LAST time around we talked about the four stages of a stock market ~ accumulation, markup, distribution and decline. The stages are generic to all asset classes and timeframes. We mentioned the importance of keeping in mind the stage we’re currently in ~ to avoid "cognitive dissonance" and keep losses in check.
Today, we’ll drill down to focus on time-frames. Many years ago, Charles Dow wrote a series of articles in the Wall Street Journal about how the stock market works. These articles constitute the "Dow Theory" which is regarded by many as the basis of technical analysis. The theory identifies three time-frames and, consequently, trends:
The Primary trend is the underlying trend and lasts between several months to several years. This represents the long-term forces of supply and demand to which even big market participants align themselves.
The Secondary trend is constituted by counter-moves within the Primary trend and typically lasts from two weeks to three months. These are created by large participants (e.g. pension funds) offloading positions. Inventory changes hands as new buyers step in and the primary trend resumes. The Minor trend is constituted by ripples which typically last less than two weeks. These are fluctuations in the secondary trend and are typically emotion-driven.
Choosing your time-frame: One of the keys to successful trading is choosing the time-frame that’s right for you. This is determined by several factors: capital base, risk-tolerance, time available to monitor the markets etc. Depending on these factors you slot yourself as a long-term investor (primary trend-following), swing trader (rides the intermediate-term cross-currents) and the day trader (darts in and out of the market with very short holding periods).
No matter what your timeframe, you need to align yourself with the trend. A useful way of doing so would be to look at what the higher time-frames are doing. For example, long-term investors may want to start with a weekly chart of three years’ data, swing traders with a daily chart and day traders with a 30 minute chart.
Thus, a swing trader may start by selecting his stocks on the basis of a trend analysis on daily charts. She may then want to identify stocks with attractive risk-reward structures using a 30 minute chart ~ the drill-down into a lower time-frame allows better identification of support and resistance levels.
Once a potential trade has been identified and the target and stop determined, the swing trader needs to find a decent entry. That’s where the lowest time-frame comes in. For a swing trader this could be a five-minute chart. Understanding the nuances of this lowest time-frame leads to lower-risk entries i.e. higher reward-risk ratios.
Once you’ve identified the time-frame you’re comfortable with, it is very important to stick to it. For example, a swing trader’s main focus should be on the 30-minute chart. If she gets caught up in the price action and starts spending more time looking at the three minute chart, very soon she will find herself taking trades at a lower time-frame. This will lead to over-trading and, inevitably, to less-than-stellar trading results.
Avoid the chop: The objective of market timing is to trade only when there is a clearly discernible tend and avoid trading those periods where the market is going sideways. If you’re trading a time-frame higher than the day time-frame, there will be days of "chop" (sideways movement) when it’s best just to sit on the sidelines. Even for day traders, there are periods of purely rotational activity ~ no trend, only the liquidity-providers trading back and forth. Lunchtime trading or trading ahead of a major news release comes to mind. The name of the game is to preserve capital.
Sideways markets can be swing-traded using options and "theta burn". We have previously discussed such strategies ~ we refer to the series of articles on the "iron condor". For those who only trade directionally using stocks, even when broad market indexes are going sideways there are usually individual stocks that move in a manner uncorrelated to the broad market. It is important though to trade on the basis of actual price action, not theoretical correlations. Only price pays.
Notice: Trading options involve substantial risk of loss and is not suitable for all investors. You may lose all or more of your initial investment. Information shared here is for educational purposes only.
The writer is managing partner of a financial engineering company based in Italy.