A key to weathering – and potentially profiting from – a market correction is planning and implementation.
Market Timing Strategies
By Brian Bachelier, Vice President Active Trader Strategy
Spotting a market trend and finding the right time to get in and out of it are both part of an active trading strategy. Successfully achieving those goals requires you to find a trade setup that conforms to your rules, determine an entry point, know the right amount of funds to apply to your trade, and exit without taking a loss you’re unprepared for.
According to the Dow Theory, there are three stages in a market trend:
- Accumulation – the beginning period of a new trend (and the ending of the previous trend) during which experienced traders sense a coming improvement in underlying fundamental conditions.
- Steady Advance – the period when other investors catch on to the new trend in progress and the trend continues.
- Distribution – the end of a trend when the first comers begin distributing their shares to other traders who were late to the party.
So what are the keys to helping you get in during the accumulation stage and out during distribution? Again, there are three: use a signal you trust, have the tools you need to interpret the signal correctly and be disciplined enough to act on your signal rather than your emotions.
Finding Momentum Signals Early in the Trend
To catch a trend at its beginning, you’ll need to be aware of momentum changes early in their development. Traders can identify and gauge momentum changes in a variety of ways including using reversal signals, Connors RSI or sector trends indicators.
A 3-bar reversal up or down can signal the beginning of a new trend and, if you’re ready to trade off the reversal pattern, help you get into the trend at its early stages. While 3-bar reversals are very short-term signals, and though the trader won’t know this at the time, they can potentially coincide with the beginning of a more significant move in the market.
Connors RSI combines several key technical components to create a momentum oscillator that can be used to spot overbought and oversold conditions for a stock or index. Those overbought or oversold conditions could be the first step to a stock or index changing directions.
Using a combination of widely used formulas such as standard deviation, moving averages and average true ranges, the sector trends formula identifies momentum and, by normalizing the average true range of the underlying index or stock, provides a measurement of the trend’s strength. Knowing the trend strength can help you determine how viable a trend is and whether or not you want to enter the trade.
Confirming Trends with Moving Averages
A moving average trading system is one of the most popular methods traders use to confirm trends. Because moving averages are designed to smooth out random price fluctuations during a volatile market, they can be used to validate that a true trend exists. Traders who use moving averages might sell when a stock’s price falls below the average and buy when it rises above the average. Other moving average systems trigger when one moving average crosses over another.
Note: Moving averages are trend-following indicators that can help you identify upward or downward movement, but it’s important to keep in mind that trend-following indicators don’t have much value in a sideways market.
Establishing Your Exit Point
There are two components to consider when you’re building an exit strategy:
1. Where will you get out if the stock doesn’t move in your favor?
2. Where will you lock in a profit if the stock does move in your favor?
When a Stock Moves Against You
When you enter a new position, it’s crucial to have a plan for what you’ll do if the position goes south. If your plan includes knowing how much of a loss your trading portfolio can withstand and a predetermined exit point, you may be less likely to make emotional trading decisions in the heat of the moment.
One way to plan for stock moves against your favor is with a stop-on-quote or “stop-loss” order. When you enter into a position, you can set a stop-loss order that will trigger a sell order if the share price of your stock drops to a certain price.
When a Stock Moves In Your Favor
The old adage “what goes up, must come down” is an important one to keep in mind while you’re trading. The lesson to take from it is that your exit strategy needs to include a plan for capturing your profits without putting your portfolio at risk; it’s not just about limiting losses.
For a position with upward momentum behind it, you may be able to lock in a profit with a sell limit order. With a limit order, you set the price at which you’re willing to sell and your order only executes if the market reaches the specified price or higher.
Connecting the Dots
Each trader finds new opportunities a little differently. From reading different news and preferring different indicators to having different overall goals, there are a lot of variables when it comes to a trading system. But one consistent factor across all trading plans is the need for top-of-the-line tools that can give you an edge on the market.
Our most advanced trading platform, ScottradeELITE, was designed specifically to provide that edge for your trading strategy. Sticking with the examples we used above, ScottradeELITE would help you quickly scan the market for any stocks nearing reversal signals using an Advanced Scanner, measure the momentum behind the stock with our Sector Trends tool, and confirm the trend using our sophisticated charting package. And the best part is that you can do all that research in seconds with a linking feature that connects your research tools based on the symbol you’re evaluating.
Brian Bachelier has been with Scottrade for more than 15 years and is currently managing the active trader client experience. As a trader himself, Brian continually looks for ways to improve Scottrade’s active trading resources and help offer our clients a competitive edge in the market.
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