The job of the share trader is not to tell the future. The job of the share trader is to accept that they don’t know the future and then structure their share trading activity accordingly.
I think accepting that the future is unknowable is the first step in creating a sound share trading strategy.
Your whole way of thinking about the market is transformed when you look at it in this way. The first question you ask yourself when you know you don’t know the outcome is, ‘When am I wrong?’ Also you can withdraw your ego from proceedings because you aren’t trying to predict the future to prove your self-worth.
The game of share trading becomes one of probabilities.
My long term aim is to have a strike rate (percentage of winning trades) of at least 50% and a risk reward of 2:1, meaning that I will make twice as much on my winners as I lose on my losing trades.
The fact is that the long term results contain a lot of volatility. You can have periods of a 20% strike rate and then periods of an 80% strike rate which averages out to 50%. It can be pretty tough to keep your eyes on the long term figures when you have been share trading with a 20% strike rate, I can assure you.
The psychological battles that a share trader must engage in are immense. And it’s usually this issue that brings most share traders undone.
Anyone can repeat the top ten trading rules that are necessary to succeed, but actually adhering to them in the heat of battle is another thing entirely.
It is only through actual experience trading the markets with real money that we can learn about our own weaknesses.
And the market is determined to prod at our weaknesses at every opportunity.
Most of the price action these days is trading algorithms hunting for share traders’ stop losses. First they suck you into trading and then whip you out of your position. It really is a battle of man vs machine and at the moment I reckon the machines are winning.
The only way to survive in the current market as a share trader is to start thinking like the share trading algorithms. Where are share traders stop losses? Once share traders are stopped out the market will usually reverse.
It is this sort of thinking that lead me to focus on false breakouts rather than breakouts.
There is a far higher probability that a breakout will fail to follow through than continue. The risk that needs to be taken when fading (going against) a breakout is minimal because you are selling into strength or buying into weakness. Therefore you can place your stop loss above or below the most recent extremity in price.
With this method you can join longer term trends by, for example, buying the false break of the lows in an uptrend or selling the false break of the highs in a downtrend.
With this in mind let’s have a quick look at the current chart of the DAX, which is the index for the German stock market.
The DAX has broken out to new multi-year highs recently, but the momentum has shifted back to the downside over the past few weeks.
Click here to enlarge
My intermediate trend signal is now down (The 10 day EMA below the 35 day SMA) and share prices are now resting on the high from April 2011 (see solid blue line in chart above).
If prices snap below the lows from last week of 7,537 I would expect to see some profit taking come out of the woodwork. I wouldn’t be surprised to see a pretty sharp fall towards the 200 day moving average at 7,060 which is over 6% lower than current levels.
Also notice the indicator in the bottom half of the chart. It’s a 10 day average true range as a percentage of the price and inverted on the scale. It basically shows rises and falls in volatility. As the line rises volatility is falling and vice versa.
You can see on the chart that whenever volatility has fallen to current levels over the past few years and then turned back up a top has formed and the market has sold off over the next few months.
Will history repeat? I think so.
But as I said at the start, I know that I don’t know the future. All I know is that now is a good risk/reward moment to start looking at the German DAX as an investment opportunity to profit from the short side.
Editor, Slipstream Trader
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