From the November 2013 issue of Futures Magazine • Subscribe!

Using moving averages to target the trends

Risk control

A trader who sells a falling stock or buys a rallying stock has invested in the likelihood that the trend will continue. A trader who buys a falling stock or sells a rallying stock has bet on a reversal in the larger trend. Of course, reversals happen, but over time the safer bet is to go with the trend rather than assume the moment you make your trade is one of those rare moments when price turns.

“Down and out” (below) shows the market price of Indian steel giant Jindal Steel. This stock has been in a bearish trend from the beginning of 2013, with some pullbacks seen in between. The stock hasn’t managed to close above the 21-day moving average, and every time it comes near it, selling pressure is seen and the stock drifts lower.

Jindal saw a sharp sell off in June and then later consolidated for a greater part of July. Resistance formed and provided some trading opportunities. A trader going with the larger trend would have shorted it around 230 and waited for the stock to fall, but a trader who bet on a trend reversal would have bought it and waited for 230 to break. This is a key price, both in terms of resistance and moving average vicinity.

If the trend on a larger time frame is bearish, then trades should be taken with a bearish view around the resistance levels. If the trend is bullish, then the trades should be taken with a bullish view once the resistance on a smaller time frame breaks.

When a trade is taken on a breakout basis and the price is above the 21-day moving average, positions should be held until the price breaks the average. In most cases, these positions are held for one to two months. Traders should maintain a stop loss shortly below the moving average, but if the risk involved is greater than 7%, consider a dollar-based stop instead — one that better fits a more conservative risk appetite. Short-term traders can use a stop loss of a close below the candle that provides the breakout confirmation.

Trend trading is an important tool for all stock traders to have in their arsenal. The benefits are that trending stocks move in one direction steadily; there is little confusion over the direction of price. When timed correctly, profits come quickly. Generally, trend moves are supported by strong fundamental underpinnnigs.

Of course, this approach isn’t perfect or foolproof. Downsides of this strategy are that it’s tough to decide on proper profit targets and stop losses. As quickly as profits appear, they also can disappear. Plus, breakout trend moves can be missed easily, particularly by traders paralyzed by fear. Once gone, it may be some time before a trend opportunity re-presents itself.

Raghav Behani is a trader and investor in the Indian stock markets. Reach him via his website

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