TRADING INSIDER: 4 Weapons Every Trader Should Have In Their Armoury

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LOS ANGELES, CA – FEBRUARY 19: Fans dress as their favorite character at Walt Disney Pictures & Buena Vista Records ‘Alice in Wonderland’ Fan Event at Hollywood & Highland on February 19, 2010 in Los Angeles, California. (Photo by Kevin Winter/Getty Images

When I was a full time currency strategist my job was to identify trends, trades and make forecasts about the direction of currencies, particularly the Aussie dollar against the US dollar and Aussie dollar on the crosses against the Yen, Euro and Pound.

On top of this I was expected to do the same for the major currencies, the Canadian dollar, Kiwi dollar, and basically any other market that might come up when talking to clients.

I remember sitting at BP headquarters in London once opining about the direction of oil and the spread between the Nymex and Brent Benchmarks and thinking ”how am I adding any value here?” Funny thing was I was right in the end.

It was a fun period but identifying the trades and getting clients and traders into trades always reminded me of Alice, in Lewis Carroll’s tale of Wonderland, coming to a fork in the road and asking the Cheshire Cat for guidance.

Alice: “Which road do I take?”
Cat: “Where do you want to go?”
Alice: “I don’t know”
Cat: “Then it doesn’t matter”

Over more than 25 years in markets and almost that long trading this is the quote I always think of when I am talking to traders, new and experienced, about how to identify trades and what to trade and when.

As we discussed in our article on the types of analysis that traders can use, fundamental and technical approaches can form a very potent combination. But while fundamentals can often help you identify a stock, asset or commodity that you want to trade, knowing when to execute the trade is often the realm of technical analysis.

So here are some simple chart patterns every trader should know, and be able to identify, to help them enter or exit a trade.

Trendlines

These are the simplest form of technical analysis.

Simply wait for three tops or bottoms in a move, draw a line between them and extend it out and wait till the market gets back to it. Then either buy or sell in front of it, or do the opposite if the line breaks.

It sounds a bit too easy to be true, but everyone else is looking at the same charts and everyone else, just like Alice, is wondering which fork to take.

Here is a great example looking at the DAX over the past few months – all charts below are actual charts used in writing about markets daily.

This was a very strong uptrend with at least 5 touches (more touches equals a stronger trendline) and then a break.

After such a strong uptrend which lasted close to two and a half years, the trend – even when it breaks – has some residual strength, so it would be usual for a test back higher on the line. That’s what happened over the subsequent month.

But the key here is that nimble traders could have, and did, identify a trading opportunity.

Trading Ranges – Darvas Boxes

Nicholas Darvas was a trader who made more than $2 million in the 1950’s, in the days before the internet and instant communication, back when “the tape” was his guide and he only looked at prices once a week.

The Darvas method was to identify trading ranges – Darvas boxes as many call them – and to trade within these ranges, or to enter a trade when they break.

It is a fine strategy and one that helps traders know what levels others are looking at, and likely to trade at.

Take the Australian dollar between March and September. It traded in a very solid range of 92-95 cents against the US dollar. Traders had established 92 cents as a buying zone and from March continued to buy in this region every time it got there, until early September, when US dollar strength forced the Aussie dollar lower.

Ranges and boxes, like trendline, are important because they give traders the most important weapon they can deploy: a known entry level which can then generate a known stop loss, for risk management purposes. It doesn’t mean that every trade will be a winner, but for six months Aussie dollar longs made substantial profits buying the dips and once the level broke the stop loss would have protected them.

Pennants

Ah, pennant formations. These are much-loved by traders because they combine the elements of a trendline with a flat top and give solid trading signals when they break.

The Euro was a great example of this recently when it finally broke its trendline support after having been unable to break sustainably up and through 1.39/40 earlier this year.

Once a break happens it is often very strong, given traders look to the width of the pennant from the start to the high as an indicator of how far the asset will fall.

In the case of the Euro in the above chart, the wedge suggests a move under 1.18. Only time will tell on that one but selling accelerated once the trendline broke to the downside as the chart below shows.

Double Tops (or bottoms)

Along with the three really simple trading tools above is another one approach which simply looks at a market that makes a high, or low, sells off and then makes another high, or low, in the same vicinity in terms of price or other index levels.

Keen-eyed readers would have seen that in all of the charts above (green circles on the chart below) the signal that alerted traders that the setup was getting close for a break was in fact a double or other multiple top.

Conclusion

If you are a fundamental buy-and-hold style investor then these types of approaches will interest you less than valuations, earnings, dividend yield, and company performance.

But if you are the type of trader who likes a little more action, has a shorter holding period than the months and years many fundamentalists have, then these tools can be invaluable weapons in your armoury.

The best news is that they are time invariant – that is there are enough traders watching them in multiple time frames that you’ll find they work whatever the time frame you trade – intra-day to intra-year.

This information does not take into account your investment objectives, financial situation and particular needs. Before making any investment decision based on this information, you should consider talking to a financial adviser, and assess whether the information is appropriate to your particular investment needs, objectives and financial circumstances.

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