5 Popular Trading Strategies
08/21/2014 6:00 am EST
Just like you need the right tool for the right task in order to succeed, different trading strategies work in different market conditions, and Dean Peter-Wright of TradingMarkets.com details five here and when they work best.
This article will show you some of the most common trading strategies and also how you can analyze the pros and cons of each one to decide the best one for your personal trading style.
The top five strategies that we will cover are as follows:
Breakouts are one of the most common techniques used in the market to trade. They consist of identifying a key price level and then buying or selling as the price breaks that pre-determined level. The expectation is that if the price has enough force to break the level, then it will continue to move in that direction.
The concept of a breakout is relatively simple and requires a moderate understanding of support and resistance.
When the market is trending and moving strongly in one direction, breakout trading ensures that you never miss the move.
Generally, breakouts are used when the market is already at or near the extreme high/lows of the recent past. The expectation is that the price will continue moving with the trend and actually break the extreme high and continue. With this in mind, to effectively take the trade we simply need to place an order just above the high or just below the low so that the trade automatically gets entered when the price moves. These are called limit orders.
It is very important to avoid trading breakouts when the market is not trending because this will result in false trades that result in losses. The reason for these losses is that the market does not have the momentum to continue the move beyond the extreme highs and lows. When the price hits these areas, it usually then drops back down into the previous range, resulting in losses for any traders trying to hold in the direction of the move.
Retracements require a slightly different skill set and revolve around the trader identifying a clear direction for the price to move in and become confident that the price will continue moving in. This strategy is based on the fact that after each move in the expected direction, the price will temporarily reverse as traders take their profits and novice participants attempt to trade in the opposite direction. These pullbacks or retracements actually offer professional traders a much better price at which to enter in the original direction just before the continuation of the move.
When trading retracements, support and resistance is also used, as with break outs. Fundamental analysis is also crucial to this type of trading.
When the initial move has taken place, traders will be aware of the various price levels that have already been breached in the original move. They pay particular attention to key levels of support and resistance and areas on the price chart such as '00' levels. These are the levels that they will look to buy or sell from later on.
Retracements are only used by traders during times when short-term sentiment is altered by economic events and news. This news can cause temporary shocks to the market, which result in these retracements against the direction of the original move.
NEXT PAGE: Reversals & Momentum|pagebreak|
The initial reasons for the move may still be in place but the short-term event may cause investors to become nervous and take their profits, which in turn causes the retracement. Because the initial conditions remain, this then offers other professional investors an opportunity to get back into the move at a better price, which they very often do.
Retracement trading is generally ineffective when there are no clear fundamental reasons for the move in the first place. Therefore, if you see a large move but cannot identify a clear fundamental reason for this move, the direction can change quickly and what seems to be a retracement can actually turn out to be a new move in the opposite direction. This will result in losses for anyone trying to trade in line with the original move.
Reversals are generally used by technical based traders during times of little fundamental activity. At these times, the markets tend to 'range' or move sideways with no clear direction. Traders look for key price levels that they can use to trade directly from in expectation of a "bounce" when price hits it. These bounces provide small, quick opportunities to take a profit from low-volume market activity.
Again, the tools used for reversal trading are almost identical to those used in the previous strategies and include support and resistance and fundamental analysis.
Before trading reversals, you must be sure that there is no major news expected to be released during that session, and that no key monetary policy makers are speaking or making comments to the press. These events can trigger moves that will result in losses on your short-term trading.
Once the fundamental picture is clear, we then need to focus on the technical analysis and in particular the support and resistance levels that are near the current price.
Common levels used by traders with this type of strategy include, old highs and lows from previous trading sessions, pivot point levels, Fibonacci levels, and areas at which all three of these levels overlap. These overlaps are known as confluences, and these provide excellent areas at which to look for the price to bounce from during the session.
The reactions vary but very often traders will be looking for only a few pips of profit from these reactions, rather than attempting to hold the positions over several trading sessions.
Trading reversals is strictly for times when the market is not trending in a clear direction, and should not be employed blindly during all market sessions as this will dramatically increase the amount of losses you suffer.
Momentum trading is much less concerned with "precise" entries and more with the force and continuation of the move. Traders are not looking for the price to pull back or break out from any specific price, but merely to start moving more or less in the direction of the prevailing trend.
This type of trading is fundamentally based but also relies heavily on indicators such as moving averages and oscillators to give trading signals.
Traders will use momentum-based strategies when they perceive a long-term move to be taking place on the asset that they are trading. For example, if there is a significant change in the fundamentals of a nation that will result in an interest rate change, this will cause investors to act and begin buying or selling the currency of that nation in line with those changes. Other examples include geopolitical events that remain in place for many months and sometimes even years.
NEXT PAGE: When Position Trading Works Best|pagebreak|
During these significant shifts, professional traders will be looking to trade these currencies over the long term, often holding their positions over a period of weeks and months.
Because of the longer-term nature of this strategy, traders are not as concerned about entry points and simply wait until minor technical analysis gives them an opportunity to profit from the move. A popular indicator for this type of trading includes the 200-period moving average, and very often traders will look for price to break above or below this moving average in line with the anticipated move, at which point they will enter the market and hold their positions.
Exits are generally governed by fundamentals in a similar way to entries, with traders watching the economic and geopolitical events very closely before deciding which trading approach they will take and how they will manage those ongoing positions.
Position trading takes the momentum style of trading and further eliminates the importance of the entry. The primary concern of the trader here is to be in the market when the price does eventually make its move. Traders often build their position into the market over a period of days or weeks as the price moves. The main component of this strategy is a confidence in the prevailing fundamental conditions driving the price, and the anticipation that the market will eventually move in the desired direction.
This sounds extremely similar to the momentum style of trading but the key difference is the approach to entries that position traders very often take. When the market is expected to move in a single direction over a sustained period of time, traders will very often begin trading that asset almost immediately in extremely small sizes.
The reason for this is because during the long-term move, there will almost certainly be short-term retracements and temporary adjustments to sentiment. These events will provide traders with multiple opportunities to trade the asset as it pulls back against the overall move.
These will be used as opportunities to trade at a better price and build up their position in the market while these temporary events cause confusion and loss of confidence. Position traders are effectively taking advantage of human emotions, which causes most traders to liquidate positions and take profits during short-term market moves against the prevailing trend.
Because the market moves in this way, traders will try and add to their positions as the price gives way to better prices so that they can gradually build up a better average entry price. This also means that their initial positions may enter sustained periods of drawdown, which is why each individual position is usually extremely small in relation to the amount of capital they are trading.
Position trading should only be carried out on assets that have a very clear fundamental sentiment that is likely to last over the approaching weeks or months. Having the confidence to not only hold your position, but add to it is the key to this style of trading.
By Dean Peter-Wright, TradingMarkets.com