Trend trading guidelines, part III
This lesson will cover the following
- General thoughts on trend trading
- Why you shouldn’t go against the market
- Adequate reward for your risk
- Pullbacks that might not come
Regardless of the types of trading signals a trader chooses to rely on, he must always take advantage of strong trends and swing at least part of his position. What is most important, however, is not to try to fade strong trends, as only a small number of people can do so successfully and the average trader must accept that he is not one of them.
Counter-trend positioning during strong trends is an easy way to lose money with each trade and, upon revisiting your daily result, to be surprised by how much you’ve managed to lose. Everyone knows this, but only experienced traders can resist the temptation to go short at each new high. Novice traders will be lured into shorting each high, knowing that trends have pullbacks. They think they can at least scalp short and then buy at the bottom of the pullback. However, when the pullback actually comes, they are afraid to buy because the buy set-up does not look so strong and they fear the trend may reverse into a bear trend.
And because, as we’ve mentioned before, reversals succeed in only 20% of attempts and otherwise become with-trend flags, experienced market players stick to their with-trend positions and even add to them as a pullback progresses.
During strong trends, a bull trend for example, many traders like to buy on breakouts above prior swing highs. Although this is a sound strategy, buying a pullback before the breakout yields a better profit and carries less risk. The most common problem with entering on a pullback is that traders do not know exactly when it will end and when the price will reverse back in the direction of the trend, so they hope for a deeper or better-looking pullback. To protect himself from missing out on profits during a strong trend, a trader should place a buy stop above the previous swing high. This way, if the pullback is very short and the trend resumes quickly, the trader immediately joins the long side.
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After the trend has continued for a while, it will eventually begin to exhaust no matter how strong it was. As it becomes weaker, pullbacks will become larger and longer, setting the stage for a trading range. As soon as the sideways trading sets in, the strong bulls will begin to lock in profits above the swing highs instead of extending their positions. Meanwhile, the strong bears, who have until now refrained from shorting, will begin to scale into short positions.
However, an increasing number of shorts cannot be the sole reason to believe that the current trend has ended or is about to do so. It is only after there has been a decisive bear move that breaks below the bull trend line that you can be fairly convinced the bears have taken control. Even that might not be decisive in some cases, because you can often see a trend-line break that reverses and retests the trend’s high.
Adequate reward
In strong trends, traders should ideally swing part of their positions, taking profits along the favourable market movement, and then return to a full position on each pullback. However, many traders are unable to do that. Instead, it may be easier for them to enter early with a full position and scale out along the way, without adding to their position.
It is very important to scale out of the trade and take profit at certain points, so that you protect yourself from an unexpected trend reversal. However, this does not mean you should exit with too small a reward. After all, you put yourself at initial risk when entering the market and should feel compensated for taking that risk, without becoming greedy.
For example, if a trader enters the market long and his protective stop is 20 pips below his entry, you often see people scale out – perhaps a third of their position – as soon as the market rallies 20 pips, then remove another third after a further 20-pip rally, leaving the final third of the position in the market until a strong sell signal occurs.
During a strong trend, however, the situation generally allows you to aim at a higher profit target for the first scale-out. It would be better if that trader waited until the market advanced 40 pips, or twice his initial risk, before locking in his initial profit. You should always try to resist taking profits too early when the trend is good and aim for a risk-to-reward ratio of 1:2. Of course, if the market presents you with a very strong buy signal, you can always add to your positions, but deviating from a predetermined plan in the course of trading is not advisable for novice traders.
Remember that repeatedly scaling into a trade bears the risk of making your position too large and, because that is done in small portions, you might not even realise the scale of it before the market reverses and you suffer losses.
Once you’ve determined the market is trending and you’ve decided to enter with at least a small portion, you must place a worst-case protective stop that measures your initial risk, which is usually quite wide at the beginning. If the market moves in your direction, you need to tighten that stop; this then allows you to add to your position if you see a strong signal. However, it is crucial to remember that by scaling in, you must not exceed your normal level of risk, thus you must not allow your position to become too large, as we mentioned in the previous paragraph.
Pullbacks can be elusive
As the market edges higher, the majority of traders expect it will pull back soon, especially at new highs. We said earlier that newbie traders constantly lose money by betting on reversals at highs in strong trends, but those pullbacks don’t come. Here is why.
As the trend grinds higher, smart traders begin to buy in pieces. Their risk exposure is a move to the bottom of the spike; therefore, if – let’s say – it is twice their normal risk, they will enter with half of their usual size to keep the risk within their normal limits. As the smart bulls continue to buy near the tops, this sustains the buying pressure, which tells the smart bears that the market is moving up. There is no point in going short now if they believe they can short after a few bars at a higher price. This makes the market one-sided and it edges higher instead of pulling back. You need to be doing what the smart bulls are doing – buy a small amount at the market or on a small pullback and risk down to the bottom of the spike.
Even if the price pulls back right after you’ve added to your position, you shouldn’t worry. When everyone wants to see something – in this case a pullback – the move will be very short, because all the market players who have been waiting to buy will immediately hop in at the pullback and drive it back up. This will make your position profitable once again in no time. Once the market then advances in your favour, you can look to scale out, or alternatively you can buy more on another pullback, which will be higher than your initial entry.