5 Factors Every Trader Should Examine Before Making A Trade

The third quarter of 2008 was the most volatile and tumultuous environment in the past 80 or more years, the effects of which are still painfully present. But for stock pickers who rely on strategies that have made them successful in the past, it has made their entire trading approach feel like an exercise in futility.

More and more institutional investors, such as mutual fund and pension fund managers, aren’t bothering to sift through earnings reports and income statements weeding out winners from losers, and are instead trading large blocks of stock and other financial securities based mainly on macro concerns. The result, all variety of companies and commodities, the good, the bad, and the ugly, are trading in virtual lock step.

Data suggest that stock pickers are having a difficult time over the past few years outperforming market averages. A pure technical approach just isn’t going to work in an environment where individual stocks rise and fall in unison with the broader markets. It is now vitally important to first analyze the major market indices to ensure that you are taking trades with the market trends so that you don’t get bowled over by a market focused on the big picture.

Researching the following 5 factors before you ask yourself “which stock should I trade?” and “should I buy or go short here?” should provide you with an edge to succeed in the new market environment.

1. Is it a bull or a bear market?

In bull markets, dips tend to get snatched up by buyers and in bear markets sharp rallies are usually met with selling pressure. Fortunately there is an easy way to objectively determine whether the market is in a bull or a bear market simply by eye-balling the 200-day moving average. Pull up an index chart for the S&P 500. Is the 200-day average trending up? If so, it’s a bull market. Is it trending down? It’s a bear market.

2. Short term moving averages.

What direction are the 10-, 20-, and 30-day moving averages trending? Are they up, down or flat? Traders should always make trades in the direction of the S&P 500’s short term averages. If they are trending up, all trades should be on the long side. Vice versa, if they are down, you should be short or in cash. If they are flat, look for a choppy market that will be very difficult to trade profitably.

3. Is the market trending or is it stuck in a trading range?

Trending markets are much easier to trade. If the market is trending, it’s important to let your winners run. Market trading ranges are a bit pricklier. If the market is range bound it’s important to take profits more quickly and trade smaller size positions as your trades will be more vulnerable to stopping out in market noise.

It’s helpful to use trend lines and channels on your charts to help spot whether the market is ranging or trending.

4. What is the dollar doing?

In a market focused on macro concerns, the dollar has become an important leading indicator. Over recent years a strong inverse correlation has developed between the dollar and stocks; when the dollar is weak, stocks are strong and when the dollar is strong, stocks tend to be weak. Oftentimes, the dollar will lead the market, breaking lower before stocks break higher. You can check the performance of the dollar by tracking the Exchange Traded Fund (ETF) UUP.

5. How is market leadership performing?

Leadership stocks are one of the best ways to test the pulse of the market. Market leadership tends to rotate, but usually you can figure out where leadership is by watching those stocks attracting unusually large trading volume and stocks that have recently consistently been making new highs or new lows.

If the market is in an up trend, for example, and leadership stocks are still performing well one can reasonably assume that the market is healthy. When leadership stocks start to lag, however, it might be time to start getting a bit more defensive by tightening up stops, trading smaller positions or moving to cash.

Donald D Harder is an investment advisor with over 17 years professional market experience and is President and Chief Stock Market Analyst for Securities Research Services, an online stock trading newsletter service. Don served as a financial advisor for American Express Financial Advisors and later served on the board of directors at Nettrader.ru, a mid-sized Moscow-based online securities brokerage. Mr. Harder strictly adheres to an investment philosophy that focuses primarily on reducing risk, for if you manage risk, profits generally take care of themselves.