Buying dips & selling rallies
Trading sounds so simple when you first start out...
- “Just buy the dips and sell the rallies!”
- “Buy Low, Sell High!”
Pffft. Is that it? How hard can it be?!
The longer you spend around markets, the more you realise that it takes a lot more than a couple of platitudes to build a successful trading strategy.
A lot of those timeless phrases are good trading principles, but lack substance when it comes to execution. So let’s dig into that principle of buying low and selling high.
I’ve marked up a daily chart below of the Germany Dax 40 with some obvious levels of support/resistance. One of the first things that jumps out is the clear uptrend. We can see that buying dips would offer decent returns, and some rallies could be sold too.
Going with the underlying trend and buying dips is logical. Even if a trade entry isn’t pinpoint, the trend does the heavy lifting and often bail out imprecise entries. The question is identifying which dips to buy.
This is where factors of confluence can come into play. For trend following, some form of ‘deviation’ indicator around a moving average can be very useful.
Bollinger bands, Keltner channels, or similar are popular and easy to understand. The purpose of these is to generate signals regarding how far (measured in standard deviations or ATR) price has stretched from an average.
In this example, let’s add Keltner channels to the daily chart. These have been set to show 2 x ATR (2 x Average True Range) either side of the 20 day moving average.
What do we notice?
Suddenly the picture is far clearer. Buying the dips on one side of the channel and selling the rallies at the other side. Brilliant. You may think that If a trader just does that for a few years, the beachside villa in the Bahamas has their name on it!
Not so fast. Traders are humans, and human judgements are pretty imperfect. Trading always looks so simple in hindsight. Let’s look at the chart again, put ourselves in the traders shoes and focus on the initial rally from Point A.
Imagine the trader doesn’t get long on that first push. Waiting for a dip to buy doesn’t pay off. The train left without them. Where’s the next trade? Perhaps a short at Point B. It's a retest of a prior high and at the edge of the Keltner channel.
The trader has sold high. Now the next dilemma… Where’s the exit? If the trader waits until price hits the other side of the channel they’ll never book the profit, and probably end up stopping out.
If they respect the underlying uptrend and exit at the midpoint of the channel (20DMA), the trade works out for them.
Is this always* the case? Well, nothing __*always__ works in markets, but the Keltner channels do add context. Let’s add some more points to the chart.
In situations where the uptrend is steeper and stronger (blue arrows), the lower edge of the channel is rarely touched. A trader might be better off exiting any shorts at the midpoint of the channel. Waiting for price to pull back to the lower edge and get long isn’t optimal either as the trader risks missing a good chunk of the rally.
However, when the market is consolidating after the rallies, price does seem to find the extremes of the channels. Points C, D & E all offered good bounces.
Points Z1 & Z2 highlight an area where horizontal support and resistance worked well as a confluence with the Keltner channels.
Sadly, there are no magic indicators that tell a trader where to buy and sell, and all of this can look and work very differently in real time. However, indicators such as Keltner channels can be very useful tools to guide a trader and help them judge the merits of a trade objectively.
Not investment advice. Past performance does not guarantee or predict future performance.
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