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THE TRADING BOOK COURSE
A PRACTICAL GUIDE TO PROFITING WITH TECHNICAL ANALYSIS
By ANNE-MARIE BAIYND
The McGraw-Hill Companies, Inc.Copyright © 2013Anne-Marie Baiynd
All rights reserved.
From this moment forward, I'd like you to focus on the fact that no matter how well it is executed, even the best trading strategy and plan will yield marginal to poor results if the market environment is not favorable. This is the reason they cancel baseball games because of downpours—and if baseball professionals don't play in a downpour, why should we? Our goal, then, is to develop the ability to determine the likely weather before setting out to play the game. Recognizing the appropriate environment in which to trade is the secret to repeatable success—it minimizes the likelihood of random aberrations in price that will knock us out of the trade. Appropriate environments in which to trade have a "look," and we'll walk through these environments to show where you can make the best trades in the most likely space for success.
Let's recap my favorite technical indicators with a short note of what we traditionally look for and events that customarily trigger trades.
The most important technical indicator we have at our disposal is price (see Figure 1.1) —and, oddly, it is one of the most often overlooked. The goal here is to spend more time looking at price action and what it means for our trades. Here is the simplest and most important thing needed at the onset of a trade: a trend needs to be present. For our momentum trades, we must see a discernible pattern of either a series of higher lows and higher highs or a series of lower lows and lower highs. Simple, yes, and no doubt you already knew that, but in my experience, most traders ignore the need for a real trend to be established before they take a trade. If you cannot see a trend clearly within the time frame of your choice, there is no high-probability trade present. The more you pay attention to candlestick development and how it relates to the overall chart and the trade, the greater your chances for a successful trade.
THE MOVING AVERAGES
See Figure 1.2 for an example of moving averages. The general rule is, if the chart has a slope and the candlesticks are printing above the moving averages, the best side of the trade to be on is the long side or the buy side, and if the chart has a slope and the candlesticks are printing below the moving averages, the best side of the trade to be on is the short side or the sell side. This is only a general rule and must be confirmed through the use of other events and indicators.
Specific Moving Averages
The 8-period exponential moving average (ema) is best used when trading a very aggressive move in either direction. My decision to move is based on a crossover of the candlesticks and the moving average. If the candlesticks move above the 8-period ema, I will be looking at a long setup, and if the candlesticks move below the 8-period ema, I will be looking at a short setup. Again, this is a general rule, as all of the rules given here will be, but I stress this because many inexperienced traders just look for the event and do not consider the surroundings. We must consider the surroundings.
The 20-, 50-, and 200-period simple moving averages (smas) are used, to varying degrees, in the same way we use the 8-period ema, but both the slopes of these averages and their location become quite important when we are looking for ideal conditions. If, on the time frame in which you choose to trade, you see the 20-, 50-, and 200-period smas with flat slopes and intertwined, this is not a place to execute— that would be the hallmark of a rainy day. If there is a time where the 20-, 50-, and 200-period smas converge and cross, this is usually a place to stage a trade in the direction of the 20-period sma break. Where the 20-period sma goes, you should follow. You can use this technique with weighted, exponential, or any other type of moving average—the guidelines are the same.
Your decision whether to use an exponential or simple moving average is one of choice. Some traders focus on the simple moving averages only, and some are more inclined to use the exponential moving averages. Many people ask what differences exist between these two types of averages, and why we might use one over the other. A simplistic answer is that exponential moving averages "weigh" the candles that are closer to the current price and thus make them more important, whereas a simple moving average weighs each candlestick equally. If a chart begins to show rapid acceleration either to the upside or downside, we may want to use the exponential average if we want to use a moving average to provide a tight support region for the trade. Conversely, if my near-term candlesticks have very long wicks or large range bodies relative to later candlesticks in the string of candles, we may NOT want to use the exponential as it will tend to be further away from the candlesticks than the simple moving average. Most of us don't think about moving averages with that level of granularity, but on occasion knowing how these averages are calculated can benefit the trader. For me, I tend to enlist the help of an exponential average only when the maket action has high levels of acceleration—meaning the candlesticks begin to move rapidly away from the current moving averages I have on the chart—otherwise, I will stick with the simple moving averages.
Recent market volatility has caused me to abandon the 8 ema for the most part as crossovers can quickly reverse. How can you tell if the market activity is too volatile to use the 8 ema? By counting how many times the candlesticks cross over the moving average—if you find that you are crossing over too many times and you are forced in and out of trades (thereby ensuring death by a thousand cuts), the 8 ema is inappropriate. It could also be that you are trading in an enviromment that is not trending.
THE BOLLINGER BANDS
I have adjusted my settings for the Bollinger Bands (see Figure 1.3) from the last writing; they are now 20-period sma, 2.75 standard deviations (sd). That makes the band a little wider and opens the door to measuring and capitalizing on volatility breakouts in a better way. When using Bollinger Bands, remember that the more time your candlesticks print outside either the upper or the lower band, the more likely it is that a reversal is afoot. If a trade begins when price is so extended that it sits outside your bands, it is often a bad trade. Bollinger Bands give us a series of potential trading events in the following way: the bands contract tightly (this is called a volatility squeeze and simply means that the price action and distances between the highs and lows of the candlesticks are in a tight range) and then begin to expand. As they begin to expand, a trading opportunity often exists in the direction of the candlestick break. There are times when this expansion is a false signal to move—we'll come back to that later. Bollinger Bands are also useful when trading wide sideways channels, with the event to observe being the test and rejection of either band and a move into the other side of the band. I'd recommend that sideways channels be traded only by those who have significant command of the trending trade, as timing is very important with these sideways setups.
Volume is a simple consideration—the more of it there is, the more enthusiastic the crowd participation is (see Figure 1.4). High volume does not always mean a breakout or a breakdown, nor does it always mean continuation. All it means is participation. I will freely admit that I have made unwise decisions to enter into a trade based on volume and
Excerpted from THE TRADING BOOK COURSE by ANNE-MARIE BAIYND. Copyright © 2013 by Anne-Marie Baiynd. Excerpted by permission of The McGraw-Hill Companies, Inc..
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