Conventional wisdom says to buy at the low and sell at the high. If only it were that easy. More experienced traders will tell you it is a matter of buying high and selling higher. Now this article will explore the differences in two types of common trading strategies that refute each other. The first type of strategy we will discuss is a breakout system and later we will examine the fade trade.
The breakout system is based on the laws of Newton: Objects in motion will tend to remain in motion unless other outside forces stop them. Stocks, Currencies, Bonds, Options, and Futures are no different that objects of matter. If a stock has been bouncing between $23 a share and $25 a share for a weak and finally breaks above $25 on heavy volume this would be an example of a breakout. Now if I told you that the Stocks 52 week high was $25.43 and the stock just ran past $25.78 would you be inclined to buy or sell at this point? If you said sell then you may want to skip down to the next paragraph as the fade trading strategy may better suite you. For all those that would like to buy after a 52 week high you would be correct in your thinking because not only has the stock broken a shorter term timeframe of one week, but also a much longer term trend over the course of a year. A breakout trader loves to go long stocks breaking their all time highs. When you talk to old veteran floor traders they will tell you that stocks always go higher and lower than anyone ever expects. If a stock has broken out and has surpassed its 52 week high it has a lot of momentum behind it and it would make much more sense to go with the trend. Haven’t you heard, “the trend is your friend” from other experienced traders? There are many more indicators, patterns and even fundamental analysis that professionals use when making a breakout trade, but this gives a good premise for the strategy. Now for those that do not like buying at the top there is the exact opposite system available to you.
The Fade Trade – As one would guess the Fade Trade sells tops and buys bottoms opposite to what the breakout system would do. The idea is very simple and conforms well to human nature. In a minute you will see how this is not always a good thing in trading. If prices of a stock have gone up for 3 weeks in a row well past a previous 52wk high many traders are very reluctant to purchase the stock. They are upset that they missed the great run up and do not want to pay higher prices then other traders. They fear that as soon as they get in the party will end. In itself this is not terrible thinking. However, to be a successful fade trader it takes more than guessing that the rally is over. When taking a fade trade the trader will sell the stock after they believed it is well over priced to the high side. To be successful the trader must use filters. First they should never place the sell trade until they see price action to confirm it. For instance if a stock has risen from $50 to $75 a share and then dropped below $70 this is a sign the rally has ended and a sell would be warranted. A trader would not want to watch the stock trade up to $74, $75, $76 and then place a sell hoping at that instant the price will head down. This is wrong on so many levels. Firstly, this trader would be relying on the premise that they are all knowing and can predict the exact instant the trade will turn around. The statistics behind this are staggering. Nostradamus would not be able to make this kind of trade. Secondly, people don’t want to wait for it to come back down because they are afraid that they have already missed some of the profits and the trade will not go much further. This greed results some traders to, “try and catch a falling knife,” this refers to traders trying to fade a downward move by going long while the stock is still moving down. A fade trade can be very profitable if done intelligently, by waiting for the prior tend to cut out and be aggressive in opening the trade in the other direction.
So which strategy is right? To be honest it must be the system that works for you. Both systems have been used profitably by many traders. The important thing is making intelligent choices and forgetting greed. Potentially a trader could use both systems. For instance picture a stock that has traded between $35 and $37 for the week and its 52 week high is $43. If the price of the stock suddenly breaks though $37.60 on strong volume an intelligent trader should open up a long position. If the stock continues up to $43.50 what would you do? Since it has not retraced at all and has now broken its 52 week high you should add to your long position as this is another sign of strength. You made a good decision and the stock churns higher to $55, but then stalls out there for a few days and drops sharply to $49 the next day. This would be a great opportunity to fade the move. You went long with the momentum you increased your position as the momentum increased. Now that the charge is over and the stock has already been marked up considerably where it was just a week ago it is an intelligent time to sell it. You could place your stop at the previous high of $55 with $6 of downside risk, whereas the stock could move all the way back to its normal range of $35 and $37 which would net you a gain of over $11. This is a fade trade worth taking since the risk to reward is good and you are not trying to catch a falling knife.
Again it is more important that you trade with a system that suites you. There are plenty of systems out there to choose from, but these are two very common foundations for which systems are built. I would encourage you to select one of the systems that you are the most comfortable with and practice paper trading. As you become more experienced and see how the trades play out you will have a better sense of how the market works and this will help you develop trust in your system. One helpful hint is to trade longer timeframes. As you back your charts out from intraday to the 4 hour and daily charts you will have more success as your trades have more time to play out.
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