But when it comes to trading stocks and optimizing one’s stock trading strategy, the “Top-Down” approach is usually ignored by traders.
Now you might be wondering, “What in the world is this ‘top-down’ trading strategy that you speak of?”
Well, let me explain!
The top down approach considers the state of the market first and foremost. That means even if you have an incredible trade setup that you feel is one you just can’t pass up, you have to pass it up if the market isn’t favorable towards the direction you are looking to trade.
So let’s break what I’m saying, down a little bit further, by considering this…
The stock market is selling off hard and fast, but one of your price alerts on a stock that you have been watching all day, goes off…Should you buy it?
Just because a price alert goes off on one of the stocks in your watchlist, doesn’t mean it is going to keep going up. If the price alert to buy a stock goes off while the rest of the market is imploding, sure it might have had a moment of strength that led to that alert being triggered, but more than likely, that alert isn’t going to hold if the stock market as a whole continues to dump.
Eventually, the weight and influence of the stock market will keep the stock from pushing much higher.
Sure there will be times, where a stock will continue to buck the trend, but that is not the norm. If you fight the market just because one of your price alerts was set off, then more times than not, you will be losing on those trades, and it doesn’t help to point to that one time where the stock did continued to rally and you made massive profits as a result, despite market conditions
Because guess what? That was just one time, and profiting in the stock market is all about putting yourself in high probability situations where you can profit consistently and regularly.
Successful stock trading strategies have three important elements to them:
1. When the stock market doesn’t support the direction that you are looking to trade a particular stock, then don’t trade it.
So when the stock market is ripping higher, breaking out to new all time highs, but one of your stocks, suddenly breaks below a key support level, and triggers an alert to short the stock, that doesn’t mean you go short the stock while ignoring the fact the market is raging higher.
You sit that one out and let the market run its course before pushing higher.
Look, fighting the market is an endeavor that lacks purpose. People wear the title, “contrarian”, but those contrarians, are usually just bent on being a nonconformist that simply wants to take the path of most resistance in their effort to obtain their profits (which by and large does not lead to profits).
But the trader who can put their ego aside and simply trade based off of what the market is telling them to do, make their opinion second, and their market’s will first? Well, that is a person who is trading with a top-down trading strategy that holds the market’s opinion about trading direction as being the most important.
Put it this way, when you are examining a stock:
More than 50% of a stock’s price action is influenced by the market indices’ direction.
Another 30% of a stock’s price action is influenced by the industry it resides in.
The remaining 20% of a stock’s price action is based simply on the company itself.
Granted these percentages can be drastically influenced depending on the news of the day, like a stock’s earnings, or downgrades within an industry, or a world-wide even like Brexit.
But on a typical day – this is what you can expect in terms of averages and influences on your stock.
With that being said, when it comes to your trading strategy, why would you consider anything else besides a top-down market approach?
2. When the market changes directions, a successful trading strategy requires that you change your trading direction too.
If the market is going up, up, up, and then suddenly it reverses course, breaks numerous key levels of support, and trend lower – Why in the world would you keep buying stocks?
People will keep buying under the premise that the stock is cheap without realizing the market can make it even cheaper!
Sure there is a time and place for when you should buy the dip, but don’t do it in the middle of an ongoing sell-off. Don’t pretend that you know something the market hasn’t yet told you. Instead, if you are going to find the bottom of the market, give up the notion of perfectly timing it and instead let a bottom form, like an inverse head and shoulders, or a double bottom, or better yet, a cup and handle pattern – these are all classic bottoming patterns, that once confirmed gives you ample reason to then go long.
Now, when it gets to the point, that you don’t know what direction the market is trying to go, then that is when you scale back on the number of positions you are managing and the capital your are allocating in either direction.
And when it comes to determining market direction, if you are not entirely sure the market wants to go higher, but when looking at the charts you think their might be a slight advantage for the bulls being played out, that doesn’t mean you go “All-In” and buy up all the stocks you can find, instead consider buying some long and short positions, but balance it out to where at the end of the day, you are ‘net-long’ on the market.
Simply put, flow with the market…
When the market is going up, trade to the long side.
When the market is going down, trade to the short side.
When the market is uncertain – reduce the number of positions you are managing for maximum flexibility and consider a basket of long and short positions simultaneously.
3. When you are on the wrong side of the market don’t let your stock trading strategy stay on the wrong side of it too
Now this one is bad news – I mean, this kind of behavior will sink ships.
This here is what happens, when a person becomes so ingrained in their thinking about what direction the market should go that they completely ignore the direction it is going.
This kind of stock trading strategy is the kind you must avoid at all costs. This is where those market top callers proudly proclaim the top of the market is in, and when it keeps rallying higher, they tell themselves, “there is no way it can keep pushing higher!”.
Only it does.
And then the trader becomes ultra-paranoid of getting out in fear that he will be proven right only to have the market reverse course without him in it.
Do yourself a favor, NEVER act as if you know the direction the market will go. Never call a market top, a market bottom, or create a market forecast. Simply follow the market in the direction that it is taking you in for now. Don’t become beholden to a particular direction, and when you do find yourself on the wrong side of the market, do yourself the ultimate favor and…
Get on the right side of the market.
I know I am talking about this in terms that a kid can understand, and I do that intentionally. My nine year old son can look at the chart and tell you what direction that it is going in.
And you know what? he is right more often than most adults are.
That is because, he isn’t involving his own ego, or opinion on the matter, he is simply looking at the chart and allowing it to tell him where it is going.
If your head is so in the clouds that you can’t bring yourself to get on the right side of the trade, then ask a family member where they think the market action is going based on a daily chart of the S&P 500(NYSEARCA:SPY), and listen to what they have to say.
You might just find that it is some life saving advice for your capital.
Decide what is best for your stock trading strategy:
Now I know what you are thinking, “my stock trading strategy doesn’t require me to fight the market”, and most people’s strategies don’t. What happens though, is that traders get so caught up in the moment of having to be right and the refusal to take a loss, even a small one, that they change their stock trading strategy on the fly without even realizing it.
They double down, and when that doesn’t work, they triple down.
The market must conform to their will!
And every day that it doesn’t, the more likely they will never recover from their ill-fated decision to fight the market head on.
That is fighting the market – without even realizing it!
So push the ego to the side, the motivation and the desire to be ‘right’ and focus your efforts on conforming to the market.
There is no room for anything else.
And trade in the direction the market is going
Change course in your trading, when the market changes its course
And when you find yourself, on opposite ends from the market, take a bite of humble pie, follow the market’s lead.
In doing so, you’ll stay profitable long-term, trading will become easier, simpler, and you will become more profitable.