Differentiating between Short-term Distractions and Setups with True Potential

Traders can improve their odds by ignoring distraction signals and focusing on setups with real potential. In general, short timeframes are better suited for mean-reversion, while long timeframes are better suited for trend-following. Short-term, prices are more likely to revert back to the mean after pullbacks. Long-term, prices are more likely to trend. The “mean” is basically the long-term trend. A short-term pullback within a long-term uptrend is more likely to revert back to this uptrend. Using this concept, chartists can learn to ignore short-term distraction signals and focus on meaningful setups.  TrendInvestorPro applies these concepts in our strategies (here).

While everyone has a different definition, my short-term timeframe extends from 5 days to 65 days (one week to three months). My long-term timeframe is six months or more. Admittedly, the three to six month timeframe is a gray area. Chartists should take these timeframes into consideration when using indicators. For example, a cross above the 200 day moving average is a long-term “trend” signal.

The chart above shows QQQ with the Percent Above MA (5, 200) indicator. This indicator turns green when the 5-day SMA is above the 200-day SMA (long-term uptrend). It turns red when the 5-day is below the 200-day (long-term downtrend). Instead of using the close, I use a 5-day SMA to smooth signals and reduce whipsaws. This simple system captures extended trends and keeps us on the right side of the trend. Note that Percent Above MA is part of the TIP Indicator Edge Plugin for StockCharts ACP.

Trading is all about improving odds and we can greatly improve our odds by trading in the direction of the bigger trend. A cross below the 50 day moving average is also a signal, but hardly a long-term trend signal. When the bigger trend is up, a cross below the 50 day SMA signals the start of a pullback. This is not just any pullback. It is a tradable pullback with mean-reversion potential.

To identify tradable pullbacks, I added the Percent Above MA (5, 50) indicator to the chart above (middle window). This indicator turns red when the 5-day SMA crosses below the 50-day SMA and the blue dotted lines show these crosses – but only when the long-term trend is up (5-day > 200-day). A 5/50 SMA cross signals a pullback within the bigger uptrend. More times than not, a tradable pullback materialized when the long-term trend was up and the 5-day crossed below the 50-day. Instead of getting cautious, nervous or bearish on a 5/50 cross, we should go on alert for a short-term reversal signal and a reversion back to the uptrend.

System Trader puts the odds in your favor with fully systematic trading strategies. We offer Dual Momentum Rotation Strategies for the Nasdaq 100 and S&P 500. Trading weekly, these systematic strategies focus on the strongest stocks and rotate out when their ranking drops. We complement these strategies with a mean-reversion strategy that trades stocks in the Russell 1000. Click here to learn more.

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