This is the end…

TRA03_Shares_Pendulum

I’m not sure that there is a single book on trading anything that doesn’t remind traders that the trend is their friend – for obvious reasons, too. If you can capture large movements in price that unfold over an extended period of time, there is substantial potential to make a very decent return. Like almost all of the throwaway trading lines that you hear, though, this is another line that comes up a long way short of giving you the full picture because it gives you no idea as to when (for example) that the trend is likely to be ending. When you talk about the trend continuing or the trend ending you can only ever consider it in terms of probabilities because you can never be certain that you are correct in your assessment. Just be sure that you don’t beat yourself up when you make the wrong decision.
Rather than talking about how to determine that something is trending (or indeed about to trend) I would like to look at some of the different ways that you can determine that the trend may be coming to an end. Some of these methods may prove very effective for use when looking to exit other types of positions that you have too. Sadly, though, there isn’t much in the way of a consistent method that you can apply that doesn’t require you to give back at least some of your profits. This is part of the nature of trend following and it is something that you need to keep in mind if you are following this type of method. Everyone is very willing to adopt the concept of trend following because they can see the magnitude of the potential upside that awaits them. I am concerned though that this discipline will last only as long as the trend persists moving strongly in the right direction. At the first sign of weakness the trader may run for cover, but you can be sure that without having good reason this is the trader failing to be a friend to their trend!
Before worrying about how to exit from a trend, you need think about how to exit the trend the wrong way. The wrong way simply involves getting out of the trade despite the fact that the adverse moves in price would likely to have been expected based on pretty standard levels of volatility. I would suggest that you familiarise yourself with different ways to measure volatility on share prices – particularly the Average True Range (ATR) or standard deviation because these can give you a good idea as to how the market can be expected to behave. It’s no guarantee, of course, but it can give you a better idea as to what you may be in for.
One of my favourites that I look for when looking for a switch in price direction is the “tweezer”. This is a pretty basic candlestick setup that occurs when you have two periods in a row where the highs (or lows) are equal. Typically, you want reasonably long tails on your candles because you want to see that price has moved quite a distance only to be repelled from the highs of the day by a clear increase in selling pressure.
In and of itself the tweezer is not especially clear as a reversal signal to be acted on entirely on its own and certainly not enough to warrant a clear call that their trend has broken down. I am off the opinion that the tweezer is useful, though, when it corresponds to another technical factor such as a previous support/resistance level or a price pattern formation. If this is the case then you may potentially be seeing at least an initial sign that the upward momentum is starting to close down. You need to bear in mind too that trends can act over different timeframes so be sure that you are clear on which one you are dealing in. If you are dealing on a weekly trend then looking at signals on the daily chart may give you a premature end to the trade that you are making. You can also look for alternative patterns like the shooting star (uptrend) or the hammer (downtrend) as means of isolating potential areas of exhaustion in the price movement.
The typical type of means by which traders would say that the trend is breaking down is for it to start making a series of lower peaks and lower troughs. This to be sure is pretty much the dictionary definition that you would look for. Keep in mind though that this can make for an enormous give-back of profits with the view to getting that last bit of assurance that the trend is finished. Whilst you could argue that this is simply being conservative I think you will find that on average this is going too far – particularly when you have the option to re-enter a position if the trend resumes.
The next set of signals to start thinking about are the patterns – particularly the varieties of triangle and the head and shoulders pattern. There is no need to go into these patterns in detail because they are common and you can find out about them anywhere. The thing that I really want to address about them is what they represent as part of a wider trending price movement. When you see a pattern like a symmetrical triangle it is showing you that on the end of a trend the price is now entering into a period of price consolidation. The thing about triangles is that they have no inherent bias to a breakout either to the upside or the down. If the market is trending strongly then you may anticipate that the likelihood of a breakout to occur in the direction of the trend would be greater than it would be against it but in any case if the price breaks in a counter-trending fashion then you may need to respond by closing your position.
The head and shoulders pattern can be seen as a little more specific in that a confirmed pattern signals a reversal – it doesn’t say that it will be permanent but it would be telling you that things will likely be in some form of a rest period for a while. You can use the height of these patterns to measure the potential movement of price (and if you are a pattern trader this will be your bread and butter) but even as a devout trend follower there is every chance that you will want to step to the sidelines while this counter-trend activity plays out. As I implied previously, there is nothing to stop you from re-entering the position if the trend shows signs of resumption but would you prefer to conserve your capital in the meantime? I would suggest that you would.
A final way in which you may wish to measure the likelihood of price reversal is simply by trailing your stop-loss at the lowest level that price has traded (or a tick or two below it) in the last “x” sessions. This type of method has the advantage of being very mechanical, which makes it easy to implement. The thing that having an understanding of this type of method gives the trader is the recognition that there is a trade-off that needs to be made with any method that we use. By this I mean that if you choose a small number of days to trail your stop by you will have only a small give-back of profit on your exit – sounds great but you have a much greater chance of getting knocked out by pretty standard levels of market volatility. Choose a very large number of days and you won’t likely be knocked out by normal volatility but when the trend eventually reverses then the amount of profit you give back will be much more significant.
What I have discussed here are some fairly straightforward measures that you can take to determine when a trend may be starting to break down. The key though is not the measure so much as your ability to stick to your plan as required. As I say it’s no good trying to capture a weekly chart trending move only to close out at the first sign of weakness on the hourly. To capture big trends you need to have the discipline to deal with volatility and the bigger the trend you aim to capture, the more profit you will have to give back when you do get out. If you contemplate this irritating trade off, though, you are more likely to be able to come up with a method that is suitable for your individual preferences and requirements.

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