Top Down Investing - Trading Methodology


What is Top Down Investing

Top down investing is the process of first assessing the health of the broader market before analyzing individual securities.  This trading methodology is based on the premise that if an investor trades in the direction of the larger trend, it greatly increases the odds of putting on a winning trade.

Top Down Investing Methodology

Below is a simple process for how to analyze the market with a top down approach.  The top down approach can be broken out into 4 phases: (1) first assess the global market, (2) identify the strongest industry, (3) determine the strongest stocks in the sector, and lastly (4) locate the best time to enter the trade.

Assess the Global Market

It is important monitor more than 1 trading market.  In order for a trader to fully understand how the market works, he or she must monitor a number of markets (energy, forex, etc.)  While it is not required to be an expert in every market, it is important to understand how these global forces can influence securities within your portfolio.

Identify Strongest Sector

After assessing the global market to identify a trading opportunity, the next step is to find the strongest performing sectors.  This does not necessarily translate into raw percentage gain for the year, but the sectors with the smallest retracement from its highest point to each reaction low within the context of the larger bull market.  Remember, volatility does not equal gains, but the strength of the trend.

Locate the Strongest stocks

Once a trader has identified the strongest sector, the next step is to select the best performing stocks in the sector.  This can be done by looking at cash flow statements, earnings reports, and utilizing technical analysis techniques.  Many trading applications will plot more than one security and this can provide a quick visualization of how the respective stock compares to the index.

Entering the Trade

Below is a trading example of how to implement the top down approach.  This example will cover the bull market in oil, which saw a number of securities double and triple in price over a 2 year period.  The first step was to look at the Oil Services Holder (OIH).  Notice how the oil market was in a strong uptrend over the last few years.

Oil Bull Market
 
Within the oil industry, drilling was one of the best performing sectors.  Below is a chart of the Offshore Drilling Index (DO) which is a basket of drilling stocks.  Notice how the DO chart has a greater percentage gain than the OIH, thus outperforming the industry.
 
Drilling Index Bull Market
 
Apache was one of the top performing stocks within the Drilling Index, hence Apache would be a great long candidate.
 
Apache Bull Market
 
The last part of the top down trading approach is determine when to enter the long position.  It is always tough to buy into bull markets, because the security will grind higher with a few panic sell offs in between each successive high.  So, as a trader you must decipher when it is most appropriate to jump on board.  The best method for achieving this goal is to wait for a multi-month resistance level to be back tested.  This way you are not buying into a parabolic move and odds are on your side that there is enough support at the previous resistance level to prevent the security from collapsing on itself.  In the below example Apache pulled back to support of $72 dollars in August '07 after battling with the level for over 2 years.  This method of buying the pullback also reduces the trader's exposure to risk as the security is extremely oversold.

 

Apache Pull Back to Support