Shorting at moving averages

A common question I’m asked is: when long and a short signal emerges should I place an order for the short side too?

Most of the time these questions are about the Harami Inside Bar pattern.

But the question is equally applicable to all shorting patterns occurring in rising markets.

My answer to the question is always the same.

Nope.

A filter is needed to reverse course.

I’m personally no fan of short side trading (as most of you know), but there are many readers here that are.

And so, I wrote this post to clarify some that confusion.

 

What the eye is drawn to

There is a problem when considering counter-trend trading generally as a beginner.

It’s a problem I had for a long time – and stems from laziness or inability to conduct proper backtesting.

Here’s the issue.

When you scan a chart, your eye is automatically drawn to the times a given strategy worked out well.

And at the same time, the eye totally ignores the multiple times it doesn’t.

No more is this true than with counter-trend trades.

An example.

Say you’re looking at the recent price history of a market, and a Harami Pin Bar short setup forms well above the moving average.

That setup triggers a severe waterfall decline as can be seen below.

 

Invalid waterfall decline

(Note with other trading methods such as using indicators or sentiment this might be a valid setup. But that is not the approach taken on this site) 

You’d be forgiven for thinking shorting this pattern works well above the moving average.

Another example.

Your visually scanning price history and  your eyes are drawn to a huge rally that came from deeply oversold levels

The starting point of which is one of the price action strategies I discuss on this blog.

If you’re anything like I was as a beginner you’d be salivating at the mouth, thinking these patterns are ever so easy to trade.

Wrong!

What your eye doesn’t notice are the countless times these patterns fail miserably counter-trend.

Like when you short and the market reverses to new highs.

Or, when you buy and the trade collapses suddenly collapses like a sack of spuds dropped from a great height.

In between these two extremes, there’s a myriad of small losses and tiny wins – none of which you ever notice because your vision is drawn to the bog moves

This is one of the reasons scientific like backtesting is so important.

Many of these losing trades can be avoided with a filter.

And for me, that filter is tagging of the moving average.

 

Tagging the average

I’ve discussed ‘tagging’ before.

It’s one of my little secret weapons.

And it works for both longs and shorts.

The consensus view is you go long above a moving average, and you go short below it.

Well for the most part yes, but not always.

Some of the best longs happen from below a moving average.

Likewise, some of the best shorts happen from above it.

The trick is knowing when.

Here’s how.

If a price pattern is trading above the 10 SMA, but it’s touching or tagging the SMA in any way, this is a clear shorting candidate.

A picture always speaks a thousand words so below is an example of a Harami Pin Bar on the Hang Seng.

You can see the large blue candle circled below in black.

You can also see it is touching the SMA (black line).

The bar to the right of it is the red Harami Pin Bar itself.

The pattern is a bearish signal.

Because the first bar of the pattern is touching the black line this is considered a valid setup.

If this pattern had occurred without the touching, that’s not a valid setup – and often leads to low-quality trades.

Hang Seng Short

Next up is a short signal with the Ultimate Smash Bar.

You can see the small blue candle with the arrow pointing to it, right?

It’s nicely sat on the black SMA.

Whenever these patterns are perched so comfortably it’s a tell-tale sign for a potential market decline.

Bitcoin Short

Next up, a chart of gold.

The pattern is the Harami Inside Bar.

You can see both the mother bar and inside bar sat on the moving average.

It only takes one bar to touch for a valid signal.

But two bars are also valid.

Again it can lead to some great short setups.

Gold Short

Finally, here’s one on the DJIA.

Similar to the last one, here’s an inside bar pattern with both mother bar and inside bar perched on the average.

Dow Jones Short

 

Bracket trades

I’ve been asked about bracket trades from time to time.

If you’re unsure of what bracketing means, it’s when you place both a buy and sell order either side of the pattern as shown in the image below.

Bracket Trades

The order triggered first becomes the trade, while the untriggered order is cancelled (either manually or with an OCO order).

If you apply filtering as discussed above, the only time a bracket trade setup occurs is when the pattern touches the SMA.

Think about it… if prices are below the average and not touching, we shouldn’t be looking at going long.

If prices are above the average and not touching, we shouldn’t be looking about going short.

Only tagging or touching allows for successful bracket trading (there are exceptions but I’ll leave that for another time).

I hope that concept is clear.

 

Aggressive trading or stupid trading

I consider myself an aggressive trader.

While there is no standard definition of what an aggressive trading style is, to me it would go something like this.

An aggressive trader uses few or any indicators to confirm a trade entry. Instead trade risk is reduced by using tight stops moved quickly.

Sometimes the trade is stopped out at a loss or small gain.  Other times the trade catches the market on the exact turn leading to superior results.

If you have followed much of this blog so far, you know that my exit strategy plays a vital role.

Sure, all exit strategies play an important role.

But the reason I can avoid using all this confluence nonsense is short-term momentum is in play and a tight trailing stop loss strategy.

To me this is aggressive.

However, an aggressive doesn’t mean stupid.

Without filtering, many more trades would lose.

Which is why, although I refrain from multiple forms of trade analysis, I do believe the trend should be our friend as often as possible.

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John Scott
John Scott has been trading CFDs and FX since 2003. His favourite markets are the Dow 30, Gold and the GBP/USD. John believes short-term price action trading is the best approach for beginners to trade. Tradeneophytes is his humble attempt at helping new traders reduce the learning curve to trading success.
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