Which Trading Strategies Should You Use

...to survive and profit in today’s difficult markets?

Tue, Aug 10, 2010 - 12:00am

While many traders rely on their personal, “tried-and-true” trading strategies, it’s critical to employ a variety of strategies based on the current phase of market activity. Therefore, you must first understand the three phases of market activity and determine the market’s current phase – then strategically select your trading approach. This article outlines the three phases of market activity and the best trading strategies for each phase, including Elliott Wave and other techniques. In addition, I provide specific recommendations for today’s difficult trading environment.

The three phases of market activity are:

  • Bottoming/Topping,
  • Accumulation/Distribution, and
  • Trending (up or down).

Market Phase #1: Bottoming/Topping

A major market top or bottom is rare and, by definition, lasts a long time. Therefore, you can’t have a major top or bottom every few weeks. Recognizing a market top or bottom can be difficult, yet extremely profitable if you’re right.

However, this phase of market activity is one of the most dangerous times to trade, because it can produce repetitive losses if you continually guess incorrectly. For example, in an expanding environment, a market can be in a topping phase, yet make minor new highs over and over without changing the fact that a top is forming. Unfortunately, many people trade as if major market tops or bottoms happen frequently, which is why they can end up losing so much money.

Market Phase #2: Accumulation/Distribution

Since one is the mirror image of the other, let’s focus on Accumulation: After bottoming, the market may bounce off the low and experience a period of back-and-forth consolidation. This occurs because financially powerful traders are accumulating positions, preparing for the future market advance. While wealthy traders accumulate positions, less experienced, under-capitalized traders are selling into the retest of the market’s bottom, thinking the market will go lower. While a majority of traders are selling into the market’s decline, this “public activity” makes the Accumulation phase possible for a minority of wealthy traders to hoard large, Long positions. In other words, when the majority of traders are selling, the wealthy understand this is an excellent time to buy, and they have the “financial patience” to wait for the demand environment to change, forcing prices higher. In the Distribution phase, the opposite is true.

Market Phase #3: Trending (up or down)

Continuing our discussion from above, once nearly all positions that can be bought have been purchased, the Accumulation phase is complete. Most traders are committed – they’ve laid their claim – and are now waiting for the market to move their way. During Accumulation, wealthy traders capture nearly all supply in the hope future demand will make their long-term commitment worthwhile. This sets the stage for the Trending phase of market activity. As the economy improves – as it always does – the public realizes the “end of the world” did not occur, so their willingness and ability to invest increases. Over time, growing public demand forces prices upward. (Remember Economics 101: Increasing demand coupled with limited supply creates higher prices.)

In comparison to the prior two phases, the Trending phase lasts the shortest time. Generally, it’s the most difficult phase to profit from, because most traders are uncomfortable entering a market well after the bottom since it’s obvious they’re no longer getting a bargain.

The best trading strategies to employ during each phase

Bottoming/Topping – At market extremes, NEoWave or Elliott Wave trumps all other techniques, leaving little doubt what will happen next and what to do. Wave theory clearly portends market potential, allowing you to catch major market turns. Ironically, at such times, the public (and your friends!) will have the exact opposite market perspective, leaving you a “lone voice in the woods.” Consequently, profiting from Wave theory requires the ability to identify patterns and enter when multiple patterns simultaneously end. Identifying and entering at major market tops or bottoms makes most traders extremely uncomfortable. As a result, placing your trust in Wave theory at this time requires mental fortitude and the personal confidence necessary to buck the majority and take an unpopular position. Though it often appears contrary to “logic or reason,” following NEoWave (or Elliott Wave) during this phase of a market’s development generally offers the greatest possible reward.

Accumulation/Distribution – After a major top or bottom, a market will transition into a choppy period (above its low or below its high). Wave theory can still be useful at such times, but its usefulness starts to diminish. Instead, oversold and overbought indicators tend to be more useful, allowing you to “trade the range,” getting in or out at each market oscillation. The longer the consolidation, the longer you would initiate this strategy.

For example, let’s say you have interest in the Gold market. In this scenario we’ll assume Gold recently began rallying from the $900 level. As one who desires to accumulate Gold, you patiently watch it rally to $1,000, which in hindsight enables you to see the market created an important and obvious low at $900. That observation allows you to objectively implement your accumulation strategy. When Gold begins to pull-back from the $1,000 level, carefully watch your indicators for an oversold condition similar to what occurred near the $900 low. If that oversold condition occurs when Gold is around $950, it’s time to buy. If Gold later exceeds $1,000, you can decide to liquidate some of your position (noting the new high) OR simply wait for the next “oversold” condition to pick up even more Gold. This process can be repeated over and over every time the market exceeds the newly noted high.

Trending (up or down) – As I discussed in my previous interview, this market phase can be random and unpredictable. Here, Wave theory is least useful. During the Trending phase, it’s best to do what most people are afraid to do: buy into market strengths. Keep in mind, strong market trends are not common, especially those in which you can buy into a new high or sell into a new low. When strong market trends happen, they can yield tremendous return in a very short period, far outweighing results you might get from other market phases.

While it’s clear when a market is trending, a safe, low-risk entry may be difficult to identify. So, what do you do? To explain, let’s continue our Gold market example: Gold bottomed at $900, rallied to $1,000, then sold off to $950. If the Accumulation phase has ended, Gold will next move into an uptrend. This is when the “scary” buying-into-highs strategy actually works. In our example, you would place an order to buy Gold at $1,001; if activated, your stop would be just below $950 (say $949). This way, you are “going with the flow” of the market, letting it identify your specific entry and stop points as it progresses. When implemented at the right time, this strategy produces the greatest profit in the shortest period.

Understanding today’s challenging U.S. stock market: Which trading strategy should you use?

After rallying significantly off its 2009 low, since January 2010, the stock market appears to be in its Distribution phase. As a result, your focus should be on “selling into strength” as the market forms a top over the next few months. In this period, overbought indicators work best. Sell into overbought conditions on a Daily or Weekly basis with stops above this year’s highs. Lighten-up on shorts when your indicators suggest the market is oversold, but pay careful attention to when the market no longer bounces off an oversold condition. That is when it’s best to remain Short in preparation for the coming downtrend.

About the Author

Glenn Neely

Founder
NEoWave Institute