An Introduction to Top-Down Trading:
Top down trading is an important tool for trend followers and anyone else with an interest in technical trading.
Top down investment analysis is a key step I always use when calculating my position size. That’s because the important context you get from this analysis can help you put the odds of stock market success in your favour. So how does top down trading work?
I’m glad you asked. Because…
In this detailed article, I’ll explain what top down trading is all about, and how you can use it as a trend follower or technical analyst to try and help improve your bottom line.
Sound good? Great.
Then let’s start at the beginning…
What is Top Down Trading?
The great thing about top down trading is that it’s very simple (…both conceptually, and in practice…). But for now, let’s start with the theory…
You see the basic idea behind top down trading is that you want to try and operate with the market winds at your back. Think of it is as swimming in the direction of the current.
You want to go with the flow!
If you’re considering entering a trade or pursuing a new investment idea, a top down approach would have you looking at the stock market as a whole in order to get a bird’s eye view… (AKA top down analysis)… of what the market is doing.
From there, you can also drill down to look at a specific sector or industry to see how similar stocks in the same group as your prospective pick are performing.
But why would you do this?
Well, the main idea here is that you can be more likely to succeed in your trade or investment, if the rest of the industry and market are also moving in the same direction.
Top down trading is like the opposite of buying a falling knife. It’s about aligning yourself with momentum so you have a better chance to profit.
When you buy a breakout stock pick, you need other people to come into the market and buy that stock too. So if you want to make capital gains… which I assume you do… then you need other people to bid your stock up
Top down trading is a relatively quick and easy way to analyze what these other market players are doing. It helps you understand what they’re buying and what they’re selling, so you can adjust accordingly.
And now that you have a better grasp of the underlying theory behind top down trading, let’s take a closer look at how it works in practice.
Top Down Trading Tips You Can Use Today:
One of the best parts about top down trading is how easy it is to get started. All you need is a simple charting platform.
You can use the one provided by your broker, or a free online tool like StockCharts.com. So how do you get started?
Well, it’s actually quite simple. You just want to start by looking at the trends in global equity markets, and then slowly zoom-in to your specific area of interest.
So for example…
I usually start with a chart of ACWI. This all-country-world-index ETF is a quick and easy way to gauge the strength of global equity flows.
It’s not perfect, but in my experience it’s been a pretty good proxy.
As you can see above, at time of writing, the major trend in ACWI is upward. You can see…
Not only is the price making new highs, but the longer term moving averages are all aligned and sloping up together. This is like a green light to continue drilling down.
On the other hand…
If shares of ACWI were in a steep downtrend, I’d be much less bullish about the prospect for stocks.
Even if they were stuck in a trading range I’d be a little less optimistic about the prospects for potential breakouts.
And by the way…
You can see above that I’m using weekly charts. If you’re a shorter-term day trader then you may want to use a smaller time frame.
But for my swing/position style of breakout trading, this broader view works well.
After all… the idea is to get a sense of the MAJOR trend.
So if you look too closely you risk losing sight of the forest for the trees.
Part of what we’re trying to determine is which way the big money is flowing. And keep in mind, big institutional investors often need weeks to move in and out of positions.
On the other hand… f you use too small a timeframe for your big picture analysis… you’ll almost certainly miss the impact of this important institutional order flow.
Once you’ve got a clear view of the trend in global markets as shown by ACWI, you can bring your country of interest into focus. For most readers, this would be US stocks.
In this case, I like to keep it simple and look at the SPY ETF, which is the most actively traded security tracking the S&P-500.
If you are outside the US and want to look at a different country, the same process applies. I would just recommend that you choose the appropriate country index ETF or regional ETF.
By the way, here’s a great list of most popular country ETFs right here.
Now, let’s go back to that SPY chart:
In the example above, you can see the SPY chart actually looks quite similar to what we saw with ACWI. For stock market bulls, this alignment is exactly what you want to see.
But don’t stop there!
Next, I like to look at the sector of focus.
With US stocks, this is quite easy. You can just use the XL sector ETFs to see how your area of interest is performing.
And just in case you aren’t familiar, here’s a list of these liquid US sector ETFs to help round out your top-down analysis.
By the way…
If you’re outside the US and can’t find an appropriate sector ETF, I have another idea for you. Instead of using the sector index, you can create your own!
Just look at a few of the biggest stocks in your sector of interest and use that as a proxy. These bigger names should give you an idea for how the sector is performing.
To continue our example from above…
Say you wanted to buy shares of GOOGL: In this case, since GOOGL is a tech company, you’d want to take a quick look at the XLK technology ETF
Once again, in this example you can see the chart of XLK looks similar to the other charts we looked at. In our example, this means…
Not only is the global stock market trending higher… but… US markets are also heading up.
AND even better, the tech sector appears to be leading the charge!
So in this case, without even looking at the chart of GOOGL, this top-down analysis has given you a green light to buy.
Of course, you’ll also want to double check that GOOGL (or whatever stock you’re actually trading) has given you a buy signal according to your trading strategy.
“Do you see how this top-down context could help you feel more confident?”
And conversely, if you did some top-down analysis and got mixed signals or a bearish indication, do you see how this would help? Would you consider passing on the trade or at least reduce your position size?
As you can probably imagine…
With the rise of factor-based ETF investing and passive indexing, top down trading is more important than ever. Market correlations mean entire groups can move in convoys. And…
If you don’t pay attention to these important fund flows you really do risk being run over!
So just to be thorough, let’s examine this idea a little more closely…
Why Top Down Trading is Important to Consider:
By now I think you’re getting a feeling for this: Top down trading means waiting for the market to confirm your opportunity, and then taking action when the broad market indices are moving higher alongside your stock pick.
But why is this so important?
Well… like it or not… the stock market is highly correlated (especially in times of panic). If the S&P 500 starts crashing, then chances are your stock will experience some selling pressure too, right?
And actually, I’m sure you’ve personally seen this happen if you’ve been investing or trading for any length of time. So…
With top down trading, you may be able to save yourself some expensive mistakes by betting smaller or taking a pass all together when the overall market is in a downtrend.
And on the other hand…
When the coast is clear, top down trading can help you feel MUCH more confident jumping on an uptrend.
Speaking of trends… you might be wondering…
How Can Trend Followers Use Top Down Trading?
Top down trading is a great tool for trend following traders. It’s another arrow in your quiver that can really help give you an advantage.
So here’s what you need to know…
Trend followers can adjust their bet size and value-at-risk based on top down trading. They bet bigger when the odds are in their favour, and scale back when the top down analysis presents a muddled picture.
If the major market averages are range bound or in a downtrend, then it usually pays to place smaller bets than normal.
Risk half of what you normally would because the odds aren’t as great as you might think by just looking at your stock.
Seriously: even when buying leading stocks in strong uptrends, you may want to reduce your risk when the market at large is under pressure. Stocks are just too highly correlated to take on a lot of risk. Simple, right?
On the other hand…
If the stock market and sector you’re interested in are both in strong uptrends with no sign of slowing down, then you may be comfortable increasing your position size and taking on a little more risk.
Are you starting to get a feel for this?
While top down trading isn’t the be all and end all of market analysis, it’s a great overlay you can use to help inform your asset allocation. It’s an easy and free screen to help decide when to place a trade and when to wait.
Instead of rushing in to buy your latest stock pick, be patient. Sit back and watch.
In order to improve your chances of success, wait for the market to give you the green light.
It’s a simple technique. But it can make a big difference.
Now let me show you one more way to put it into action…
Top Down Trading Tools From FinViz.com:
If you’ve ever visited my website before, then you probably know FinViz is one of my favourite online trading tools.
After all, I’ve even shared exactly how I scan for stocks on FinViz. So before wrapping up this blog post…
I just want to show you some examples of how you can use FinViz to better see where the money is flowing.
First of all, one of the best free tools FinViz offers is the stock market heat map.
Take a look:
If you aren’t familiar, these heat maps just show you how stocks are performing.
The brighter the colour, the stronger the move. And naturally, green is good if you’re a stock market bull.
So as you can see this heat map adds a lot more context than just looking at the S&P-500!
You can clearly see which industries and stocks are the best performer.
And there’s also a world heat map so if you’re contemplating a certain country you can see how well it’s performing.
You can also change the time frame to even better suit your purpose. The default display is 1-day, but you can easily adjust this to a longer-term view, all the way back to 1 year.
Along the same lines, I also want to point out the Groups page on FinViz as well. This page provides a more concise view of how different sectors are trending.
And the great thing about the Groups page is that you can easily browse group performance over different time periods.
In fact, this can actually be a way to “reverse-engineer” your top down trading.
For instance, you could come here to find the strongest group over the last 3-12 months, and then drill down into that market sector to find the best performers in the group.
I hope so! Because…
Once you understand the concepts of top down trading, there are many different ways to apply them.
It doesn’t matter what your timeframe is or which indicators you use to time your entry. This trading strategy can be adapted to help you.
If you’re still hungry for information on top down trading, keep reading to find more resources and reading on this important topic.
More Top Down Trading Resources:
I hope this introduction to top down trading gave you a comprehensive overview of this big picture technical analysis. But…
If you’re still itching to learn more about how to trade with a top down perspective, then just check out these additional resources to help you keep learning.