The Right Way to Trade Tops and Bottoms
By Steve Primo, SpecialistTrading.com
Have you ever wondered why most traders consistently lose money? There are several reasons why this happens, but it’s usually because traders follow some outside system they picked up somewhere, and followed it blindly. It may work for a while, until it ultimately fails. Some traders can make five or six successful trades, and give all of their money back on the seventh trade. Others try to time the market, and buy when the market is at its peak, while selling when the markets are low.
In my 37 years of trading the markets, I have personally experienced all of the highs and lows of trading and struggled to maintain consistency many times throughout my career, especially early on. I have traded through bull markets and crashes, and there isn’t a trading system I haven’t seen. One day, one of my mentors on the trading floor gave me a valuable piece of advice – I was relying on way too much outside information to make trading decisions. He told me that the key to success was to strip away all of the external systems I was using and to simplify my approach to trading. He reminded me to keep it simple, and that successful trading is not about making the most money, it’s about being consistent.
One of the best strategies I learned was a very simple way to trade tops and bottoms in the markets. But first, it’s important to understand how most people trade tops and bottoms. By the way, this is also the way I used to trade when I was struggling.
How we have been Trained to Trade Tops and Bottoms
In this diagram we have an older chart of Apple. Most people use some kind if indicator, and in this case we are using a standard slow stochastic indicator to show overbought or oversold conditions. When you go over the upper threshold at 80 you are in an overbought condition, and you should prepare to short the stock. If you cross beneath the 20 threshold, the market is oversold, and you should be prepared to buy. Other indicators that are commonly used include fast stochastics and RSI to help identify overbought or oversold conditions. To summarize, conventional wisdom suggests we should be prepared to sell overbought stocks or buy oversold stocks.
In the Apple daily chart above, this system is working perfectly. The Slow stochastic indicator is under 20 at the bottom of the market, indicating a buy signal. Once it cross past the 80 threshold, and starts moving down a sell signal is triggered. So you bought on a dip and sold at a peak. Now you have a “system” confirmed by stochastics, and it should work like clockwork, right? Let’s keep the chart moving:
You’ve just had two nice wins and the stochastic indicator drops below 20. So it’s time to buy again, right? But this time you decide to double-up and buy into the oversold condition. Instead of the market going up, it goes down, erasing profits from the previous trades. The next time the stochastic drops below 20, you buy and it drops again. The last time it drops below 20, you buy and it drops once again. You’ve given away all of your profits from the first two trades, and you are now in the hole. But this is Apple. What about Forex or the E-mini S&P?
Once again, in this daily chart of the E-mini S&P. the stochastic indicators cross the 80 threshold, indicating overbought conditions, and presents a nice selling opportunity.
Next, the stochastic indicator bounces off the 20 threshold in oversold territory and presents a buying opportunity.
Two nice trades are in the books, and it’s time to look for the next overbought or oversold condition.
Will the trend continue? Let’s see how it plays out:
With two successful trades in the books, you decide to go short again. The market is overbought and starting to trend down. You are above 80 and get a signal when the stochastic lines crossover, so you decide to sell. And the market goes up. At the next crossover signal, you decide to sell again. And the market goes up. If you keep doing this, you are in jeopardy of wiping out your entire account. This is the point where many traders start to hide their brokerage statements from their spouses.
So we’ve taken a look at a stock, and the E-Mini S&P, what about Forex?
In this chart of the USD/JPY currency pair, the market is chopping sideways until it starts to go up. But the indicator starts to move into overbought territory and according to your rules, it’s time to sell. We make a little profit on the first trade, and you wait for the next trigger. Since we are so ingrained in the belief that we must sell when the market is overbought, we look for the right triggers and setups. Maybe a Forex expert has also proclaimed that the market must fall. He’s never wrong in your opinion, and the triggers are there for a sell opportunity. So you sell the USD/JPY when the lines cross over, and the market rises again. All profits were erased and you are in losing territory.
The problem with this approach to trading tops and bottoms is that short term gains are usually wiped out over time. It’s almost like gambling. The casino gives you a taste of winning and then they wipe you out once you’ve taken the bait. Remember, as traders, we are not looking for the big score, we are looking for consistency.
The Right Way to Trade Tops and Bottoms
First Rule: There is no such thing as
OVERBOUGHT or OVERSOLD
You may want to write this rule down and tape it to your computer screen. One of my mentors made me repeat this mantra to him until I drove it into my head. How many times have you seen a market rise, and just keep rising? You tell yourself it has to fall, but it just keeps going up. The same happens with markets that are oversold, and keep dropping for days or weeks. You need to develop a mindset that there is no such thing as overbought or oversold markets.
Second Rule: The right way to trade
GO With Them!
My mentors taught me to stop trying to predict tops and bottoms, and to learn how to go with them. What you are going to learn from this lesson is a very simple entry technique for trading tops and bottoms. So let’s go back to the Apple chart.
When we started with the Apple example, we lost a lot of money trying to buy off the bottoms of the market. One of my mentors told me that before trade anything, you must add a simple tool, and that is the 50-day Simple Moving Average (SMA). It doesn’t matter if you are trading a 5-minute chart of the E-mini, or a monthly chart of the British Pound. You must have the 50 day SMA plotted, and before you pull the trigger on a trade, you must ask yourself: “Where is price in relation to the 50-day SMA?”
You will only come up with two scenarios:
- If price is BELOW the 50-day SMA, as shown above, you want to SELL the market
- If price is ABOVE the 50-day SMA, then you want to BUY the market.
With the 50-Day SMA plotted, there was no reason to buy Apple. It was clearly showing a sell trend. So with this information, how do you trade Apple in this scenario?
What you want do, knowing that the 50-day SMA is indicating a bearish trend, is to first circle all of the oversold areas. Since we’re going short, we are only concerned with the oversold areas. Next we want to underline all of the short-term bottoms on the chart, and they must be aligned with the oversold areas we have circled. Once a previous bottom has been violated, that creates your entry point, indicated by the red arrows above. This entry technique shows you how to be in synch with the market when you are going with the market as opposed to trying to pick tops and bottoms. In this scenario, you would not have lost money trading Apple, because you were in synch with its overall trend.
Let’s apply this technique to the E-mini S&P example:
In our E-Mini S&P example, we were previously interested in finding opportunities to short the market, but once the 50-day SMA is plotted, the trend is clearly above the line, so we are interested in following the market and going long. First, we circle the overbought areas on the slow stochastic oscillator. Next we want to draw a horizontal line at the high points on the charts that are in alignment with our circled overbought areas on the stochastic indicator. Once a previous high has been breached, it triggers a BUY entry signal, as indicated by the arrows above.
Now for the Forex example:
In our original example, the stochastic indicator was in oversold territory, and we lost money looking for triggers to short the USD/JPY currency pair. Once the 50-day SMA is applied, the trend is obviously bullish. We start by circling the oversold areas. Next, we draw horizontal lines at all of the peaks that are in alignment with our circled oversold areas. Our entry points, indicated by the arrows, occur after a previous high has been breached to the upside.
If I were stranded on a desert island and given one trading tool, I would choose the 50-day SMA. To me, it’s the single most important tool you can use to make sure you are on the right side of a trade. And it doesn’t matter whether you are using a 5-minute, hourly or daily chart. On the day I first presented this webinar, I made a live trade using a 1,000 tick bar chart of the E-mini S&P. Here’s how it played out:
There were two areas where the slow stochastic indicator was below 20. But the 50-day SMA was not above the chart, so no trade is indicated. Once the 50-Day SMA travels below the chart, an uptrend was established, creating six triggered buying opportunities within 1 ½ hours going into the trading day.
If you take anything away from this discussion, please remember there are two key points:
- There is no such thing as OVERBOUGHT or OVERSOLD. There is no consistency in trying to pick tops and bottoms. It’s similar to a gambler’s mentality. Never, Ever try to pick Tops and Bottoms.
- Never, ever try to pick Tops and Bottoms. Markets will go as high as they want, or as low as they want. Don’t try to stand in their way, or they will run you over. Go with the markets.
If you’re interested in trading tops and bottoms, try out this method in simulation mode. Keep it simple and plot the 50-day SMA along with a slow stochastic indicator and follow the steps in this presentation. See if it doesn’t improve your trading consistency.
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