Buying on a Retracement

One of the simplest trading plans is to buy when the price retraces in an established uptrend. Inevitably, even in strong uptrends, prices fluctuate up and down. In fact, the Dow theory specifically points out the existence of the counter trend move which Dow figured would last from three weeks to three months.

In this strategy, the aim is to go with the trend, which is always considered to be less risky than the opposite. What we want to do is buy a long CFD when the retracement has completed, and enjoy the profit from the trend resuming.

In order to make this CFD strategy work, we first have to confirm that the price is indeed in a continuing uptrend to minimise the possibility of suffering further drops. There are several ways to establish this, and possibly the simplest is to look at a long-term moving average such as the 200 day which should be steadily increasing and below the current price. In fact, some traders use MACD or other moving average based indicators as a way of identifying reversals in stocks that have already started to materialise.

 

What does MACD do?

Moving Average Convergence Divergence or MACD for short is a simple and one of the most reliable technical indicators. The indicator uses moving averages (which are lagging indicators) to introduce some trend following traits. The longer moving average is then subtracted from the shorter moving average to transform these lagging indicators into a momentum oscillator. The result is a plotted line that oscillates over and below zero.

One of the most popular formulae for computing MACD is to calculate the difference between a share's 26-day and 12-day EMO (exponential moving averages). However, it is worth noting that using shorter moving averages will result in a quicker, more responsive indicator, while longer averages will result in a slower indicator. In this case a MACD over 0 would mean that the 12-day exponential moving average is trading above the 26-day exponential moving average. A rising positive MACD would result in the gap between the 12-day exponential moving average and the 26-day exponential moving average widening further which would be a sign that the rate-of-change of the faster moving average is changing quicker than the rate-of-change for the slower moving average. Positive momentum is increasing which would be considered a bullish signal.

On the other hand if the Moving Average Convergence Divergence is below zero and continuing to decline, then the negative gap between the faster moving average and the slower moving average will expand which is an indication that downward momentum is accelerating and this would be considered a bearish signal. Moving Average Convergence Divergence centerline crossovers happen when the faster moving average crosses the slower moving average. A benefit of the MACD is that it includes both traits of momentum and trend following in a single indicator. As such, as a trend following indicator, it is unlikely to post a wrong reading for long since the use of moving averages guarantees that the technical indicator will at some point start to follow the movements of the underlying share. MACD is often used to predict a trend change. For instance a negative divergence on a rising share means that upwards momentum is starting to weaken and that there could be a possible change in trend direction from up to bearish which acts as an alert for CFD traders.

What Next?

Having a suitable candidate for this strategy, we now look and wait for a retracement. This can be identified by technical indicators, or by looking for a low price which is lower than the previous two weeks lows. This is a rule of thumb, and these rules can be changed to suit the particular security and the way it behaves. You should note that it is difficult if not impossible to capture the total extent of each move, as it is best to wait for confirmation that the price is truly going in the direction that you hope for, and inevitably this takes up some of the price move.

At this stage, we are poised to buy a long CFD and ride up with the trend. The next question is how to determine that the retracement is ended, and that the uptrend is about to resume. In order to keep the analysis simple, we can look at the price chart and decide that the uptrend has resumed when the price has risen above the highest price of the previous week. This is a reasonable and obvious way to decide that the uptrend has recommenced. Once we have that signal, then we should go long with a CFD, leveraging our trading capital and anticipating a resumption of the uptrend.

Now any time we place a trade, we should have a clear idea of what constitutes a failure and a signal to cut our losses and exit the trade. In this case, the trade fails if the retracement continues, so if the price drops lower than the lows of the previous couple of weeks this is a sign that we should exit and accept a loss.

The profit target for this trade is not clearly defined by the chart. The trade should be exited on the basis of a trailing stop, or if it appears that the uptrend is stalling. To gauge this, another simple indicator would be a 20 day simple moving average. If this SMA were to stop rising, and start to turn down, then this would be a good signal to complete the trade and take our profits.

A quick note on consolidations. The way I read consolidations is that the longer a consolidation continues the more likely it is to eventually break in the same direction of the previous trend. The psychology being that investors have held for an extended period of time so they have faith in the long term prospects.

 ...Continues here - Trade CFDs: Trading System Based on Moving Averages

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