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In the investing arena, you will find investors whom you can call trend traders because they attempt to isolate trends and make money off them. There are actually several ways to do this. However, keep in mind that no single indicator will work all the time to make you rich since trading has many facets. One has to know about risk management and trading psychology, to name a few.
There are certain indicators that trend traders have found to be reliable over the years. Indicators are additions or overlays on the chart and by doing some mathematical calculations on the price and volume, they can provide extra information. The cool thing about them is they can predict the direction of the stock’s price.
1. The Relative Strength Index (RSI)
First on the roster is Relative Strength Index (RSI). It is data that analysts plot on a separate scale which would indicate momentum. You will find here a single line with a scale from 1 to 100 that identifies overbought and oversold conditions in the market. If you get a reading over 70, that indicates an overbought market while anything under 30 means an oversold market. Simple, right? Anyway, you will understand better when we go to the illustration.
To profit from the RSI, one must be able to pick the tops and bottoms and get into the market as the trend reverses. This is how you can take advantage of the whole movement.
You can also use RSI to confirm trend formations. If the RSI is above the 50-level on the scale, the market is usually in an uptrend. On the other hand, if it is below 50, the market is in a downtrend.
If you refer to the chart below, you can see 2 examples using the RSI to confirm the formation of a downtrend (red circle) and an uptrend (green circle).
Just before the red circle mark, you will notice that the BNP Paribas broke the bullish trend line then formed lower tops and subsequently, the prices lose momentum. You can see that the share tested the support level two times at EUR 54.80 before breaking it as the red circle shows. If you don’t like risks, it’s better to wait for trend confirmation before doing anything. You’ve got to choose between two things. First is to make a lot of profit by getting into a trend early and second, risk being wrong more often and potentially lose a lot of pips (point in percentage) to your stops.
Or, you can wait for the confirmation of the trend and be right more often, but you’ll miss a portion of the move. In this case, you stand to make less profit.
The decision will depend on your risk disposition. Are you comfortable getting many small losses and a few big winners? Or, are you patient enough to settle for several smaller winners?
The call is totally up to you. We’re here to provide you with the methods and tools to help you play the game – it’s your job to decide how you are going to use them.
2. Bollinger Bands
More than anything else, Bollinger bands indicate a stock’s volatility. It uses a simple moving average and 2 lines running at standard deviations on either side of the central moving average line. The outer lines identify the band.
The simple rule to follow is to just look at the appearance of the band. A narrow band means a quiet market while a wide band is a loud market.
The Bollinger Bands are very helpful for traders to analyze both ranging and trading markets.
In a ranging market, you should pay attention to the Bollinger Bounce. The price will behave in such a way that it will bounce from one side of the band to the other but will always return to the moving average. You can liken this movement to regression to the mean. The price will naturally return to the average as the trading time goes on.
When this happens, you can consider the bands as dynamic support and resistance levels. If the price reaches the top of the band, you can place a sell order with a stop loss just above the band to protect yourself against a breakout. Normally, the price would go back down to the average and if you’re in luck, even to the bottom of the band, making your profit even higher.
Assuming that you believe that 95% of all prices should be within the Bollinger bands. One thing you can do is to buy when prices fall below the lower band and sell once they go over the upper band.
Watch out when prices fall outside the bands because it shows an extreme situation where market prices are uncharacteristically volatile. The likelihood that prices will tumble back inside the band is very high in this case. In the chart above, you will note that it’s often a spike in volatility that shoves prices off the bands. The wicks or shadows of the candlesticks indicate the volatility.
The key is not to automatically buy or sell when the prices fall outside of the bands.
It does not mean that when prices are outside the Bollinger bands, they will automatically reverse. Sometimes, it is but the start of a strong trend. The idea is to trade with the trend. The markets always follow their own directions, so it is never a wise move to go against the trend because it could mean huge losses for you. In an uptrend, the prices form higher peaks and higher troughs. In the chart above, you will note that prices going outside the lower band are just the start of a strong bearish trend on the EUR/USD currency pair.
Watch Out For The Bollinger Bounce
To summarize, watch out for the Bollinger Bounce in ranging markets because the price tends to go back to the mean. In trending markets, you should use the Bollinger Squeeze. When the bands come close together, it shows a period of low volatility, but experts say that after this time, a period of high volatility follows. Although it doesn’t show you which direction the price will go, you know that there will be a significant advance or decline about to follow soon.
As we’ve mentioned, the bands are also useful for identifying periods of low volatility (Bollinger Band Squeeze). Normally, it occurs before a moment of high market volatility. When prices remain nearly constant, that’s the time that the bands narrow.
Often, this happens when the market anticipates an important development or announcement like a central bank decision. As soon as the decision comes out, volatility rises so the bands widen immediately thereafter. You can take advantage of tight bands because it means bigger volatility in the future. You can see the illustration by the black arrows on the chart above.
A Candlestick chart displays the high, low, open, and closing prices of a security for a specific period and traders use it to see when prices are about to reverse (reverse patterns) or when they are losing momentum. It can also indicate if the existing trend is weakening (indecision patterns) or when prices will remain in their present direction (continuation patterns).
This is why investors love it for “aggressive trading” where they buy at the support level and sell on the resistance level. Others call it a “classical approach” where an investor buys after breaking through the resistance level and sells after breaking below the support level. A piece of basic knowledge is distinguishing bullish candles from bearish ones and you can learn this by analyzing the color of the candle.
If the color is green or white, it generally means a bullish candle where the closing price is above the opening price (refer to the green hand on the chart). Conversely, you will see a black or red candle if the closing price is lower than the opening price (check out the red hand on the chart).
Volatility And Intensity
Another thing is, you can understand volatility and the intensity of market movements with candlesticks.
To understand it better, take a look at the representations. The body of the candle indicates the opening and closing prices. The wicks, which others also call the shadows, show the highest and lowest levels that the stock reached within the period of analysis. The sizes of the candle and the wicks reflect market psychology. Therefore, a long and a short candle mean different things. The size of the body then describes the intensity of the movement.
You can also look at it this way:
A longer body signifies an intense buying or selling pressure because when the closing price is far from the opening price, it creates a long body. If it’s a long green or white candlestick, the buying pressure is strong. On the other hand, if it’s a long red bearish candle, it means that it is a time of high uncertainty where there is panic among market participants. Or it could be that a large financial institution or fund is disposing of a sizeable volume of a given asset which causes the prices to go down. One very good example of a strong candle is the Marubozu.
The Marubozu candlestick pattern is a one candle pattern, easy to spot and almost has no shadows (check out the red and green circles). The good news about it is that it conveys a very clear meaning. If you see a long green or white Marubozu, it flashes a clear bullish signal because the opening of the trading session is the lowest and it ends at the highest level.
The Marubozu Candlestick – How It Works
If you find a red or black Marubozu, it means a strong bearish signal, especially if it happens on a resistance level. It means that the priced closed at the period low. It usually stands for support in a bullish market or a resistance in a bearish market (check out the red circle).
Using the candlestick patterns, it becomes easy to see significant levels where the prices could react. You can also use this as a tool to help you manage your funds by knowing where to place protective stop-losses.
On the other way around, the shorter the candlestick, the more indecisive the market participants would be.
4. Fibonacci Retracement
Chart traders who make use of a retracement trade should be patient because not only is this a bit more technical, it also takes time for the entire scenario to fully evolve. There are times when the retracement entry point may stagnate for days before anything useful to the trader shows up. Another thing is that this trade setup is most suitable for swing traders and not so much for scalpers or day traders.
The big idea of the retracement trade using the Fibonacci tools is to catch the price area to which a retracement will settle on before the price continues its initial trend. This is good for late birds to come in and participate in some trend trading action. Basically, the Fibonacci retracement tool traces from one price extreme to the other while the retracement is going on.
What is the reason for this sequence? Doing this allows the 2nd price extreme to form and show up in the charts. After the trace, five Fibonacci retracement lines will appear on the chart and these five lines will correspond to possible areas the price can retrace.
In some cases, you can add the 6th line by adjusting the settings of the Fibonacci retracement tool. The right sequence traces the Fibonacci retracement tool from a swing low to a swing high in an uptrend, or the other way around in a downtrend, going from a swing high to swing low.
Here are the conditions for a long trade entry:
- The initial trend is an uptrend with a current downside retracement
- The Stochastics oscillator shows an oversold signal (ex. Line cross at <25) as the price retraces to a Fibonacci retracement level.
- Perform a long trade by buying at the open of the next daily candle, when you see that the lines of the Stochastics oscillator have crossed with the price at a Fibonacci retracement level.
Take a look at this chart of the EUR-USD currency pair that shows the setup parameters. You will notice that the initial trend is up but with a downside retracement. The swing low reference date was July 4, 2013. Come August 19, 2013, the highest price on the chart, or swing high, stood at 1.34655. You can also see from the chart the correct trace of the Fibonacci retracement tool from the July 4 swing low to the August 19 swing high. As the price retraces, traders should use the Stochastics oscillator to mark the Fibonacci level that will serve as the right price support for an upside retracement entry.
Using this example, you will notice that the Stochastics lines cross on September 5, 2013, the same time the price has retraced to the 50% level. As the bearish red candle faded, a new bullish candle opened the next day, September 6, 2013. As a result, the open price of this new bullish candle pegs the correct long entry point. (To know more about candlesticks, click here.)
Here are the conditions for a short entry:
- The initial trend is a downtrend with a current downside retracement.
- The Stochastics oscillator shows an overbought signal (ex. Line cross at >75) as the price retraces to a Fibonacci retracement level.
- Do a short trade by selling at the open of the next daily candle, when you see that the lines of the Stochastics oscillator have crossed with the price at a Fibonacci retracement level.
Take a look at this daily chart of the GBP-USD. On December 20, 2015, you can see that the swing high for this trade took place. On January 21, 2016, you will notice that the lowest point on the chart (swing low) was at 1.4058. Price retracement to the upside started and ended at the 50% Fibonacci retracement as the Stochastics oscillator crossed at >75 (overbought). From this point, the downtrend continued on.
At the 50% Fibonacci level, it shows the re-entry for the short trade. Traders will do the re-entry by going short at the open of the next daily candle following the finalization of the Stochastics lines cross.
In both cases, do not forget to always set a profit target.
In stock trading, the volume is of utmost importance because it tells the interested parties how active the players were during a given period. The trading volume can help you understand realistically how much traction a trend or a price rally has.
A higher volume means a stronger market so you can be confident of the current trend. When the volume is low, it depicts a weak trend and traders opt not to enter the market because the trend might not carry on. So, you can say that volume is not just a profitable and very common tool but something you can use to reduce your risk
Since volume basically shows you the number of trades in the market, an increasing trend leads the way for a rising volume. The bulls call for higher prices and more engagement so they can sustain their long positions. This explains why you sometimes see an uptrend but a decreasing volume – this means that there is a lack of interest and the trend may soon reverse downward. So, remember that a seemingly sharp trend with a declining volume sends an unpleasant signal. In short, volume paints the market’s interest – it has to support the trend.
When the stock goes up or down for some time, you can expect exhaustion moves, which are sharp moves. These moves, along with higher volume, means a possible reversal of the trend.
The Bottom Line
Indicators are very useful in a sense that they clarify price information and provide trend trade signals or alert for reversals. You can use indicators on all time frames and have variables you can use according to your needs and specific preferences.
Combine indicator strategies, or come up with your own guidelines, so you can clearly mark your entry and exit thresholds for your trades. Each indicator is not independent of the others so you can use it in more ways than what we’ve discussed. If one indicator seems impressive, do some research or study it more and then, test it out offline. It is important that you do a simulation test before you try it out on live trades.