3 tests to be confident you’re not buying into a sucker rally

 

When trends get going, underlying value becomes almost irrelevant – this is how bubbles form, whether it’s gold, Bitcoin, Gamestop …

When these bubbles form, there’s no shortage of doomsayers warning us that it’s about to burst, but the nature of bubbles is that they run far beyond expectations. This makes some people rich – but can be risky.

I know I talk a lot about trend-following, but how do we differentiate between a trend-following strategy, and just jumping on the latest bandwagon?

In every position we take, there’s a flipside.

When we buy, someone else is selling. When we sell, someone else is buying. To be profitable, we need to be a step ahead of the person on the other side of this transaction. But this doesn’t mean that we should be going against the trend.

Trying to trade against a trend means picking tops and bottoms. Given that markets only change direction occasionally, this is making your job of trading very difficult.

But buying into a market that’s already trending shouldn’t be confused with blindly following the crowd.

We don’t want to look at a chart with an upward trend and automatically buy that instrument. Trends are littered with pullbacks. If we get in just as other buyers are realizing their profits, we can easily find prices falling on us, so there are some tests we should demand …

1. Trend analysis

Just as Facebook posts aren’t a good way to formulate your views on science; news, hearsay and pundits are no substitute for reading actual data on the markets.

What do the charts say about the price direction?

Be sure to look at charts in a relevant timeframe. For example, if you’re looking to make hundreds of points profit – you don’t just want to see that the price went up yesterday. You want to see a multi-day trend in that direction.

2. Buy on a pullback

We know that markets don’t move in straight lines, so if we don’t look to get in on a pullback, we’re leaving ourselves open to heading straight into a price correction.

By entering the market when the price has pulled back, we get the benefits of a lower entry price (more profit potential); plus a nearby area of support, so tighter stop (less risk). This combination gives our trades a better risk-reward ratio – something we’re always striving towards as traders.

Of course, the worry with a pullback is that the price is actually changing direction. Yes, this will happen, and our set-ups will get it wrong. However, with that boosted risk-reward profile, we can afford to be wrong some (even quite a lot) of the time.

Plus, as the price moves away from a pullback, we often get the third key test …

3. Buy on momentum

The final test is to watch the momentum. I’ll show you two key ways to do that here …

The first is hidden divergence. In an uptrend, when the price hits a higher low, we want to see if our momentum indicator has hit a lower low – this tells us that the price is relatively MORE oversold than it was at the last pullback.

The indication here is that buyers will come back in, driving the price up from here.

The second way to use momentum is to wait a little longer to see the momentum building behind the move up. Here’s the same set-up as the previous example, but we get in a little later, as the Stochastic indicator crosses over …

The entry here is later, which means we’re not getting in at such an advantageous price, but we can be more confident that the price has resumed the direction of the trend.

For more information about momentum indicators, please check out this post.

And, of course, the most vital way to avoid being taken for a sucker by the market is to prepare for a loss – always know that losers are around the corner. If we’re ready for them, they needn’t knock us off course.

 

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