I have a good friend who earned his chops in real estate. He's very good at what he does, and the results show it. Real estate is an overly broad term that could mean all kinds of different things, but my friend kept things simple. He had a couple of go-to techniques that worked well, and he applied them over and over again with similar results.
His simple approach has proven to be highly effective, and by any measure he would be considered a financial success. In fact, his success led us to what we are reading right now. With his success came the desire to diversify into something besides his real estate holdings, and trading seemed like a new and exciting venture.
While trading is often portrayed as a glamorous job, the reality is quite different. For every Wolf of Wall Street that exists, there must be dozens of folks that are wearing sweat pants and an old t-shirt while they slave away over their home computer. In the real world away from Hollywood, there isn't much glamour in trading.
But just because something isn't glamourous doesn't mean that it isn't rewarding or enjoyable. I happen to feel most comfortable in sweats and a t-shirt, so trading appeals to me just fine. I digress. Knowing my friend's approach to real estate, I set out to find a similar approach to trading. Rather than bombard him with all of the different techniques traders use to make money, I decided to choose one simple technique that he could apply over and over again.
My goal was to come up with as few rules as possible, and for those rules to provide a reasonable expectation of a good trade. The following chart is what I came up with.
Make sense? It should after a few minutes. It's a pretty simple process.
For this exercise, we want a stock that has been in a good solid uptrend. We will determine the trend by the slope of the 50-DMA, so we want one that is clearly sloped higher. That means we automatically eliminate anything with a flat or falling 50-DMA. By doing this one step, we eliminate anything that has been in a downtrend or is stagnant on an intermediate-term time frame. That's good, because the trade we are doing works on the simple premise that "an object in motion stays in motion" long enough that we will be able to earn our expected profit.
Now that the rising 50-DMA eliminated everything that isn't in an uptrend we have far fewer stocks to sift through. Next, we want a stock that has drifted sideways or declined by enough to touch the 50-DMA. Remember, the medium-term trend is up, which is what caused the 50-DMA to slope higher. But we are looking for a stock that got a little ahead of itself in its ascent. We want something that rallied sharply, and is now drifting sideways or slowly sinking towards the 50-DMA.
Next, we want to see the price test the 50-DMA. It might barely touch it, or it might even spend a few days beneath the 50-DMA, but it should stop its decline at or near the 50-DMA.
Next, we look for a reversal at or near the 50-DMA. I like to see the price reverse and bounce high enough to exceed the previous day's high. This is called a swing low, and it provides a solid spot to use as a stop.
Once you own the stock, set your stop just below the low of the move, and your target at the previous high. Done. You should now have a trade that offers a solid reward that is at least two times as much as the total risk, and it should have a reasonable probability of succeeding. Of course, it might turn around and head right back down, but that is what the stop is for. The stop should be close enough that the loss on the trade will not exceed more than 1% of your portfolio. You can size the trade accordingly, with most trades requiring 10-20% of your total portfolio.
If you do this trade over and over again, you will find that some will reach their target, others will stop out, and still others will deviate from your expectations in a way that requires you to change course and adapt. For example, the stock might make it halfway to the target before turning lower. But if that happens, we have a sell signal indicator that will tell you when to exit. Absent the sell signal, we hold until the price reaches our target, at which point we exit for a profit and look for the next stock to trade.
Here is a chart that shows the same trade, but it isn't yet ready to harvest.
As you can see, this one has so far made it about halfway towards its target. With this short lesson, you should be able to spot the entry, exit, and the stop. On the chart below, you can see it is the same trade, repeated.
For simplicity, we removed the other moving averages from our Wanderer Financial indicator (easily accomplished by clicking off the boxes in the indicator's settings). You will notice that the buy signal usually prints very close to the swing low. The exact entry will only be obvious with the benefit of hindsight, but it isn't important to nail the entry with exact precision. To review we look for:
Of course, there are variations of this trade. For example, you can do the same trade off of the 20-DMA. You could also sell half at the target, and then hold the other half until you get the next Wanderer Indicator sell signal. By doing that, you give yourself the opportunity to capture bigger wins occasionally. The chart of Litecoin shows how selling half at the target and keeping half until the next sell signal can result in additional profit.
By doing this trade over and over again, you will become proficient at it. You will find some will work perfectly, and some won't work at all. But it will provide a setup where the target is at least twice the distance that the stop is, so the reward-to-risk ratio is 2:1 or better. And for the losers? Stick with your stops so they remain small. Once a trade has gone your way a bit, you can raise the stop accordingly. I like to use the rising 20 or 50-DMA as my trailing stop.
And that's it! My goal was to make it as simple as possible, and by following just three steps you could reproduce new trades every week. Keep in mind that even the best trading systems produce losers as well as winners. That means every system results in occasional losses. That is just part of trading. As long as you follow the concept and stick to your stops, the winners should outweigh the losers, and the account should slowly grow.