Wisdom of the Markets by Andrew Dawson - HTML preview

7 Trading Styles

Momentum Trading

This approach aims to trade only with the prevailing trend but to enter trades as momentum builds in line with the trend and (possibly) close trades as momentum declines.   It is based on four important beliefs about markets.  If you accept these then this style might be for you.

1. A trending market is more likely to continue to move in the direction of the observed trend than to reverse.  The trend continues until it is seen to end and a trend only ends once.  Favourable momentum increases the odds that the trend will continue.

2. Established trends generally do not just fizzle out but end in euphoria and then capitulation.  This means that while some of the fastest gains come towards the end of the trend this is also a warning that the trend is coming to an end and a sharp reversal will result.  This final rush also sees a big move away from the mean, for example, a sustained move outside a Bollinger band. 

3. Increases in momentum tend to occur before – and therefore lead – moves in price.  Similarly divergences in momentum tend to signal an increased probability of reversal.  This will be seen on indicators, a jump in trading ranges or a gap.  The best trades are entered before the price move based on the indicators.  However, an extreme move in an indicator may signal a blow off top or capitulation i.e. a warning that the the end of a trend in nearing.

4. Low volatility in a trading range often precedes a breakout and an increase in volatility soon after.  Not every successful trade will start with one of these things happening.  However, if you do observe them then they can form the basis to plan a trade and give extra confidence.  In particular, do not trade against the direction that may be implied by such an observation. 

Swing Trading

Swing trading aims to use technical analysis to identify trading opportunities where there is a potential for a strong high momentum move in a period of a few days.  Many private traders use this approach and a successful entry may develop into a longer term trade if a trend emerges.  Only technical analysis is used and timing is very  important with good risk control. 

To be a successful swing trader you must:

• Know the overall trend of the market at a time period longer than the one you intend to use to time the entry and only trade in line with this trend irrespective of what a chart of an individual stock might indicate;
• Make sure the charts at various timeframes are not conflicting;
• Look to enter close to the start of a trend and although you might enter an established trend, beware of entering a mature trend;
• Use multiple indicators such as moving averages, volume, MACD and stochastics and trade only when you get confirming signals;
• Specialize in a limited number of markets that you know well;
• Always have a trade management plan in place before you enter.  This will show an appropriate stop, a target, and an indication of when you intend to move the stop closer and add to the position.  Simply identifying an opportunity and timing the entry is not enough;
• Only take trades that have a reward to risk ratio of a least 2 to 1;
• Make sure you have the mental preparation to stay with a good trade for a long period, to exit a poor trade quickly and to re-enter a position following an exit if the signals are good.