imbalance will right itself and bring the two correlated assets back into sync with each other. In this manner, traders don’t have to worry about individual direction – rather, they’re betting on the assets becoming correlated again.

ETF Pairs Makes it Easier to Find Arbitrage Opportunities

The proliferation of Exchange-Traded Funds (ETFs) means that investors have many more opportunities to find highly correlated asset pairs that have deviated in price. The appeal of a pairs trade is that overall market direction doesn’t matter as much as the correlation between the two assets. That makes it a relatively low-risk trade that can be repeated any time two correlated assets become disconnected for a brief period of time.

Let’s use two gold ETFs as an example. Take a look at the performance of the SPDR Gold Shares ETF (GLD) and PowerShares DB Gold ETF (DGL).

GLD Chart Analysis

Notice how both ETFs tend to trade along the same path most of the time. Both track the price of gold bullion and are highly correlated ETFs. However, notice how they occasionally diverge from one another. To initiate a pairs trade on these ETFs, all you would need to do is place a buy on the lower priced ETF and sell short the higher priced ETF. You would profit on the difference between the two ETFs regardless of the overall performance of gold itself.

Let’s say you sold short 100 shares of GLD in late February at $116 and subsequently bought the price equivalent worth of shares in DGL. To simplify our example, we’ll say that it equates to $115 per share. Now, it’s irrelevant that both ETFs fell a week later. If you sold both when they matched up again at $110 per share, you would have a profit of $6 per share in GLD and a loss of $5 per share in DGL. That means that even though gold itself and the ETFs fell in value, you would’ve earned $100 on the trade.

It’s easy to see why pair trades are appealing. By utilizing this strategy, traders can completely disregard price direction and market uncertainty. The only unknown to deal with is how long the two ETFs will trade out of balance. Generally, similar ETFs like GLD and DGL won’t stay divergent for long. A month will likely be the longest you’ll have to wait.

Trading similar ETFs that track the same index isn’t the only way to profit from a pairs trade. Trading sector ETFs can be another good way to capitalize on pricing inefficiencies. With the upcoming interest rate hike, an opportunity to pair the utilities sector and the financial sector could prove profitable. Utility companies are generally highly debt-leveraged entities and therefore extremely sensitive to interest rate changes. Banks and other financial companies, on the other hand, should see higher margins as long-term rates on loans go up. An investor who wanted to pair trade this possibility would short sell the SPDR Utilities Select Sector Fund (XLU) and buy the Financial Select Sector SPDR (XLF).

Timing trades according to the business cycle may result in a much longer time frame though, so risk is higher with this type of trade. It’s important to keep track of sectors that tend to trade opposite each other so you know as one sector rises, the other will fall.

Reducing Risk With Pair Trades

Ultimately, the pairs trade is about correlation rather than performance. ETFs allow you to trade indexes, stock sectors, commodities, currencies, and virtually any other type of asset class so long as there’s an ETF that tracks it. Watch for high positive or negative correlations between two ETFs and analyze how they’ve performed against each other in the past to see if there’s a long-term trend you can trade off of. Once you’ve established a pair, you’ll be able to hedge your investments and profit from arbitrage strategies without needing to accurately predict the direction of the market.


Types Of Technical Indicators – Choosing the Right Type of Technical Indicators

When it comes to investing, we use a ton of different metrics to derive a stock’s value.

Digging deep into a firm’s balance sheet and checking sales, debt levels and a variety of other information are used to create statistics like P/E or PEG ratios. We can use this to compare various stocks across the board.

The thing is, none of these metrics work when it comes to trading.

That’s because trading is all about the short-to-medium term. Traders rely on a different set of indicators and metrics to determine whether or not to buy or sell a stock or options contract. And these indicators are very different than what we use for more traditional buy & hold investing.

But how do you know your Bollinger Band from your MACD? How do you choose what indicator is right for your portfolio and needs? Luckily, here at TraderHQ, we’ve done some of the legwork for you. Here’s our quick guide to choosing the right technical indicators.

Click here to visit our Trader University section where we put up relevant educational pieces specifically geared toward traders.

A Focus on Signals & Charting

Perhaps the biggest difference and what gets a lot of investors into trouble when they start trading is that we aren’t looking at fundamentals. A firm’s sales, price or other “value” determining metrics are pretty meaningless when it comes to trading. What we are really looking for are signals that will determine a stock’s movement in the short-to-medium term. It doesn’t matter if a stock’s P/E is a screaming bargain if the signals are not there to move it higher. All in all, technical indicators are mathematical calculations that can be applied to a stock’s past performance to help determine its future position

To that end, successful investors-turned-traders need to switch up their thinking and focus on these short-term signals. And they basically come in four flavors: Momentum, Trend, Volatility and Chart Studies. Individual indicators under these categories can either be leading, which predict a future pattern, or lagging, which can be used to conform and ride a trend.

Besides normal trading strategies, it is equally important to keep track of the broader market via different types of economic indicators. Click here to have a broad idea about these indicators.

To start, momentum indicators are used to determine the speed of price movements over time. Like Isaac Newton said, “objects in motion tend to stay in motion.” This is true for stocks. Stocks that are moving higher or lower will generally keep that pattern for some time. Momentum indicators like Stochastic oscillators and the Relative Strength Index (RSI) tend to be leading indicators, in that they predict the pattern of movement.

Trend indicators are designed to measure the direction and strength of a stock’s price. After establishing a baseline, trend indicators such as the 200-day moving average can be used to see if a stock is moving higher or lower. For example, if a stock breaks through its 200-day MA, it can be thought of as a bullish sign for future movement. A stock’s Moving Average Convergence Divergence (MACD) seeks to quantify this movement down to a signal number – above zero and the price trend is likely up. Below zero and the opposite is true. Traders can base their buying/selling decisions on that number.

Volatility is a measurement of the magnitude of price fluctuations over time. Basically, you’re looking at how far a stock will move in either direction. And that’s just what volatility indicators are trying to do. You’re looking to see how much a stock is moving relative to its past performance or broader index. For example, Bollinger Bands measure the highness and lowness of a stock’s volatility to create a range. Breaking through this range tends to indicate a new pattern of highs and lows.

Finally, traders rely on charts to determine indicators for future movements. Charts can be helpful in measuring volume of shares traded or finding patterns in trend lines. The very popular Fibonacci series of charting techniques uses volume patterns within a chart to show break-outs and drop-offs in a stock.

A Combination of Indicators Is Critical

Certainly, there are traders who only specialize in one of these major indicator categories or sub-metrics. However, the best traders often use a few different indicators to place their bets and optimize their performance. The key is making sure you don’t choose redundant indicators.

Given the four basic varieties of technical indicators choosing two signals from the same category will produce similar results. Both stochastics and RSI metrics tend to predict the same thing with slight variation. Running both on a stock may not produce different results and that could lead to confirmation bias and a bad trade. It’s best if traders pick one or two indicators from different categories to provide a correct signal for the trade. Complementing indicators is the best way to help fight redundancy.

Want to know more about trading indicators? Check our trading indicators section here.

A prime example of this could be combining RSI, Bollinger Bands and MACD for a stock. Here, the relative strength index can be used to gauge a firm’s momentum, up or down. The Bollinger bands look to see the volatility of the stock’s price movements. Has it been more volatile lately and broken through its trading range? Finally, comparing this to its 50- and 200-day moving averages can underscore future price/movement trends. The following chart of beverage firm Coca-Cola (KO) shows the three indicators in action and you can see how KO has trended higher across all three metrics.

Coca Cola Indicators
Source: Stockcharts.com

The Bottom Line

Unlike investing, trading comes down to indicators. It’s all about whether or not a signal has gone off to support a movement higher or lower. And there are a variety of different signals to choose from. The key is for investors to find complementary metrics to confirm a trade. Picking one from each major category is what separates the just-ok traders from the good ones. Helping fight redundancy in the signals is what makes for profitable trades.


– What You Need to Know About Sentiment Indicators

Most long-term investors focus on a company’s growth and valuation when making decisions. By contrast, most short-term traders are focused on emotion when buying and selling stocks. The effects of emotion can be seen in everything from long-term chart patterns to short-term order books. Sentiment indicators help gauge the market’s mood at any given point in time to put prices into context.

In this article, we’ll take a look at some common sentiment indicators and how traders can use the information to gain an edge in the market.

Be sure to also see the 10 Market Indicators Every Trader Watches.

Sentiment Indicators

man running against the trend

There are many different ways to gauge the market’s sentiment, depending on the metrics measured to questions asked. For instance, the put-call ratio looks at the market’s expectations for the future based on options contracts, while many different surveys assess the market’s mood by asking questions. Traders should be aware of the major sentiment indicators and the direction they’re pointing.

CBOE Put-Call Ratio

The put-call ratio measures the volume of put options relative to the volume of call options traded over a period of time. When call options outpace put options, the ratio signals a bullish attitude in the market and vice versa. The key turning point for the ratio is 1.0x, where anything above that level is considered to be bearish and anything below that level is considered to be bullish.

Traders should keep an eye on both the ratio itself and trends in the ratio over time that could signal a reversal in trends. For example, a negative reading of 1.1x might be considered bearish unless a trader looked back and saw that the number actually moved down from a prior reading of 1.6×. In that case, the trader may take a bullish position in the market in anticipation of the trend continuing to reverse.

See also Trend Reversals: How to Spot and How to Trade.

AAII Sentiment Survey

The American Association of Individual Investors (“AAII”) survey measures the percentage of individual investors who are bullish, bearish, and neutral on the stock market over the next six months. With a weekly survey of AAII members (one vote per week per member), the poll provides a detailed picture of both short-term and long-term sentiment, as well as changes in the survey data over time.

As with the put-call ratio, traders should watch for changes over time in the AAII survey rather than individual readings in order to gain the greatest insights. Reading the actual surveys is self-explanatory with higher bullish percentages being more bullish for the market and vice versa. Traders can also access data going all the way back to 1987, which provides useful data for further analysis.

NAAIM Exposure Index

The National Association of Active Investment Managers Exposure Index represents the average exposure to U.S. equities reported by members. While the NAAIM warns that its index isn’t intended to predict future price movements, traders commonly use the index to gauge interest in equities over time. Managers also use the data to provide insight into the actual adjustments active risk managers are making.

In general, higher levels of equity participation indicate a bullish sentiment in the overall market. When equity participation starts to decline, it’s a sign that investment managers are starting to reduce portfolio risk, which could be due to a predicted decline in the market. As with the other sentiment indicators, traders should look at trends over time rather than any individual reading.

Investor Movement Index

TD Ameritrade’s Investor Movement Index™ is a proprietary, behavior-based index designed to indicate the sentiment of retail investors’ portfolios by measuring what investors are actually doing. Using the data from a sample of 6 million funded client accounts, the index creates a valuable snapshot that can be monitored over time, compared to other indicators, and provide clues into current sentiment.

In general, increases in the IMX indicate that investors are becoming more bullish and vice versa for bearish scenarios. There are no bullish or bearish thresholds for the index, which means that traders should look at scores relative to other periods rather than analyzing a specific number. In addition to the indicator itself, TD Ameritrade provides an insightful commentary on changes in the index over time.

CNN Fear & Greed Index

The CNNMoney Fear & Greed Index looks at stock price momentum, stock price strength, stock price breadth, put-call ratios, junk bond demand, market volatility, and safe-haven demand to calculate the level of fear or greed in the market. The idea is that too much fear can sink stocks below appropriate levels, while too much greed can send them far higher than they deserve to be based on valuation.

See also Everything You Need to Know About Market Breadth Indicators.

In addition to providing an overview of readings over time, CNNMoney provides a detailed analysis on each of the components of the index on an individual basis. Traders can look at these indicators separately or in aggregate, as well as analyze the trends over time. Readings over 50 suggest a greedier market, while readings below 50 suggest a more fearful market environment.

Using Sentiment Indicators

Traders should use sentiment indicators as a small part in a larger trading plan, which should include indicators and other forms of technical analysis. Often times, traders will use sentiment indicators to determine the direction of trades and then use technical indicators or chart patterns to identify specific entry and exit points for their trades in order to increase the overall probability of success.

Be sure to also read the 7 Rules Every Contrarian Investor Must Follow.

The Bottom Line

Sentiment indicators help traders quantify the market’s overall emotion and sentiment. Using these indicators, traders can get a sense of overall market direction, while using other technical indicators to identify specific entry and exit points for trades.