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The Trend is Your Friend Until…

The Trend is Your Friend Until…
March 12
23:30 2012

Most traders have heard the saying, “The trend is your friend until the bend.” This article will provide an example of this statement as shown in the stock market. Below is a snapshot of a 5 minute chart of Costco (Symbol: COST) on Friday, December 23, 2011. The following are the steps we would take to trade this instrument.

Step 1: Look for entry

A trader can find entry in many forms. Whether entry is determined by candle pattern, price, or technical indicators, your assessment on how you enter trades is very crucial to your success. In this scenario, before entering a position, a trader should notice that the market is predominantly producing small green candles. This should signal that entry will require more patience so as not to get in at the top of any green candle. This is why the entry point becomes very important.

Step 2: Enter Trade and Set Stop Loss

For this trade, the yellow circle highlights a potential entry point. The trader would have entered on the green candle directly after the red candle (or pullback). The argument for this entry is based on the technical indicators, the 8 and the 20 period simple moving averages (blue and red line, respectively). When the pullback occurred during the red candle, the price found support at the moving averages and never broke past them. Another argument for this entry is that the price stayed above the 200 period moving average (yellow line). It is important to wait for the pull back to finish and witness the price make a higher high before entering.

When entering this trade the stop loss should be at the bottom of the red candle. Once in the long position, the price of the instrument rises and starts to move along the Bollinger Bands (purple lines). As the trade goes positive it is a good practice to keep moving the stop from the bottom of one candle to the next.

Step 3: Exiting the Trade

After an extended period of buying, markets tend to either pull back or go sideways until buyers or sellers drive prices higher or lower. Picking the top or bottom of any market can be extremely difficult. By looking for signs that a trend is slowing or stopping is key to being a professional trader. Sideways movement appears as candles fail to make a clear higher high or a lower low. In this case we see that the market started to trade sideways, the beginning of the sideways movement is highlighted in the blue circle. This is also the point where we would exit the trade.

After exiting this trade we watch as the market begins to ignite again after trading sideways into the moving averages and never breaking below the 8 and 20 moving averages. At this point it is more risky to trade the next move up because there has been an extended period of buying and the next few candles up may just be exhaustion, a practice known among traders as buying at the top.

In closing, trading requires developing each phase of the trade. As your trading ability grows the ability to protect capital should become more important than making money. Good risk management guarantees long term profits for those interested in a long-term trading career. This includes analyzing how you will trade based on technical indicators, price, or candle stick patterns; using good entry and setting and adjusting your stop loss as the trade develops; and lastly, exiting the trade before the trend is completely over.

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