Multiple timeframes can multiply returns

To consistently make money in the markets, traders must learn how to identify an underlying trend and trade accordingly. Common clichés include: “trade the trend,” “don’t fight the band,” and “the trend is your friend.” But how long does a trend last? When should you get in or out of a trade? What exactly does it mean to be a short-term trader? Here we delve deeper into trading timeframes.

Time frame

Trends can be classified as primary, intermediate and short term. However, markets exist in multiple time frames simultaneously. As such, there may be contrarian trends within a particular stock depending on the time frame considered. It is not unusual for a stock to be in a primary uptrend while stuck in intermediate and short-term downtrends.

Typically, beginning or novice traders lock in on a specific time frame, ignoring the more powerful primary trend. Alternatively, traders may trade the primary trend but underestimate the importance of refining their entries in an ideal short-term time frame. Read on to learn about what time frame you should follow for the best trading outcomes.

What timeframes should you be watching?

A general rule of thumb is that the longer the time frame, the more reliable the signals given. As you drill down into timeframes, the charts become more polluted with spurious movements and noise. Ideally, traders should use a longer time frame to define the primary trend of whatever they are trading.

Once the underlying trend is defined, traders can use their preferred time frame to define the intermediate trend and a faster time frame to define the short-term trend. Some examples of using multiple time frames would be:

A swing trader, who focuses on daily charts for decisions, may use weekly charts to define the primary trend and 60-minute charts to define the short-term trend. A day trader can trade off 15-minute charts, use 60-minute charts to define the primary trend and a five-minute chart (or even a tick chart) to define the short-term trend. A long-term position trader can focus on weekly charts while using monthly charts to define the primary trend and daily charts to refine entries and exits.

The choice of which group of time frames to use is unique to each individual trader. Ideally, traders will choose the main time frame they are interested in, and then choose a time frame above and below it to complement the main time frame. As such, they will use the long-term chart to define the trend, the intermediate-term chart to provide the trade signal and the short-term chart to refine the entry and exit. One caveat, however, is not to get caught up in the noise of a short-term chart and overanalyze a trade. Short-term charts are typically used to confirm or dispel a hypothesis from the primary chart.

Trading Example

HollyFrontier Corp. (NYSE: HFC ), formerly Holly Corp., began appearing on some of our stock screens in early 2007 as it neared its 52-week high and showed relative strength against other stocks in its sector. As you can see from the chart below, the daily chart showed a very tight trading range that formed above its 20- and 50-day simple moving averages. The Bollinger Bands® also revealed a sharp contraction due to the reduced volatility and warning of a possible rally on the way. Because the daily chart is the preferred timeframe for identifying potential swing trades, the weekly chart will need to be consulted to determine the primary trend and verify its alignment with our hypothesis.

A quick glance at the weekly sheet revealed that HOC was not only showing strength, but that it was also very close to new record highs. Furthermore, it showed a possible partial pullback within the established trading range, indicating that a breakout may occur soon.

The projected target for such a breakout was a juicy 20 points. With the two charts in sync, HOC was added to the watch list as a potential trade. A few days later, HOC tried to break out and after a volatile week and a half, HOC managed to lock down the entire base.

HOC was a very difficult trade to make at the breakout due to the increased volatility. However, these types of breakouts usually provide a very safe entry on the first pullback after the breakout. When the breakout was confirmed on the weekly chart, the probability of a failure on the daily chart would be greatly reduced if a suitable entry could be found. Using multiple time frames helped identify the exact bottom of the pullback in early April 2007. The chart below shows a hammer candle forming on the 20-day simple moving average and middle Bollinger Band® support. It also shows that HOC is approaching the previous breakout point, which usually also provides support. The entry would have been at the point at which the stock cleared the high of the hammer markers, preferably with an increase in volume.

By drilling down to a lower time frame, it became easier to identify that the pullback was nearing an end and that the potential for a breakout was imminent. The chart below shows a 60-minute chart with a clear downtrend channel. Notice how HOC has been consistently pulled down by the 20-period simple moving average. An important note is that most indicators will also work over multiple time frames. HOC closed above the previous daily high in the first hour of trading on April 4, 2007, indicating the entry. The next 60-minute candle clearly confirmed that the pullback was over, with a strong move on an increase in volume.

The trade can continue to be monitored over multiple time frames with more weight being assigned to the longer trend.

The chart below shows how the HOC target was achieved:

The Bottom Line

By taking the time to analyze various time frames, traders can greatly increase their odds of a successful trade. Reviewing longer-term charts can help traders confirm their hypotheses, but more importantly, it can also alert traders when the separate timeframes don’t match. By using narrower timeframes, traders can also significantly improve their entries and exits. Ultimately, the combination of multiple timeframes allows traders to better understand the trend of what they are trading and instill confidence in their decisions.