Follow trend, mean pullback, breakout, overbought, oversold. When it comes to the markets, it’s not uncommon to hear these terms, but they often create more confusion than clarity. Let’s try to simplify it.
What is the market trend and what is a crowded market? In my editorials I often talk about these two concepts and periodically receive emails from readers asking me to explain the reward and the answer.
Trend following indicates that the market tends to continue the current trend: if it touches a new high, it will tend to continue higher, and if it touches a new low, it will likely continue lower. The strategies used in these types of markets usually buy when the price is high, and try to make money by “riding a horse already”.
If you want to know more about the trend-following concept, watch this video at hack systems >>
The “declining” market, in Italian “returning to the mean”, is acting in the opposite direction. When approaching a maximum or minimum, the market tends to reverse course and return to average prices. The mean reversion strategy buys when the trend is downward, thus when the price is below the mean, and then sells back after a future reversal that causes the price to go up.
In the following image we show how the door can be opened near the extreme of both possibilities: there are stocks that tend to break previous relative extremities (beyond the red rectangle) and others that tend to touch the red rectangle and then decline.
But how do you apply this information in practice? By knowing the trend-following and counter-trend markets, you can choose the best strategy to use.
To determine the nature of some markets, we conducted tests on FTSE Mib 40, FTSE Star and on commodities: we applied two systems to the markets of interest, the first earns if the market follows the trend and loses money if the market is falling, and the latter does just the opposite. The result shows that the FTSE Star is a shifting market, while the FTSE Mib 40, and more, the commodity market, are following the trend.
Today, if we want to follow a trend-following strategy on Italian stocks, we should watch SNAM (SRG), which is close to breaking the 52-bar low, the lowest in the past year. In this case, note that the potential breakout is the minimum, not the maximum, so instead of buying, we will short SRG when the price drops below €4.62. However, remember that statistically, a short trade, using this strategy, is less likely to succeed than a long trade.
Another interesting stock is SARAS (SRS), which, after breaking the annual highs between the end of April and the beginning of May, has prolonged the bullish impulse towards new heights. The highest price for last year was recorded in the week of June 6, when it touched 1.37 euros. Following the trend following strategy, we had already rode the bullish wave, and now we will wait for the breakout of the new high at 1.37 €, confirming the upside, to expand our position.
On the other hand, if you think you are more inclined to use a mean reversion strategy, you can keep AVIO (AVIO) in check: in this case, the RSI, a very popular technical indicator created by the great Welles Wilder, rotates to identify an oversold condition. . Moreover, the price is close to the lowest level in the last 365 days, which is a second condition that can reinforce the idea of a price reversal, given that AVIO is a stock in the FTSE Star index, which, as we said before, means a return to normal nature. Before buying, we wait for the RSI to drop below the value of 15, and the price is approaching the low of €9.44, in order to take as much profit as possible after the final reversal.
However, always remember to set a stop loss for your open positions. A stop loss of around 7% is well suited for these types of strategies.
(Marco Cavallari Collaboration)
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