Before you use a trading strategy, be it an options trading strategy or otherwise, to work, it is important to test it. The fundamental ways to evaluate options trading strategies include backtesting and forward testing.
Backtesting trading strategies refers to testing your strategy using historical data sets.
Forward testing refers to evaluating your trading strategy using simulated environments.
As a trader, testing your options trading strategy is of utmost importance, as it will not only help you avoid huge losses but also help you trade stress-free.
With backtesting, you can understand how viable your trading strategy is without the need to risk your money. Yes! It’s basically testing how good your trading strategy is when tested with real market data.
You can test both – simple and complex options trading strategies requiring multiple parameters and inputs with backtesting using options backtesting software on an algorithmic trading platform.
The analysis that you get from backtesting can help you optimize your trading strategy.
Here’s how you can perform these backtest options strategy with ease on PHI 1:
Step 1: Open the Option Leg Builder on PHI 1.
Step 2: Select the index or stock, expiry, and the strike price whose options you want to trade to create your desired strategy.
Step 3: You can save this strategy for future use as a template by clicking ‘save strategy.’ Read how you can create the straddle strategy with PHI 1 here.
Step 4: This strategy is saved.
Step 5: Select Create Options Backtest.
Step 6: Select strategy to backtest, select symbol or stock on which you want to backtest the strategy, select test parameters like expiry date, period, etc. and run the backtest.
Step 7: Voila! You can see the result on the next screen within a minute or two!
Step 8: You can check monthly trades, equity charts, and logs for your strategy
Kudos! You have successfully backtested the strategy created by you.
You can backtest any other options trading strategy in the same way.
Watch our webinar on “How to backtest your options trading strategy using PHI 1.”
In this webinar, you will learn to create popular options strategies like an iron corridor, straddle and strangle and deploy it too!
And hey! Before you watch the video, one more thing.
There’s a lot of automated trading tools available in the market which offer the backtesting option.
But, what if you could see payoff charts, Greeks, and more along with robust screening and deployment on a single automated trading platform?
That’s PHI 1 for you!
Avail of the free trial to experience trading automation in full throttle.
Using PHI 1 for options trading will give you uninhibited access to detailed charts and data sets. You have the choice of displaying any chart, symbol, price-related data across various time frequencies. This means minute-to-minute trading actions and movement will be available at your fingertips.
For displaying charts, you need to click on the graph symbol on the left side of PHI 1. All NSE instruments are available here. You can choose any scrip you want.
For Options, you would need to click the F&O selector in the header and choose your desired scrip, expiry, strike price, and whether it is a call or a put option. Once that is done, click generate.
With PHI 1, you can get access to data across various time periods. Whether it is daily swings or market ticks by the second, you can generate data for any time you want.
There is no restriction on the number of indicators you can apply here. You can use multiple indicators at a time.
Another useful feature that needs to be highlighted is the ease of transactions.
If you have connected your broker to your account, you can place a buy or sell order directly from PHI 1’s interface.
There are two ways to select the option instrument on PHI 1:
A. One is by directly inputting the precise strike and expiration date, or
B. You can choose from the dynamic monthly and weekly options available. You can choose any strike price like at the money (ATM), and the software generates various options that get updated daily.
In case you want to come back to the charts in the future, you can do so by saving the chart. Just click on ‘Save’ in the header with the name you want.
Your chart template is now saved and you can continue your technical analysis whenever you want.
Built-in strategy templates
For viewing the various strategy templates available at hand, click on the menu options on the right-hand side, and select strategy.
Under the strategy, you have two options to choose from. You can either start with the form mode or code mode.
With form mode, you have basic strategy templates available with various indicators so you can algorithmic trading without coding.
You just need to select the strategy template that you require (SMA, EMA, etc). You get a basic buy and sell condition on which you can add a stop loss and take profit.
If you have your own entry and exit rules, you can enter them using either the form mode or code mode. Also, if you need any coding help, just contact PHI 1 support and they will help you out.
Once your strategy is ready, all you need to do now is click on ‘Run and Save’.
When the run completes at the day frequency, you get the default run for the entire year.
There are other trading performance metrics that you get access to at this stage such as your overall returns, long-short trades, profitable trades, loss-making ones, each entry, each exit, and overall return.
It’s super easy to get started with the form mode. You can add as many indicators as you want to experiment with in order to get the results you require.
Even with code mode, you have access to 10 templates, to begin with.
Let us understand code mode with an example.
When we choose the first strategy template – Bollinger, it gives you an initial indication for you to calculate and take buy and sell orders based on where your current price is in terms of the Bollinger band with default parameters.
You can change the parameters and buy/ sell orders based on the metrics you want to analyze.
If your current strategy isn’t working, and you want to include an additional trading indicator of your own, you can introduce the code under initialize code here.
In the screengrab below, the code for MACD is added in the box.
Next, you will need to add the set of conditions under step code.
The first condition is that, from the top, MACD should be < zero.
And on the opposite side, before the uptrend, we want the MACD to be >zero.
This added indicator helps filter out unfavorable trades and allows you to focus on trades that may work in your direction.
The code mode is not limited to only the 10 indicators visible in the drop box.
You can access nearly 119 indicators available in the learn section on the left-hand side to add to your strategy.
You also have the option of using multiple indicators at one go, to analyze market trends, and review the metrics you need.
You can experiment with trading strategies, time frequencies, add stop-loss conditions, and different instruments.
When building a trading strategy for options, the process is exactly the same.
You just need to choose your desired option and strike price and run the strategy.
You can choose different time frames from hourly to monthly, visually inspect all trades to see how the premiums have changed over time, etc.
With PHI 1, options trading gets bigger and better.
You can not only try out tested and experimental strategies but also see payoffs, backtest, and simulate trades.
Finally, you can deploy your trades with the broker of your choice using the multi-broker integration.
In a nutshell, PHI 1 offers total freedom for the trader to exploit market opportunities while trading options by managing mundane tasks that take away time and effort.
Bollinger bands are used for measuring deviation, and therefore, this indicator can be very beneficial in recognizing a trend. We can generate two sets of Bollinger bands, one set with the help of “0.5 standard deviation” and the other using “3 standard deviations”.
In the chart of Tata Consultancy Services shown below, we can observe that whenever the price holds between the upper Bollinger Bands +0.5 SD and +3 SD away from the mean, the trend is in the upward direction, and therefore, this channel is known as the “buy zone.”
Contrarily, if the price is within the Bollinger Bands –0.5 SD and –3 SD, it is referred to as the “sell zone.” Finally, if the price moves between the +0.5 SD band and –0.5 SD band, then it is in a “neutral zone.”
Bollinger Bands keep on adapting to the expansions and contractions in price, because of the increase and decrease in volatility. Because of this, bands widen and narrow down in sync with price action, creating a highly accurate trending envelope.
Coming back to the chart again, the trader may take a long position when the price enters the “buy zone”. The trader’s target should be able to stay with the move for most of the uptrend and exit only when the price starts to consolidate at the top of the new range. An exit from this trade should be made when a red candle is formed and more than 75% of the candle’s body is below the “buy zone”.
2. Squeeze and Breakout Strategy using Bollinger Bands
This trading strategy is based on predicting price breakouts using volatility.
The volatility of the market is constantly changing from low to high and vice versa. This implies that if the market is in a low volatility phase, eventually, volatility will pick up in the future, leading to large price movements and breakouts.
Bollinger Bands can be used both for intraday and swing trading, depending upon the time frame which the trader wants to use.
For using this strategy, we need to find conditions of low volatility or specific less volatile markets and predict when a breakout might happen and in which direction it will be.
For this purpose, we need to find a market that is moving in a range. We can quickly identify this by looking at the middle SMA line. The line needs to be relatively flat, as shown in the chart of Nazara Technologies Ltd., and the two bands must be close to each other.
This task can be made easier by using an indicator called the BBW or Bollinger Bands Width. You can easily get this on a trading platform. This tool shows the distance between the two bands.
If the BBW is low, it means the gap between the two lines is close, and if it is high, it means that the gap is set further apart. The two indicators need to have the same settings for them to work.
Further, to predict the price breakout, we need to wait for the standard deviation lines to start expanding, which can be easily identified by the rise of the BBW. This means that there’s an increase in volatility and a breakout is likely to occur.
The direction of the breakout depends upon whether the candle is breaking the upper line or the lower line. Accordingly, selling or buying of stocks is done.
In this chart of Nazara Technologies Limited, we are using a 15-min time frame. We can observe a flat SMA, meaning that the market is in a range and the two bands are contracting, which a low BBW confirms.
After some time, the bands start to expand, which is also confirmed by the rise in BBW. Then, a red candle breaks out of the lower line, which is an excellent opportunity to take a sell position and make an entry. The lowest point of this same candle is taken as “Stop Loss.”
As shown in the figure, the exit should be made when the price breaks the middle SMA line.
Let’s look at another example.
In this chart, we are analyzing Wipro Limited with a time frame of 1 day.
We can observe that the market is in a range as shown by the flat SMA, and the gap between the two bands is close, which is also represented by a low BBW.
Next, we can see that the bands are starting to expand, confirmed by the rising BBW. Then, a green candle breaks out of the upper line, and this is an excellent opportunity to take a buy position and make an entry.
The lowest point of this same candle can be set as stop loss. As shown in the figure, the exit should be made when the price breaks the middle SMA line.
As you can see, Bollinger Bands can be one of the best trading indicators to use. On an Algo trading platform like PHI 1, you can use over 120 technical analysis indicators and customize them as per your trading strategy.
In fact, PHI 1 offers charting, screening, back testing and forward testing as well as strategy grading and deployment – all on a single automated trading platform.
You can explore Bollinger Bands and a lot more by availing a free trial!
Experience the power of automated trading at full throttle!
Among the many trading indicators used for technical analysis, Bollinger bands are a popular technical indicator. Bollinger bands are a momentum indicator used to characterize price and volatility.
What are Bollinger Bands?
Bollinger Bands are a technical analysis tool defined by a set of 3 lines.
The middle line depicts a simple moving average of a stock’s price while the upper and lower lines depict positive and negative standard deviations, respectively, which the user can adjust to one’s preference using a technical analysis charting software.
Bollinger Bands were introduced by John Bollinger, and no prize for guessing, they have been named after him.
How to calculate Bollinger Bands?
As seen in the picture above, Bollinger Bands consist of 3 lines.
The first one in the middle is a simple moving average line usually calculated using the 20-day simple moving average or SMA of the security we are analyzing.
The next two lines, i.e. the upper and lower lines depict the standard deviation of the security’s price we are analyzing.
The upper line denotes positive standard deviation and the lower line shows negative standard deviation. Typically, the upper and lower lines are 2 standard deviations higher and lower from the simple moving average line, respectively.
In the PHI 1 image above, the red line signifies the 20-day moving average and the standard deviations are +/-2, which is the default setting on a trading platform.
Standard deviation is a method to measure the average variance, i.e., how spread out the numbers plotted on a chart are from an average value.
You have the option to change the gap between the SMA line and the positive and negative standard deviation lines on a technical analysis charting software. We skip the formula for calculating Bollinger Bands as they are available easily on the charting tool you may use.
What do Bollinger Bands tell you?
Bollinger Bands are used by traders to identify when a security is oversold or overbought.
As mentioned above, standard deviation shows the price variance of the security from the simple moving average.
So, as the lower and upper line gap widens, it shows more price volatility, and as the lower and upper line gap contracts, it depicts less volatility.
Bollinger Bands can also be used for trend following and to identify breakouts.
Identifying overbought and oversold conditions with Bollinger Bands
The rule is simple:
When the security’s price breaks below the lower band, it may be oversold and due for a bounce-back.
When the security’s price breaks above the upper band, it could be overbought and due for a pullback.
Thus, the closer the price of a security goes to the upper standard deviation line, the more overbought security is believed to be, and the closer the price moves to the lower standard deviation line, the more oversold the security could be.
This rule is based on the premise of mean reversion, which assumes that if a price moves too far away from the average, it will eventually return to the mean.
(Watch this space for more trading strategies using Bollinger Bands. Subscribe to our blog.)
Limitations of Bollinger Bands
1. It should be noted that Bollinger Bands are not a standalone trading indicator.
They only provide insights regarding price volatility to traders. It is always advisable to use them in combination with other technical trading indicators.
2. Bollinger Bands don’t always give the correct buy and sell signals.
For instance, with a strong trend, you may risk placing trades on the wrong side, as the indicator may give overbought or oversold signals too early.
You can avoid this by considering the overall direction of price.
3. They are calculated using a 20-day SMA.
Here, the weightage given to older data is the same as more recent data, which may cause the older data diluting the newer and more relevant data.
Also, the 20-day SMA setting with +/- 2 standard deviation may not be suited for each security in all market conditions. Traders need to use their discretion to adjust the SMA and standard deviation as per their assumptions.
All said and done, Bollinger Bands are still the rockstars of trading indicators.
You can access them along with over 120 other indicators on a trading software like PHI 1, which lets you customize them based on your needs.
You can accomplish charting, screening, strategy creation and testing, simulation, and order execution all in one unified trading software.
Momentum indicators or MOM indicators are tools that measure momentum of securities. Momentum trading indicators are popular technical analysis tools that measure the rate at which the price of a security changes.
Momentum indicators are readily available on intraday trading software platforms.
These trading indicators are used with other indicators as they mainly help determine the time frame in which the price change occurs and not the direction.
Advantages of momentum indicators:
Momentum indicators show the change in the price of a stock over time and how strong the movement is and will be. They are particularly useful for traders to identify points when the price direction can reverse.
Given that momentum indicators only show strength of movement, they are used with indicators such as moving averages which show the direction of price movement.
Concept of divergence in trading
Divergence typically indicates that the momentum of the price movement will stop soon or is about to reverse.
It occurs when the stock price is moving downward continuously along with the momentum indicator, however, later, the momentum indicator stops following the downward price movement or turns upward.
Thus, it is essentially a divergence of the indicator from the actual price movement, showing that the momentum of the current price movement is dropping.
Popular momentum indicators
1. Relative Strength Index (RSI):
RSI is a popular momentum indicator in technical analysis that measures the magnitude or extent of recent fluctuations in the security’s price.
It evaluates whether the stock is overbought or oversold. Showed as a momentum oscillator, RSI can have values from 0 to 100.
Typically, RSI values over 70 indicate overvalued or overbought and below 30 indicate undervalued or oversold.
RSI can be calculated using a formula involving the use of 14-period data of average gain and loss. However, we can easily access this on a trading platform.
So, let’s dive straight away into how to use RSI for trading.
As you can see, in the Wipro chart above, RSI values crossing 70 may indicate that it is becoming overvalued and may generate a sell signal, indicating the possibility of a trend reversal soon.
An RSI of 30 or below indicates an undervalued condition and may indicate the start of uptrend soon.
If RSI remains in a range, it denotes a trend.
For example, between Oct 2020-Jan 2021, the stock was in a steady uptrend. An uptrend may also be indicated when the RSI remains above 40 and frequently hits 70 or above like between April-July 2021. The opposite is true for Jul-Oct 2019.
A bullish divergence occurs when the RSI is in the oversold region followed by a higher low that corresponds to lower lows in the price. This is when bullish momentum is indicated. Any break above the oversold region can be taken as a signal for taking a long position.
A bearish divergence is when the RSI generates an overbought signal followed by a lower high corresponding with higher highs on the price.
Limitations: True reversal signals are rare, and false signals could lead to false alarms. A false positive, for example, would be a bullish crossover followed by a sudden decline in a stock.
RSI is suitable in a market where the stock price is alternating between bullish and bearish movements.
2. Average Directional Index (ADX):
ADX indicates trend strength. It does not show the direction of the trend but only its strength. Hence, it would need to be used with another indicator.
The red line indicates ADX.
When the ADX rises above the threshold (generally 25), it means that the stock price trend is showing strength. Combined with an indicator like Moving Average, it can help general buy/sell signals.
For example, in the figure above, the price crosses the 50-SMA and ADX crosses 25, which generates a ‘buy’ signal.
On the other hand, a flattish ADX indicates a weak trend, i.e., the stock price moves in no particular direction or is range bound.
ADX is an excellent trading tool to use to identify strong trends for trend trading.
A common mistake traders make is considering a falling ADX line for a trend reversal. That’s not true! A declining ADX line generally implies that the trend strength is reducing and not reversing.
Moving Average Convergence Divergence (MACD) is a trend-following momentum indicator that shows the relationship between two moving averages of a stock’s price.
Primarily, the 26-period exponential moving average (EMA) is subtracted from the 12-period EMA to get the MACD line. The signal line is the 9-day EMA.
MACD is presented using a histogram that plots the difference between the MACD line and the signal line. When the MACD line is above the signal line, the histogram will be on the top of MACD’s baseline.
MACD can be used to identify points to enter or exit trades when they form divergences and crossovers.
You can check out an example of a MACD crossover from our previous blog
As mentioned earlier, you do not have to manually calculate these momentum indicators. You can get them easily on an algo trading platform.
PHI 1 is a unique algo trading platform that offers 120+ technical indicators that are completely customizable to suit your trading analysis.
PHI 1 is not just any intraday trading software. It offers stock screeners, technical analysis charting software, option trading, backtesting trading software, simulations, and order execution – all on one single platform.
No download or installation is necessary.
Simply sit back, relax, and upgrade your trading process. You deserve it!
“The trend is your friend until the end when it bends.” – Ed Seykota
Trend following is a trading strategy that seeks to identify a trend (which is a general price direction of a market or security) and then follow that trend to take a favorable position. Trend following or trend trading is a commonly used intraday trading strategy.
How does trend trading work?
As mentioned earlier, a trend is an upward or downward movement in the price of a security for a certain period.
The key is to identify the trend right.
For instance, a stock that was INR 100 on 19th June, INR 117 on 25th June, and INR 125 on July 1 is said to be in an upward or bullish trend.
However, if the price moves in both directions within a range, it is not in a trending phase, but in a consolidation phase. Traders follow trends and hold on to positions until they believe the trend has ended.
The rule is simple:
For an uptrend and long position, one needs to place the stop loss below a swing low that has occurred before entry or below another support level.
For a downtrend and short position, one needs to place the stop loss above a prior swing high or above another resistance level.
A few things to keep in mind when trend following:
Buy high, sell higher makes sense, although avoid overbought stocks that are ripe for a reversal.
Follow the price objectively – look for higher highs and lower lows.
Expose yourself to multiple markets and get used to identifying trends first.
Commonly used indicators for trend trading
Traders use a variety of indicators in isolation or combination to identify price trends and reversals.
For instance, some may use breakouts to figure out the start of a trend and use moving averages as criteria to enter the trade.
Momentum indicators, like Relative Strength Index (RSI), Average Directional Indicator (ADX), Moving Averages or MA (specially crossovers), and MACD are commonly used indicators for trend following/trend trading.
Trend lines and chart patterns are widely used to determine the pullback likelihood and confirm market trends or stock trends. Flags and triangles are also widely employed for evaluating the continuation of a trend. But more on this later!
Let us move on to an example.
Trend trading – An illustration using Moving Averages
Both simple (SMA) and exponential moving averages (EMA) as well as crossovers are used extensively in trend trading strategies.
How to identify trends:
An angled-up moving average shows an uptrend, and an angled-down MA shows a downtrend.
Observe in the image below that the price has stayed well above the 50-day simple moving average (50-SMA).
As the price crossed the SMA, it entered ranges in most cases. You can use mid-term MAs like these as a filter using the daily timeframe and aim to trade toward the MA in smaller time frames.
How to trade trends:
In simple terms, when the price crosses above the MA, it can be taken as a buy signal, and when the price crosses below the MA, it can be considered as a sell signal.
Trading using crossovers:
In the image below, we have plotted the longer-term 50-SMA and the short-term 10-SMA on a chart of TATA POWER.
A buy signal occurs when the 10-SMA crosses above the 50-SMA. A sell signal occurs when the 10-day crosses below the 10-day.
However, you must bear a few things in mind when using MA for trend trading. As the price of a stock is more volatile than its MA, this strategy may likely give more false signals.
Further, a fast MA may give false and early signals as it reacts too much to price movements and even make you exit early in case of a trend change. A slow MA may give you late signals.
If you’re willing to explore trend following, consider trying it on PHI 1. As shown above, PHI 1 is super easy to use even for a complete beginner and offers a plethora of advanced options for the expert trader.
Also, you can screen securities, create buckets, create charts and save them, and even experiment with strategies. Once you test your strategies, you can deploy them on the same all-in-one tool with the broker of your choice.
Let us carry the burden of mundane tasks while you focus on trading opportunities.
A breakout is defined as a stock price movement beyond a predetermined level of resistance or support with increased volume. Breakouts show the potential for the price to move in the breakout direction.
If there is a breakout to the upside, there is a high chance that the price will go higher, and similarly, if there is a breakout to the downside, the price will probably go further down.
The reason for the breakout to occur is that the stock’s price has been contained below a resistance level or above a support level for some time. When the breakout occurs at a high volume, the price is more likely to move in that direction.
Breakout trading can be used for intraday trading as well as short-term (one week to a month) and long-term (more than a month) trading using different time frame charts.
Several chart patterns can be used for breakout trading; however, the most commonly used pattern is the triangle pattern.
There are three types of triangle patterns: ascending, descending, and symmetrical triangle patterns (as shown below), which can be identified in the chart for trading.
Let’s discuss these patterns one by one.
Ascending triangle pattern:
This breakout pattern is a bullish formation and occurs when the stock price breaks the upper horizontal trend line with surging volume.
This upper horizontal trend line acts as a resistance. The lower trend line is inclined at an angle and rising diagonally.
The lower diagonally rising trend line shows the higher lows formed in each swing as the buyers slowly increase their bids.
Later, the buyers rush into the stock above the resistance price, triggering more buying as the uptrend continues. The upper trend line acting as resistance until now becomes the support for the stock.
Descending triangle pattern:
This breakout pattern is a bearish formation, which is an inverted version of the previously discussed ascending triangle.
The lows which are formed inside this pattern are almost the same, resulting in a horizontal trend line.
There is a decline in the upper trend line towards the apex, resulting in forming a triangle. The breakdown takes place when the price breaks the lower horizontal trend line, which was acting as a support. Now, this support line works as a resistance.
Symmetrical triangle pattern:
A symmetrical triangle is formed with the help of a diagonally falling upper trend line and a diagonally rising lower trend line.
As the price moves toward the apex, it breaks the upper trend line and uptrend with rising prices or breaks the lower trend line and downtrend with falling prices.
How to use triangle patterns for breakout trading
The steps which are involved in breakout trading using triangle patterns are common to all three patterns discussed:
1. Look for stocks which are trading in a range for sometime, so that this setup can be applied easily.
2. Draw the trend line joining the high and low prices of the stock.
3. An ascending, descending or symmetrical triangle pattern should form after joining these points.
4. More consolidation happening at the triangle’s apex shows that it may give a good breakout.
5. In an ascending triangle chart pattern, a trader should enter a long position after the confirmation, which is given by a green candle above the resistance line. Also, the green candle should show good volume (can be determined using a volume indicator).
The stop loss should be kept at the lowest point of the same green candle. The target should be an amount equivalent to the broadest section of the triangle.
In the descending triangle chart pattern, the trader should enter a short position once a red candle breaks the support line. Stop-loss should be kept at the high point of this candle.
The difference between the entry point and the vertical distance between the two trend lines should be the target price.
In the symmetrical triangle chart pattern, a bullish or bearish trend depends on whether the breakdown is happening from the upper or lower trend line. The stop loss is generally kept just below the breakout point.
What are the limitations of breakout trading?
Every strategy comes with limitations, and so does breakout trading.
When a stock is trading in a range, there are very high chances of false breakouts. A false breakout occurs when the price breaks the support or resistance, but then comes back within the previous range.
The problem of false breakouts can be tackled by avoiding entry immediately after the price breaks the support or resistance. A trader should wait till the candle closes (confirming the breakout’s strength) and then make an entry.
Sometimes, after giving a breakout, the price increases sharply. The trader is pleased to see this; however, the price again comes back closer to the entry point in the next few seconds or minutes.
The trader gets confused by this scenario with a false breakout and exits the trade with a small profit. However, the price corrects and starts moving back in the breakout direction.
Key takeaways from this Breakout trading guide
Breakout trading seems to be a straightforward trading strategy to execute, but there are few limitations to using this method, such as false breakouts and corrections to breakout points. With the right practice and tools, you can master breakout trading in no time!
Many of us do not have the time to trade intraday or prefer not to do so. Swing trading may be an option for people who do not want to do day trading. Swing trading focuses on trading over a short-term period (say a few days to a week or even 1-2 months). Here, a trader holds positions for more than a day. Usually, the target profit in swing trading is 10 to 20%.
Swing traders mainly focus on stocks that are highly liquid and heavily traded on the exchanges and often swing between widely defined high and low points. This gives advantage to the trader to ride the wave in a particular direction and make a profit.
Let us see some Pros and Cons of Swing Trading.
1. Low time commitment: Day trading can be hectic, especially when it requires the traders to actively participate during market hours. (You can solve this problem with automated trading. Read more.) In swing trading, a trader can keep their position open for over a day to a few weeks and does not need to be a full-time trader.
2. Flexibility: One of the most significant advantages of swing trading is that a swing trader can square off positions according to their convenience, whereas a day trader needs to square off their positions on the same day.
3. Profitability: Swing trading can be profitable with proper risk management.
1. Exposure to overnight and weekend price gaps: This is the most significant disadvantage of swing trading. Suppose any negative news or poor quarterly earnings of a company emerge after the closing of the market or on the weekend, the swing trader cannot exit their position and may face substantial price gaps the next day or week.
The only way to minimize the risk linked with the price gaps is to trade with smaller quantities or use a tool like PHI 1 that allows you to automate your strategies, such that trades are executed when certain criteria are met.
2. Locking of Capital
An intraday trader has the advantage of buying and selling the stock many times, and thus, they can rotate their capital to earn good profits. However, in with swing traders, their capital gets locked into a single trade or a few trades and does not free up until the trades are exited
3. Unsuitable for Extreme Market Scenarios: In full-fledged bull and bear markets, swing trading can be tough. This is because markets are highly volatile and may not move as desired by the trader.
Now, let us understand the MACD Crossover, an efficient strategy for swing trading.
Moving Average Convergence Divergence (MACD) is a trend-following momentum indicator that shows the relationship between two moving averages of a stock’s price. Primarily, the 26-period exponential moving average (EMA) is subtracted from the 12-period EMA to get MACD.
MACD=12 Period EMA – 26 Period EMA
After this simple calculation, we get the MACD line. Further, the nine-day EMA of the MACD is calculated, which is called the ‘signal line’.
MACD is presented using a histogram that plots the difference between the MACD line and the signal line. When the MACD line is above the signal line, the histogram will be on the top of MACD’s baseline.
If MACD is below its signal line, the histogram will also be below the MACD’s baseline. Swing traders use this histogram to analyze when the bullish or bearish momentum is huge.
We can interpret MACD indicators in many ways: crossovers, divergences, and rapid rises or falls. However, MACD crossover is one of the commonly used techniques for swing trading.
Let us understand this technique.
The Buy/Sell signal forms when the MACD line and signal line cross each other.
A bullish trend is indicated when the MACD line crosses above the signal line. This is the right time to enter a trade.
Later, when the MACD line touches the signal line and crosses below it, it is the ideal time to exit the position and book profits.
Let us illustrate how you can do this on PHI 1
Shown below is the chart of CIPLA Limited with a time frame of 1 day. The buy signal is generated when the MACD line (blue colour) crosses above the signal line (red colour). The trader may enter at this price.
In the later part of the chart, traders could exit the trade when the MACD line reverses and crosses below the signal line.
You can create this strategy without any code. PHI 1’s form-based code creator allows you to create this using a drop-down mechanism.
In our previous article, we covered the basics of moving average. To give you a quick glimpse, moving average is an indicator used to get a comprehensive idea of the trends in a dataset. It adds up the stock price over a specific period and then divides the summation by the total number of data points to get the average.
The reason it is called a ‘moving’ average is because it is continually recalculated based on the latest price data.
We also discussed two types of moving averages: simple and exponential. Read our previous article for a detailed introduction.
Now, let’s come back to how moving averages can be used in trading.
We illustrate some instances for you:
1. Determining trends using MA
The direction and position of the moving average gives us crucial information about the price trend of a stock. If the price of the stock is increasing, the moving average rises; whereas, if the price of the stock is declining, the moving average falls.
A price placed above the long-term moving average reflects an overall uptrend, whereas a price placed below the moving average reflects an overall downtrend.
If the stock price rises above its moving average, a ‘buy’ signal is established, whereas when the stock price has dropped below its moving average, it generates a ‘sell’ signal.
In the below picture, we can see the chart of ICICI Bank with the time frame of 1-Day. We have used the 10-day EMA (Exponential Moving Average) for our analysis. When the stock price is above the moving average line, a ‘buy’ signal is generated, and it is the ideal time for a trader to enter a position. Similarly, when the price falls below the moving average line, a ‘sell’ signal is generated and it is a good time to exit.
2. Determining support and resistance using Moving Average:
Moving averages can also determine support and resistance. If there is an uptrend in the stock, long-term moving averages such as 50-day, 100-day, or 200-day act as a support level.
This is because once the price of stock touches the moving average line, there is a high chance of it bouncing back. Similarly, during a downtrend, a moving average acts as a resistance level. Here, the moving average acts as a ceiling, and if the price hits this level, there is a high chance of the stock price dropping.
Let us understand this concept with the help of an example. In the below picture, we can see the chart of Wipro Limited and the time frame is 1 day.
The moving average used for the analysis is the 100-day SMA. When there is a downtrend, the moving average acts as a resistance. After consolidation for a few days at the same level, the price declines.
On the contrary, when there is an uptrend, the same moving average line acts as a support, and once the stock price reaches the support level, it bounces back.
3. Identifying the crossover
The crossover forms when two different moving averages cross each other. Primarily, two types of crossovers are used in trading: the golden cross and the death cross. In both these crossovers, one moving average is for a shorter duration, while the other is for a longer duration. Generally, 50-day and 200-day moving averages are used to identify these crossovers.
In a golden cross (bullish signal), a short-term moving average crosses above a long-term moving average, whereas in a death cross (bearish signal), the short-term moving average passes below the long-term moving average.
Let us understand this concept with the help of an example. In the below picture, we can see the chart of TATA Motors Limited with a time frame of 4 hours. Also, for our analysis, we use the 50 and 200 SMA.
The death cross forms when the short-term moving average (50 SMA) crosses below the long-term moving average (100 SMA). After the formation of the death cross, the price of the stock declines sharply. Therefore, we can say that most of the time, the death cross shows that there is the potential of a massive sell-off.
Also, in the later part of the chart, we can see the formation of a golden cross. This forms when the short-term moving average (50 SMA) passes above the long-term moving average (100 SMA). After the formation of the golden cross, the price of stock has increased gradually. Therefore, we can say that it is a good time for the trader to buy the stock.
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Moving average is one of the most common indicators used by traders. It is an easy-to-use statistical tool primarily used for forecasting trends.
Let us understand the basic definition of moving average.
Moving average is an average of any subset of numbers. In trading, it is an average of closing prices within a time frame and is used for predicting future trends.
Because the moving average is based on past prices, it is a trend-following or lagging indicator. Further, what makes it more dynamic is the customization it offers.
Any time period (such as 15, 20, 30, 50 days) can be chosen by the trader while calculating the moving average. Sensitivity to price changes can be regulated by changing the time period. If the period is short, there will be more sensitivity to price change, and vice versa.
An intraday trader prefers a shorter-term moving average, whereas swing traders prefer longer-term moving averages.
Trend analysis Using Moving Averages
A rising moving average shows that the stock is in uptrend, whereas a declining moving average confirms a downtrend. Further, traders use two different moving averages to decide whether there is upward momentum or downward momentum in the stock price.
When a short-term moving average crosses above a long-term moving average, a bullish crossover forms (known as golden cross), which confirms that there is an upward momentum.
Similarly, if a short-term moving average crosses below a long-term moving average, then a bearish crossover is created (known as death cross), which confirms downward momentum in the stock.
Types of Moving Averages:
There are two types of moving averages: Simple moving average and exponential moving average.
A)Simple Moving Average
A simple moving average or SMA is an arithmetic moving average calculated by adding the recent prices and dividing the summation by the number of time periods in the calculated average.
Let us understand SMA with the help of an example:
The table above shows the closing price of a stock for 7 days. While calculating the SMA, the first 5 days’ values are considered. Here, the SMA comes out to be 7. Similarly, while calculating the next SMA, the Day 1 value is excluded, and the Day 6 value is considered to calculate the SMA value. Finally, the Day 3 value is excluded and the Day 7 value is taken to calculate the SMA.
Exponential Moving Average
Exponential Moving Average or EMA gives more weight to the most recent price data, which is considered more relevant than older data.
There are three simple steps that are followed in calculating EMA:
1. First, the SMA is calculated. Suppose you want to use 5 days as the number of observations for the EMA. Then, you must wait until the 5th day to arrive at the SMA. On the 6th day, you can then use the SMA from the previous day as the first EMA for yesterday.
II. After this, the multiplier (k) for weighing the EMA is determined.
Multiplier (k): [2 ÷ (number of observations + 1)]. Here, the number of observations = total time period. Taking the previously discussed example, number of observations = 5. Therefore, the multiplier in this case is k = 2/ (5+1) = 0.33.
III. Finally, the current EMA is calculated.
EMA = Closing price x multiplier + EMA (previous day) x (1 – multiplier)
Generally, 12-day and 26-day EMAs are used to identify short-term trends, whereas 50-day and 200-day EMAs are used to identify long-term trends.
Sensitivity to recent price point changes is more in EMA compared to SMA, making it more responsive to the latest price changes. We can observe how quickly EMA responds to price changes compared to SMA from the below graph.
This feature of EMA makes the results more timely and accurate, thus explaining why many traders prefer to use this indicator for trading.
PHI 1 offers custom moving averages such as SMA, EMA, EMA Cross, and so on among its 120+ technical indicators to choose from when trading.
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