Each time a trader decides to enter into a new trade, there is some underlying reason that causes him or her to take that particular action at that particular moment in time. We refer to this reason as a “catalyst”. A trading catalyst can be thought of as a single or multiple set of criteria that triggers a trader to take action.
The universe of potential trade catalysts is vast and at times it seems as if no two traders rely on exactly the same set of criteria to tell them when to enter a new trade. In a sense this is what “makes markets”. In other words, if all traders relied on the same catalyst to tell them when to trade, there would be no one to take the other side of the trade. So a vast network of traders utilizing as many different trading catalysts as possible is ideal for creating liquid markets.
Primary categories of catalysts
The majority of traders tend to rely on one or more of three primary categories of trade catalysts.
|Trend trading||Involves analyzing technical and/or fundamental factors to determine the current dominant trend for a given stock or other asset and then trading in the direction of that trend. Once a trend-following trader feels confident that the current trend for a given stock or other asset is up, they will look to buy in hopes of profiting from a continued price advance.|
|Countertrend trading||Involves analyzing technical and/or fundamental factors to identify the current trend for a given stock or other asset and then trading in the opposite direction of that trend. In some cases this may involve trading against the dominant trend while more commonly it involves trading shorter-term pullbacks within the dominant trend.|
|Chart pattern-based trading||Involves looking for particular patterns to form on a price chart – for example a double bottom for bullish traders or a double top for bearish traders. This type of analysis typically involves drawing and extending lines across a chart of previous price action and looking for either a particular pattern to form or for price to break out above a particular line as a trigger to take action.|
Each of the above catalyst categories offers pros and cons. Answering the following questions can help in determining which catalyst best fits your trading style:
- Which indicators do you use to identify the trend?
- What is your trading timeframe: long-term, intermediate-term, short-term or indefinite?
- When to actually enter into a trade once the trend is designated bullish or bearish?
- How to determine if the trend has reversed?
- When will you consider taking a profit if the trend is still moving in the right direction?
- When should I cut a loss?
Having answers to these questions can help a trader maximize the effectiveness of their trading strategy.
Trend trading as a catalyst
Many traders who rely on trend-following techniques as a catalyst for identifying trading opportunities have come to realize that picking tops and bottoms with any sort of accuracy is a very difficult task. In many cases they have also learned the benefit of heeding the old adage “The Trend is Your Friend.” A trend-following bullish trader essentially gives up the goal of buying low and selling high and instead attempts to buy high and sell higher if bullish and sell low and buy back lower if bearish.
The primary advantage of using trend-following as a trading catalyst is that it affords traders the opportunity to “ride” price action at times and does not always involve the need for precise timing. The primary disadvantage of using trend-following as a trading catalyst is that a trader often forgoes a certain amount of profit potential while waiting for an identifiable trend to develop.
Countertrend trading as a catalyst
Traders who rely on countertrend trading techniques as a catalyst for identifying bullish trading opportunities are typically willing to take a more aggressive approach to trading than traders who rely on trend-following techniques. To rely on a countertrend technique as a catalyst, a trader must have great confidence that that technique will come reasonably close to identifying a turning point in price action. Otherwise the trader may be faced with the need to realize a loss before the desired price reversal occurs. Buying a stock in the face of a price decline is occasionally referred to derisively as “trying to catch a falling knife.” There is clearly an element of risk involved. The same is true of selling short a stock in the face of a meaningful price advance.
A common practice for many countertrend traders is to look for intermediate term trends that head in the opposite direction of the longer-term trend as potential trading opportunities. In other words, for bullish traders, by buying pullbacks that occur during a longer-term uptrend, the trader attempts to achieve the best of both worlds – buying close to the bottom of a shorter-term pullback while still trading in the direction of the major bullish trend. And for bearish traders, selling short during rallies that occur during a longer-term downtrend, the trader attempts to achieve the best of both worlds – selling short close to the top of a shorter-term advance while still trading in the direction of the major bearish trend.
Chart patterns as a catalyst
Chart pattern-based trading fits into the realm of research known as technical analysis. Traders who rely on chart patterns as a catalyst for finding trading opportunities spend their time perusing price charts, looking for certain patterns of price action to develop as a potential sign of future price direction. It should be noted that most chart patterns fit into the trend-following or countertrend categories, as some patterns suggest a continuation of an ongoing trend while others portend an imminent reversal in price. Still, because of their unique nature and the fact that many traders rely on chart patterns as standalone techniques, chart pattern trading is considered by most as a separate category of trading catalyst.
The primary advantage of using chart patterns as a trading catalyst is that it’s another tool a trader can use by itself or in conjunction with other indicators to help identify potential changes in price direction. The primary disadvantage is that it can involve a significant amount of subjective analysis on the trader’s part. Also, while a particular chart pattern may seem obvious in hindsight, identifying it in real-time and actually pulling the trigger to make a trade can be more challenging for many traders.
One of the most important decisions any trader can make is deciding what specific criteria will cause them to take action in the market. The good news is that there are many choices available and in many cases a trader can alter the standard interpretation of a given catalyst to create their own custom trading trigger. The most important part of this endeavor for each trader is to develop a set of criteria that they are comfortable with, confident in and which can be reused on a regular basis.