Image Source: http://www.newtraderu.com/2013/07/25/7-ways-to-trade-with-an-edge/
“If you can’t define your edge, you don’t have one!” 😀
A stock trading strategy that definitely has a statistical edge is buying/shorting on a pullback. But how do you know when this pullback ends? In other words, how do you know when this temporary pause in the trend ends?
In the stock market, no one knows for sure what will happen next, but a great guideline for predicting when pullbacks end is the 20 day EMA.
Here are the criteria to enter long/buy stock. You can also reverse the three criteria below for when you want to short sell a stock.
The criteria are based on the daily chart, but can also be used on the weekly or monthly chart. The longer timeframe signals will produce less results, but are more accurate.
- The 50 and 200 day SMA are upward sloping, meaning the stock is in an uptrend.
- The 20 day EMA is above the 50 day SMA which is above the 200 day SMA. This proves the stock is in a very strong uptrend.
- The buy trigger is a break below the 20 day EMA. If you are more patient, you can wait for the entire body of the candle to be under the 20 day EMA. This again will produce less signals, but be more accurate.
The pullback represents a temporary pause in the upward, as profit takers and aggressive short sellers take control of the price action of the stock and drive the price down temporarily before the price moves up again.
Adam Grimes (a famous author of many wonderful stock trading books) did a blog post on pullbacks to the 20 day EMA. On a side note, I will start doing book reviews in the near future, with Adam Grimes in it of course.
You can find his related posts here: https://adamhgrimes.com/pullback-trade-works/
Below, I give a visual example of this trade. I use the QQQ as an example.
Figure 1 shows the yearly performance of QQQ.
The Green Line represents the 20 day EMA.
Notice that the 50 and 200 day SMA are upward sloping (as seen in the blue and red lines respectively).
The circles represent when the index pierced/touched the 20 day EMA.
The index gave roughly 12 signals which averages to 1 signal a month for a low risk buy entry. With proper risk management, there are at least 9 profitable trades out of the 12. The February 2018 drop would be one spot where you should have been stopped out for a loss.
Please test this statistical edge on your own to see if it works.
On a final note: Confirmation bias destroys traders. If you are interested in confirmation bias, please read my short post titled “Confirmation Bias” to learn more.