It seems many traders and newcomers to the markets think that using sophisticated methods or expensive tools will help them make larger profits in the markets.
They could not be further from the truth. By keeping trading simple we can still extract sizeable moves in both bull and bear markets.
A very simple method which is often overlooked is the use of a Moving Average indicator. This tool is found in practically every piece of trading software and yet ignored or misused by the masses. Sometimes we fall under the spell of looking for the elusive and magical formula which just does not exist. What we should focus on instead are the following five factors:
1. The major trend
2. The current direction within the major trend
3. A low risk entry point
4. Risk management
5. Trade management
Let’s first take a look at the following chart which is a MONTHLY chart of the FTSE 100 index.
If you look carefully you will see that from the low of March 2003 to July 2007 the number of blue bars were more frequent than the number of red bars.
Straight away we can say that there were more up months than down months. Therefore the trend is clearly up or bullish.
Since July 2007 however we have seen more frequent red bars and also greater in size than the blue bars. Here we can conclude that the move to the downside is not only more frequent but also falling with more strength. We also know that markets tend to fall faster and deeper than rising markets.
So with this chart we can conclude that the major trend had been bullish from March 2003 until July 2007. Currently the major trend remains bearish.
The next step would be to see how the current trend fits into the larger degree trend and it is at this point that we would use Daily charts. The following chart shows the position of the FTSE 100 index on a daily timeframe and also we can see how the index had been declining for the majority of 2008.
We can now conclude that if the market is trending lower in two timeframes of which the longer term (monthly) and the shorter term (daily) charts are heading lower then we should only consider SELL positions within the market.
At this stage we can add a technical indicator such as the simple moving average to help us make a more quantified decision.
A simple moving average is created by calculating the average price of a security over a specified number of periods. One can create moving averages from the open, the high, and the low prices but the most popular moving averages are created using the closing price.
So for example: a 5-day simple moving average is calculated by adding the closing prices for the last 5 days and dividing the total by 5.
20+ 21 + 22 + 23 + 24 = 110
(110 / 5) = 22
Therefore if the current price of the market is above the 22 price level we can say the market is trading above its average price and therefore stronger and conversely when the price is below the 22 price level the market can be considered weak.
For trading purposes we would only consider short positions when the market is below the moving average and buy positions when the market is above the moving average.
To improve the odds of trading if the major trend is up then we should wait for the market to close above the moving average and buy to go long. And if the major trend is down then we would wait for the market to close below the moving average an initiate a sell order for a short position.
Using our example of the FTSE 100 index and adding a 20 period moving average we can see that there were many opportunities to capture profits during the recent decline of the market. The chart demonstrates
with the red arrows that the majority of the trades taken would have been profitable and some would have had minor losses. No single method will produce a winning trade every single time and this must be understood and accepted by traders and investors.
Not only did we stay on the right side of the trend but by keeping risk to a minimum and exiting the market when it tells us that it is on the wrong side of the fence we were able to manage trades respectively. This method works very well in trend markets but can result in choppy trading results during a sideways or trendless direction.
Of course money management and trade management are paramount to ones success and these factors should not be ignored.