Buy Signals Sell Signals

1. Price Action Trumps Fundamentals

Values are based on buyers and sellers and not opinions or fundamental valuations.

Market's True Value. The real value of a stock is determined by what buyers are willing to pay, not by its theoretical worth based on balance sheets or earnings reports. Fundamental analysis can be useful for identifying potential investments, but price action is the ultimate arbiter of value. For example, a company might have great financials, but if no one is buying the stock, its price will stagnate or decline.

Disconnect between company and stock. A company's performance and its stock price are two different things. A company can be profitable, but its stock price can still fall due to market sentiment, fear, or other factors. The stock price is driven by the supply and demand of the stock itself, not necessarily the underlying company's results. This is why technical analysis, which focuses on price action, is so important for traders.

Price action is king. Traders should focus on price action, which reflects the collective decisions of all market participants, rather than relying solely on fundamental valuations. This approach allows traders to profit from market trends and avoid getting caught in losing positions based on outdated or inaccurate fundamental data. The market is a voting machine in the short term, and a weighing machine in the long term.

2. Trade Price Signals, Not Emotions

If you want to make a quantum leap in profitability, the first step is to stop buying or selling anything without a solid, quantifiable, external reason for doing so.

Emotional trading is costly. Most trading errors stem from emotional reactions like fear, greed, hope, and pride, rather than rational analysis. These emotions lead to impulsive decisions, such as buying high, selling low, or holding onto losing positions for too long. For example, fear can cause a trader to exit a winning trade too early, while greed can cause them to hold onto a losing trade in the hope of a turnaround.

External signals are key. To overcome emotional trading, traders must rely on quantifiable, external signals based on price action. These signals provide a clear, objective reason to enter or exit a trade, removing the influence of emotions. For example, a trader might use a moving average crossover as a buy signal, or a stop-loss order to limit potential losses.

Discipline over emotions. Successful trading requires discipline to follow a trading plan and execute signals without emotional interference. This means sticking to pre-defined entry and exit points, managing risk, and avoiding impulsive decisions based on feelings. The market doesn't care about your feelings, so you shouldn't either.

3. React, Don't Predict the Market

Instead of trying to predict a market direction, their strategy is to react to the market's movements whenever they occur.

Prediction is futile. Trying to predict future market movements is a waste of time and energy. The market is too complex and influenced by too many factors to be accurately predicted. Instead of trying to guess what will happen next, traders should focus on reacting to what is happening now.

Reactive technical analysis. Reactive technical analysis involves using price action to identify trends and patterns, and then entering or exiting trades based on those observations. This approach is flexible and allows traders to adapt to changing market conditions. For example, a trader might enter a long position when a stock breaks out above a resistance level, or exit a short position when a stock closes above its 200-day moving average.

Flexibility is crucial. Successful traders are flexible and can quickly change their positions based on market signals. They don't get attached to their opinions or predictions, and they are willing to admit when they are wrong. The market is always right, and traders must be willing to adapt to its movements.

4. Adapt to Market Types: Range, Trend, Volatility

No trading signals are profitable in all markets at all times because markets change from trending to not trending, and from not volatile to very volatile.

Markets are dynamic. Markets are not static; they constantly shift between different states, including range-bound, trending, and volatile. Each market type requires a different trading approach. For example, a strategy that works well in a trending market might not be effective in a range-bound market.

Range-bound markets. In range-bound markets, prices move within a defined range, with clear support and resistance levels. The best strategy is to buy near support and sell near resistance. Technical indicators like RSI can be useful for identifying overbought and oversold conditions in range-bound markets.

Trending markets. In trending markets, prices move consistently in one direction, either up or down. The best strategy is to follow the trend, buying on pullbacks in uptrends and selling on rallies in downtrends. Moving averages are useful for identifying trends.

Volatile markets. In volatile markets, prices move rapidly and unpredictably. It's important to be cautious and use smaller position sizes. Strategies that work well in other market types may not be effective in volatile markets.

5. Beyond Signals: Risk, Psychology, and Discipline

I think investment psychology is by far the most important element, followed by risk control, with the least important consideration being the question of where you buy and sell.

Signals are not enough. Having a good buy and sell system is only one part of successful trading. Risk management, trader psychology, and discipline are equally important. Many traders fail because they lack the emotional control and risk management skills necessary to succeed.

Risk management is crucial. Risk management involves controlling position size, setting stop-loss orders, and limiting overall risk exposure. It's essential to protect your capital and avoid large losses that can wipe out your trading account. For example, a trader might risk no more than 1% of their capital on any single trade.

Psychology and discipline. Trader psychology involves managing emotions, avoiding impulsive decisions, and sticking to a trading plan. Discipline is the ability to follow your plan consistently, even when it's difficult. These are the most important factors for long-term success.

6. Build Your Own Signals for a Trading Edge

The purpose of creating buy and sell signals is to capture a trend’s profitability inside your trading timeframe.

Customized signals. Creating your own buy and sell signals allows you to tailor your trading system to your specific goals, risk tolerance, and market beliefs. This approach gives you a unique edge over other traders who are using generic signals. For example, a trader might combine moving averages, RSI, and MACD to create a unique entry signal.

Trend identification. The primary goal of buy and sell signals is to identify and capture trends in your chosen timeframe. By trading in the direction of the trend, you increase your odds of success. Moving averages are a common tool for identifying trends.

Risk/reward ratio. A good trading signal should offer a favorable risk/reward ratio, meaning that the potential profit is greater than the potential loss. This is achieved by entering trades with a stop-loss order placed at a level that limits losses, and a profit target set at a level that maximizes gains.

7. Technical Tools for Buy and Sell Signals

Just like builders use hammers and saws to build houses, traders use technical tools to build their own trading systems.

Variety of tools. Traders use a variety of technical tools to build their buy and sell signals, including price action, moving averages, MACD, RSI, chart patterns, trends, momentum, candlesticks, and price gaps. Each tool has its own strengths and weaknesses, and no single tool works in all market conditions.

Moving averages. Moving averages smooth out price data and can be used to identify trends, support, and resistance levels. They can also be used as entry and exit signals. For example, a trader might use a 50-day moving average as a support level in an uptrend.

Momentum indicators. Momentum indicators like MACD and RSI measure the speed and change of price movements. They can be used to identify overbought and oversold conditions, as well as potential trend reversals. For example, an RSI reading above 70 might indicate an overbought condition.

Chart patterns. Chart patterns are visual representations of price action that can be used to identify potential breakout points and trend reversals. Examples include flags, pennants, triangles, and cups and handles.

8. Mechanical Systems for Consistent Trading

For the average trader, being a 100% Mechanical System Trader usually maximizes the chance of success in the markets, especially if you are using a historically proven, profitable system.

Mechanical vs. discretionary. Mechanical trading systems are based on pre-defined rules for entries, exits, and position sizing, while discretionary systems rely on intuition and judgment. Mechanical systems remove emotions from trading and promote consistency.

Rules-based trading. Mechanical traders follow a strict set of rules and do not deviate from their plan. This approach eliminates the influence of emotions and biases, leading to more consistent results. For example, a mechanical trader might enter a long position whenever a 50-day moving average crosses above a 200-day moving average.

Backtesting and optimization. Mechanical systems can be backtested on historical data to evaluate their performance and optimize their parameters. This allows traders to identify systems that have a high probability of success.

9. Basic Trend Following and Range Trading Signals

In range bound markets buy signals are near support, and sell signals are at resistance until a range bound breakout changes the chart pattern into a new trend.

Trend following signals. Trend following systems aim to capture trends by entering trades in the direction of the trend and exiting when the trend reverses. Examples include entering on a 20-day breakout and exiting on a 10-day breakout in the opposite direction.

Range trading signals. Range trading systems aim to profit from price movements within a defined range. The basic strategy is to buy near support and sell near resistance. For example, a trader might buy a pullback to the 50-day moving average in an uptrend.

Combining signals. Traders can combine trend following and range trading signals to create more robust trading systems. For example, a trader might use a trend following system to identify the overall trend and then use a range trading system to enter trades within that trend.

10. Momentum, Gaps, and Moving Average Signals

The 10-day exponential moving average (EMA) is my favorite indicator to determine the major trend.

Momentum signals. Momentum signals aim to capture fast price movements in one direction. Examples include buying a 52-week high or a new all-time high and trailing a stop loss with an ascending moving average.

Gap signals. Gap signals involve trading price gaps, which occur when a stock opens at a price significantly higher or lower than the previous day's close. For example, a trader might buy a gap up in price at the end of the day with a stop loss at the low of the gap up day.

Moving average crossover signals. Moving average crossover signals involve entering trades when a shorter-term moving average crosses above or below a longer-term moving average. For example, a trader might enter a long position when the 5-day EMA crosses above the 20-day EMA.

11. Simple Systems Beat Buy and Hold

The "easier money" in this difficult business of professional speculation is following the path of least resistance until that path has changed.

Buy and hold limitations. Buy and hold investing, while popular, exposes investors to significant drawdowns during bear markets. Simple trend following systems can outperform buy and hold with lower drawdowns.

Trend following advantages. Trend following systems can protect capital during bear markets by exiting long positions and potentially entering short positions. This allows traders to avoid large losses and capture profits during both uptrends and downtrends.

Simple systems are effective. Simple trading systems based on price action and moving averages can be highly effective. The key is to follow the system consistently and manage risk effectively. For example, exiting mutual funds when the SPY price crosses under its 200-day SMA can dramatically reduce drawdowns.

Last updated: February 1, 2025