Trading with the Trend: a Simple, Powerful Method
I would like to share my favorite trend following method.
This method is suitable for traders who prefer a high R (return on risk) at the expense of a lower hit rate; winners are often 2 or 3 times the risk but only around 50% of the trades that the method generates are winners.
This method is extremely simple. Here is what you need to get started.
Pull up a naked chart and apply the following moving averages:
a) 50-period SMA (dark red)
b) 21-period EMA (dark blue)
c ) 6-period smoothed moving average applied to highs (dark grey, dotted line)
d) 6-period smoothed moving average applied to lows (dark grey, dotted line)
Here is how I trade the method:
a) the 50-period SMA is my long term (strategic) buy/sell line. When price trades above the 50-SMA, I only look for long setups. When price trades below the 50-SMA, I only look for short setups. In other words, I use the 50-SMA to determine the directional bias.
b) the 21-EMA is my short-term (tactical) filter. As with the 50-SMA, I must be on the right side of the 21-EMA to take a trade (below for shorts, above for longs). In addition, the 21-EMA must not point against me; if I am looking for a short, the 21-EMA must not point up (it can be flat).
Finally, the 21-EMA must be on the right side of the 50-SMA. I will only go long if the 21-EMA is above the 50-SMA, and vice versa.
c) the 6-period smoothed moving averages form what I call the tunnel of 6. The tunnel of 6 is my noise filter. I do not take trades inside the tunnel of 6. I use this filter for two purposes: 1) I will enter a trade when price closes and opens outside the tunnel of 6 (provided that the other conditions for entering a trade are met), and 2) I use the tunnel of 6 to keep me in an open trade because I don't close a trade until either the target has been met (2 or 3 R) or if price closes back inside the tunnel of 6.
I recommend being aware of the key support and resistance levels on your chart. I usually draw my levels on a D1 chart and check that I am not opening a long trade right under a big D1 s/r level or going short right before it hits a level that was a major D1 resistance area in the past. I believe that s/r is the most important component of any trading method so be sure that you keep this in mind.
Let's look at an example.
In the chart I have marked two potential trades. In the first scenario (long break out), all the conditions that I explained above are present, except one. The 21-EMA is below the 50-SMA, so we can't take the trade. In the second scenario, however, all the conditions are met. So we go short!
I will prepare another article about stop placements and exits. These are both highly "personal" topics in the sense that there is no right answer; each trader will have his or her own comfort zone. A good starting point would be to place the stop above 2 resistance levels (if you are short). This could be the 21-EMA and a horizontal D1 level that you have previously drawn on your chart. The target could be set a fixed 2:1 or you could aim for the next significant s/r level on your D1 chart.