Finding Key Trading Levels – Anchors for your trading
Many traders are lured into the idea of picking tops and bottoms. And why wouldn’t you when so much of the commentary on the markets refers to the price move from the bottom to the top. But the reality is no one catches the top and the bottom consistently. It’s just not possible.
Other traders like to trade off the peaks, in other words to trade reversals. It sounds cool at first sight – you’re a “contrarian”, a smart and independent individual! What could be wrong about that?
But let’s consider the big picture. Look at the trend in NASDAQ100 below.
For the last year, how many times there were meaningful trend reversals? There were two! That’s it!
What is easier? Trying to catch the events that happen only a few times a year or use the market state that’s available the rest of the time?
Trading with the trend has the highest probability of winning. It also has the higher risk to reward ratio. You are more likely to be profitable trading with the trend than against it. The key to trading with the trend is knowing when to stay in and when to get out.
The struggles to stay in the trend
Looking at the previous chart of the trend in NASDAQ100, we can see numerous pullbacks along with the major move. Each of the pullbacks will test your patience. Each of them will try to convince you, that it’s the end of the trend and it’s the time to get out. Many traders succumb to these thoughts and jump out of a trend too early, thinking they are picking the top of the trend.
When the market is in a strong trend, it is hard to sit through pullbacks thinking “How much higher can it go?” or “I don’t want to lose any of my profits!”. But getting out at minor pullbacks means you are missing out on the rest of the trend move.
Nobody knows when the trend will stop; however, we can use the principles of the trend structure to our advantage to capture more of a trend. Using Anchors, we can show you how to take some profits off the table on a pullback and keep the rest to take advantage of the next up move in the trend.
What is the trend structure?
The trend is the market condition when the price continuously makes higher highs and higher lows (in case of an uptrend). Conversely, in the downtrend, the market keeps making lower lows and lower highs. We intuitively feel that the market is trending when we see the price starts in one corner of the screen and ends in the diagonally opposite.
Let’s look at the basic structure of the uptrend in the illustration below.
Major parts of the trend
The trend consists of major moves and retracements. Below is the chart of Australia 200 index. The index turned into the trending mode in the middle of May, when it failed to break down the minor support (a short grey line-area around 5300), and started heading up breaking out the resistance around 5600.
The blue arrows mark the major moves up, and the red arrows show the major retracements.
Anchors as the critical swings of the trend
Here is the same chart, but this time let’s focus on the higher lows that come up during the uptrend. The anchor signs show each higher low that is significant for us – we call them “anchors”. Let’s find the anchors in the chart below.
Notice that the anchors are different in size, just as their respective anchor signs. Each major move forms the major anchor as the higher low of the move (big anchor signs).
Zooming in, we can find the smaller retracements within each major move. The higher lows of those retracements are minor anchors.
In general, major anchors are significant for the higher timeframes, while minor anchors are important for lower timeframes. Sometimes we can disregard minor anchors when we’re trading on a higher timeframe. It would be dangerous though not to pay attention to the major anchors trading on the lower timeframe.
How can we use the anchors in trade management?
We use major anchors to place our protective stop loss for the total position. Look for the lows of the major retracements to locate your major anchor. A new anchor forms after a retracement has formed and price moves back up to the previous high of the trend. Move your stop loss for the total position to the point right below the new major anchor. Always wait until the price has moved up past the previous high to confirm that the retracement has been completed before you move your stop.
You can see the spots (short black horizontal lines) of the stop losses for the total position in the chart below.
If the market broke down the anchor, it would invalidate the major trend structure, and it would make sense to exit the position.
The minor anchors are useful to manage the risk within the major move while remaining in the main trend. We can trail our partial stop (for example, 1/4, 1/3, 1/2 of the total position size) behind the minor anchors.
In the chart below the potential spots for the partial stops are marked with the short black lines.
The minor protective stops allow you to take some profits during the first up move of the trend, reducing the risk along the way. You also stay in the trade to ride the major trend. This is a smart move from a profit perspective, and also takes some emotion out of the trade. Then you can stay in the trade for a potential second and third leg of the trend. It is the bigger moves that really add profits to your account.
This is a process to manage your trade allowing you to take an early win and ride the longer trend. It is also a valid and effective exit strategy.
Why not pick tops or bottoms?
Many traders are trying to pick tops or bottoms of a trend. In other words, they attempt selling on the top of the major move. Overall, it is a dangerous endeavour in the long-term, as we never know when the major move ends. We risk exiting too early, while the market often continues climbing higher.
It is always better to let the market tell us the trend is over, rather than trying to play smart picking tops or bottoms. The desire to pick tops or bottoms may come from a strong bias to be right. After all, there are hundreds of educators and software signals that advertise their products showing the profits as if they picked to absolute top and bottom of the market. Don’t be fooled! In the environment of uncertainty (which the market is) such bias is dangerous for our psychology and can lead to poor habits in trading.
Instead, have a strong trading strategy of trading with a trend. Use anchors to take partial exits along the way and utilize your exit strategy. This is a sustainable approach for trading profitably over the long-term. It also takes much of the stress and emotion out of your trading, so you avoid poor trading decisions.
When we understand the basic trend structure, we can manage the risk effectively, maintaining peace of mind during a trend. Anchors are an excellent way to find the right spot for a stop loss. We use the major anchors to place the stop loss for the total position. The minor anchors help us to trail the partial stop, allowing us to take profits as the major move starts retracing. Then keep the majority of the position to ride the primary trend to maximise your profit on the trade.
Learn more about anchors here.