We are trying the build-up layers of evidence to help us identify trading setups where the balance of probabilities is in our favour. We are not trying to find 100% nailed down certainties – those just don’t exist in trading. We’re trying to identify 51:49 or 52:48 type probabilities in our favour – the markets are just too big and efficient to deal in certainties.
Our analysis process follows these three broad steps:
Working out the prevailing trend is done in shades of grey and never black or white. We check where the price is in relation to the 200/50/20 period simple moving averages and the slope of the SMAs. If it is above all three and all three are sloping up then this is the most confident we be the trend in that timeframe is bullish. If the price is below all three SMAs and sloping down in all three then this is the most confident we can be the trend is bearish. Normally these checks won’t all align, so we also use S&R techniques like trendline analysis to support our assessment of the prevailing trend.
If we are confident there is a prevailing trend in the two longer timeframes we can move on to the next step. Remember this trend does not have to exist in our trading timeframe.
Next, we see if we can identify any relevant price patterns.
We use stochastics or RSI to find overextended market conditions – we are looking for overbought if we’re considering going short and oversold for a potential long.
We use candlestick analysis to help with the trade confirmation – and the entry point.
We didn’t show you in this example but we’d also be having a look at the economic calendar to see if there are any relevant announcements coming up that might spark volatility in that market. Normally when there are we’d stay out of the market because we’re trying to trade a trend – announcements can sometimes dramatically invalidate technical analysis and trends very quickly.
We are looking to use everything we know about technical, even fundamental analysis to get to a point where the weight of evidence is in our favour. When we find a piece of evidence it comes in different degrees of quality. As a rule of thumb, we always try to find at least three good pieces of strong and clear evidence for a trade-in the direction of the prevailing trend.
We use the technical analysis we’ve conducted to guide us in this respect. So, in our example where we’re interested in a short trade, we could set the stop loss above the resistance line because if the price hit this level while we had the trade on it would largely invalidate most of our technical analysis.
We would set our take profit limit order in a similar way, using technical analysis to guide us. After we’ve worked out the stop loss and limit order levels we check the risk to reward ratio – we’re looking for a minimum of 1:2 if we’re trading intraday and a minimum of 1:3 if you’re a swing or position trader.
If at any point something doesn’t stack up – from the analysis of the prevailing trend through to the risk to reward ratio – we walk away.
- We are trying to build up layers of evidence towards placing a trade.
- First, we assess the prevailing trend and always trade in that direction.
- Then, we built up the layers of evidence for a trend using technical and even fundamental analysis.
- Finally, we set up the trade and the risk management levels using our analysis to guide us.
- Don’t be afraid to walk away from the trade if it doesn’t all line-up.
