Technical Indicators and Chart Patterns
Moving Averages (50, 100, 200-day):
Moving averages are crucial for understanding the broader market trend. The 50-day moving average gives insight into short-term trends, while the 100-day and 200-day moving averages highlight long-term market direction. These moving averages often act as dynamic support or resistance levels, helping traders decide where to enter or exit trades. When the price crosses these averages, it can signal trend changes or provide trade confirmation.
Relative Strength Index (RSI):
RSI is a momentum oscillator that fluctuates between 0 and 100, providing insights into whether a stock might be overbought or oversold. Typically, an RSI above 70 signals overbought conditions, while an RSI below 30 indicates oversold conditions. However, RSI itself is not a direct buy or sell signal; stocks can remain in overbought or oversold territory for extended periods.
In our trading strategy, RSI is particularly useful for spotting divergence. Divergence occurs when the price of a stock is making new highs or lows, but the RSI is not confirming these moves. For example, if the price is making a lower low while the RSI is making a higher low, this divergence can signal a potential reversal from oversold conditions. Conversely, if the price is making a higher high while the RSI is making a lower high, it may indicate a potential reversal from overbought conditions.
The reason divergence works is that RSI reflects the balance between buyers and sellers in the market. When the price is making lower lows but the RSI is making higher lows, it indicates that there are fewer sellers driving the price lower, suggesting a weakening downtrend and a potential shift in market sentiment. Similarly, when the price is making higher highs but the RSI is making lower highs, it shows that there are fewer buyers pushing the price up, signaling a potential trend change to the downside. This imbalance between price movement and RSI helps traders identify potential reversals.
Percentage Price Oscillator (PPO):
The Percentage Price Oscillator (PPO) is a momentum indicator that measures the difference between two moving averages of a stock’s price, expressed as a percentage. It is designed to help traders identify the strength and direction of a trend by comparing short-term and long-term price movements. The PPO is calculated using the formula:
PPO = [(EMA(short) - EMA(long)) / EMA(long)] × 100
Where EMA(short) is the short-term Exponential Moving Average and EMA(long) is the long-term Exponential Moving Average.
The PPO provides two key components: the PPO line, which represents the difference between the two EMAs, and the signal line, which is a moving average of the PPO line. When the PPO line crosses above the signal line, it can indicate bullish momentum, while a cross below can signal bearish momentum. Additionally, the PPO histogram displays the difference between the PPO line and the signal line, helping to visualize the strength of the trend.
We use PPO to identify both divergence and bullish/bearish crosses as part of our trading strategy. Divergence occurs when the price is making new highs or lows, but the PPO is not confirming these moves. For example, if the price is making a higher high while the PPO is making a lower high, this divergence can signal a potential reversal from overbought conditions. Conversely, if the price is making a lower low while the PPO is making a higher low, it may indicate a potential reversal from oversold conditions. This divergence reflects an imbalance between price movements and the strength of momentum, signalling potential trend changes.
In addition to divergence, we also look for bullish and bearish PPO crosses. A bullish PPO cross happens when the PPO line crosses above the signal line, suggesting a potential buy signal. Conversely, a bearish PPO cross occurs when the PPO line crosses below the signal line, indicating a potential sell signal. We anticipate these crosses as trade signals and seek confirmation to validate their strength. Confirming the cross helps us decide whether to stay in the trade, enhancing our strategy with additional confidence in the trend direction.
By weighing both divergence and PPO crosses equally, we gain a comprehensive view of market momentum and potential trend reversals, allowing us to refine our trading decisions effectively.
Price Patterns:
At TOR Trading, we focus on patterns that have proven to be reliable over time. There are many chart patterns that traders analyse, but from our experience, we’ve found a few that consistently provide actionable signals. In order of reliability, we pay attention to the following:
- Falling and Rising Wedges: These patterns are highly reliable for signalling potential reversals. A rising wedge occurs during an uptrend and signals a bearish reversal, while a falling wedge occurs during a downtrend and signals a bullish reversal. The wedge formation shows a narrowing price range, indicating weakening momentum and a likely breakout. These patterns are effective because they represent a gradual shift in supply and demand, signalling when momentum in one direction is losing steam.
- Double Tops and Bottoms: These patterns are reversal formations that signal a change in trend direction. A double top forms after an uptrend, indicating a potential downward reversal, while a double bottom forms after a downtrend, signaling a potential upward move. These patterns are considered reliable because they visually show a market's failed attempt to break past a support or resistance level twice, signalling exhaustion of the prevailing trend.
- Flag Patterns: We use flag patterns primarily to confirm continuation moves rather than as standalone entry or exit signals. A flag forms after a sharp price movement, followed by a brief period of consolidation, typically sloping against the prevailing trend. The continuation occurs when the price breaks out in the same direction as the initial move. Flag patterns work because they reflect market pauses before a strong directional move resumes, allowing us to capitalize on trend continuity.
- Head and Shoulders Patterns: These are among the most well-known reversal patterns. The head and shoulders (or inverted head and shoulders) indicates a trend reversal. The pattern shows a peak (shoulder), followed by a higher peak (head), then another peak (shoulder) roughly at the same level as the first. This symmetry signals a weakening of the prevailing trend and an impending reversal. It works because it reflects a clear shift in market sentiment—buyers or sellers are no longer able to sustain the previous direction.
These patterns give us a deeper understanding of market behaviour, helping us make informed decisions regarding trade entries and exits based on reliable formations.
Trend Following vs. Countertrend
At TORtrading, we place a stronger emphasis on countertrend trading as opposed to the more common trend-following approach. While countertrend trading carries higher risk, it offers the potential for better risk-to-reward ratios by capitalizing on trend reversals. We use the tools and methods we've discussed—such as PPO, RSI, price patterns, and support and resistance levels—to identify with greater probability when a trend may be about to change.
Countertrend Trading:
Countertrend trading involves going against the current trend, and it is riskier because you're betting on a reversal. However, when done correctly, it allows us to enter at ideal points with a favorable risk/reward setup. For example, we might look to buy in a downtrend if key indicators show a bullish reversal is imminent, or sell in an uptrend if there are signs of exhaustion or bearish divergence.
Trend Following:
While we focus more on countertrend setups, we don't ignore trend-following opportunities. In markets that are steadily trending up or down, we look to ride the trend by entering during minor pullbacks or rallies.
Now, this strategy comes with a critical caveat: there are multiple trends across different time frames. Markets can be trending in one direction on a yearly or monthly basis, while trending in the opposite direction on shorter-term daily or hourly charts. Success in trading often hinges on understanding which trend is taking precedence—usually the longer-term time frames.
Mastering Trend Identification:
There is no secret trick or easy formula for determining which trend is dominant. It takes extensive time and experience in the market to develop this skill. At TORtrading, we've spent years honing our ability to identify which trends are most significant at any given time. This isn't something that can be learned overnight—it requires continuous practice and learning through real-world market conditions.