Everything Begins With The Long Term Trend
Without getting into advanced theory or trading principles, the majority of all stock market trading action is divided into two primary trends. The main trend and the minor or the short term trend.
The main trend drives the predominant cycle of trading action and guides the overall direction of the movement of the asset. If you know how to identify the main trend you will know the direction in which to initiate your position.
The example below demonstrates the strong long term trend of NVDA stock.
One of the most important rules in trading is to trade in the direction of the main trend.
While this sounds very simple, a large percentage of beginners fail to follow this simple rule and end up paying a hefty price, since most assets revert back in line with the main trend after a short period of deviation.
How To Identify The Main Trend?
There are many different ways to gauge the overall trend of the asset being traded.
The first and one of the most commonly utilized methods of long term trend identification is with the use of the simple average indicator.
This indicator is available on every technical analysis program and simply averages the price data over time to show the overall trend of the market based on the number of days that’s entered.
Look For Subtantial Reduction Of Volatilty During The Inside Day Set Up
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Tail Gap Down Pattern
The strategy is a pullback away from the main trend that is accompanied by a gap. You can see several tail gap pattern set ups in this example of Sands Hotel stock. Notice that I'm only taking long tail gap trades because the long term trend is clearly up.
The tail gap set up usually lasts just a few days because I want to see the stock go back quickly in line with the trend. A reduction in volatility and trading range is not what I want to see after the set up is triggered with this set up. I like to see the stock get back in line with the trend within a few days of triggering the set up. You can see in a few examples on this chart how the stock falls very quickly back in line with the trend after trading higher after the set up is triggered.
The 50 day simple moving average is the most frequently used setting for this indicator and continues to be used by numerous large institutional traders and hedge funds to determine the overall direction of the stock market. You will find that hedge funds tend to sell stocks that are trading below the 50 day moving average and accumulate stocks that are trading above the 50 day moving average over time.
This is the same stock NVDA. This time it’s showing the 50 day moving average on the chart.
Notice, the majority of the time price trends higher, it remains above the 50 day simple moving average.
Another method of identifying the major trend is with the use of relative strength. Please don’t confuse relative strength with the RSI oscillator, they are not related.
Relative strength is a simply measuring the gain in all related stocks against each other to see which stock gained the most momentum over the same period of time.
Essentially, the stocks compete with each other and the one that gains the most strength over time is deemed to have the strongest long term trend.
Relative strength analysis is one of the newest forms of trend analysis and continues to gain popularity with institutional traders.
To perform relative strength analysis, you must compare the percentage gain over the 6 month, 3 month and 1 month time period to determine which asset gained the most over all three time periods.
One of the biggest reasons why relative strength analysis works well is because the assets performance is what drives the actual selection of the asset. In other words, performance of the asset will determine whether or not the asset will continue to outperform all others.
The logic behind relative strength is identical to professional horse racing.
The horse that has the highest performance typically holds the worst odds – since that particular horse has the best historic performance, which implies futures performance in line with the past.
Finally, the last and one of the simplest methods of identifying the long term trend is to find assets that are breaking the 3 month price high.
Typically, assets that are trading at or near the 3 month price high are demonstrating strong directional bias.
More importantly, the trend at this stage of the cycle is mature enough, that continued price movement in the same direction is expected over time.
If you try to use less time than 3 months, you run the risk of finding trends that are premature and are prone to collapse prematurely – this is called false breakouts and occurs when the predominant long term trend is premature.
Target The Short Term Trend
Once we identify the long term trend or the predominant trend of the asset that we’re targeting, it’s time to identify or target the short term trend.
The lowest risk entry opportunities occur precisely at the moment when the long term trend and the short term trend intersect.
This is the double trigger that we’re looking for!
Take a look at the NVDA chart below and notice the 3 circles.
Each of the circles represents the nexus between the short term pullback or the short term trend and the predominant or long term trend.
Notice, each time price pulls back against the trend for a few days, it reverts right back to the main trend and price continues trading higher, it’s really that simple!
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In a nutshell, there’s three crucial parts to all of this:
First, you have to identify very solid and stable long term trend. If the long term trend is not strong, the pullback may cause too much pressure on the asset and ultimately cause the long term trend to snap!
Second, you have to target short term trends that have a high probability of reversing back up. If the short term trend is too strong and powerful and drives too much momentum against the main trend, it may turn a simple pullback into a full-fledged reversal.
Third, you have to know exactly where to get in, where to place your protective stop loss and where to take profit each time you trade the double trigger pattern.
In summary, understanding the exact point in time when the long term and the short term trend intersect can offer investors powerful low risk trading set ups.