Trading Rule #2 - Identify potential trade set-ups
With trend-following trading, you want to identify and trade the strongest stocks in the market you are following. This goes against the conventional investing advice of buy low, sell high. When trend following trading, you want to buy high and sell higher. The majority of trend following traders will buy on a breakout, or on the retracement of a breakout, from some defined level. This defined level could be a breakout above a new 4-week high (20-day moving average), a 40-week high (200-day moving average), a 52-week high, a new all-time high, or some other level that allows you to catch the momentum of the trend. You will need to choose a level that you have tested for your market and that you are confident with.
The goal is to keep your trading strategy routine simple, so that it takes no more that 15-20 minutes a day to implement. Part of your daily routine will be to scan the market for potential trading candidates. This will allow you to filter the hundreds of stocks on the market you are trading, so that you have a list of 20-50 potential set-ups that you can stalk until the time is right to pull the trigger and enter the trade. If you decide to trade a breakout retracement strategy, you can use your breakout level as the scan criteria (i.e. 20 DMA, 200 DMA, 52-week high, etc.) as your screening criteria. If you decide to trade the actual breakout, you may want to scan for stocks hitting levels slightly below your breakout level (i.e., 15 DMA, 195 DMA, 51 high, etc.). There are several websites, such as Stockcharts.com, that have good scanning tools. Remember that you want to keep your watchlist to 20-50 candidates, so you may need to adjust the scanning criteria, such as minimum price and minimum volume, so your list does not become too large. You will also need to update your list daily, so you delete stocks that are no longer showing good momentum as you add new candidates.
In the next lesson we will develop Trading Rule #3 - Entering the Trade.
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