Trading Rule #1 - Market Trend

The beauty of trend-following trading is that it works on any trending market, whether it be futures, currencies, exchange traded funds (ETFs), or stocks.  Although trend-following trading was originally developed to use on the futures market, the average trader should consider initially focusing on stocks, as it is easy to set up an equity trading account with any online broker; and equities don’t have the same leverage risk as currencies and futures.  Trend- following trading works in both up and down markets.  When the market is rising, you place long orders; and when it is falling, you place short orders. It is suggested that until your trading strategy has a proven track record of at least 100 trades you concentrate only on trading the long side.

For most traders, it makes sense to initially focus on your local stock market.  By focusing on your local stock market, you avoid the need to convert currencies, as well as issues involving time zones and dealing with foreign tax regulations.  Although trend following trading works on all trading time frames, it is suggested that traders focus on either daily or weekly time frames.  Focusing on hourly charts (i.e day-trading) would require that you closely follow the market throughout the day.  Our goal is to keep our trading strategy as simple as possible and only spend 15-20 minutes a day executing it. 

Since your strategy will initially be trading long only, you will need a filter that tells you when you can trade and when you should stay on the sidelines.  Markets are generally classified as being in a bull market when the price is above the 200-day moving average, so this could be a filter to consider.  You may want to experiment with higher or lower moving averages to see if they are more appropriate for the market you are trading.  If the price is below your moving average threshold, you should consider trading another market or move your money into a money market fund until the price once again moves above your moving average threshold.  This simple step will help you avoid the 40%-plus drawdowns that buy and hold investors experience approximately once every decade.

In our next lesson we will develop Trading Rule #2 - Identify potential trade set-ups.

Download our step-by-step guide - "How to Build a Systematic, Rules-Based, Trading Strategy" and start trading your way to financial freedom!

download guide