Technical Analysis Measures used to Recognize Swing Trading Patterns

Technical Analysis Measures used to Recognize Swing Trading Patterns

By Larry Swing

To begin with, we typically restrict our selections to stocks that are at least $12 in price, having an average (20 day) daily volume of at least 500,000 shares. Since market makers can more easily manipulate low price, low volume stocks, we stay away from them.

For long swings we are interested in identifying stocks that are in an uptrend. One of the indicators we use is a simple moving average (SMA). A moving average is simply the average closing price for a particular number of days. It’s called a moving average because on each new day, the current day’s price is added to the average while the oldest price is dropped. We typically focus on three moving averages, those based on 10 days, 20 days and 50 days. All moving averages smooth the price movement and make it easier to identify trends. It is also significant to know where today’s price is relative to the moving averages and whether the shorter time-frame moving average is above or below the longer time-frame moving average.

Two indicators that a stock is in an uptrend are:

• Today’s closing price is above both the 10-day and 20-day moving averages

• The 10-day moving average is above the 20-day moving average When looking for a long swing, we would like to identify stocks that are experiencing a brief decline (pullback). We can identify a 3-day pullback as follows.

• Today’s high price is lower than yesterday’s high

• Yesterday’s high is lower than the high the day before

We also use a technical indicator developed by Dr. Alexander Elder called the Force Index. This index combines the magnitude of the price change with the direction of the change and the trading volume. In order to confirm the relative force behind an uptrend and a pullback, we use a 3-day moving average and a 13-day moving average of the Force Index. The following conditions demonstrate that the bears have been winning the short-term battle while bulls are dominating the longer frame:

• The 3-day moving average of the Force Index is less than 0, and

• The 13-day moving average of the Force Index is greater than 0

Another technical indicator we like to use is the Directional Movement Index (DMI) that was developed by J. Welles Wilder Jr. It is used to determine whether a stock is trending or not trending (i.e., moving sideways). In SwingTracker we provide the two components of this indicator – the Positive Directional Index (+DI) and the Negative Directional Index (-DI) – along with a 20-day moving average based on these two measures (ADX). An uptrend is confirmed if …

• ADX is higher than 30

• +DI is greater than –DI

WHAT is the Master Plan

The Master Plan is a set of rules that determines when to enter and exit a trade. At first, it might seem a little complicated, but once you have place a few trades using the system, you’ll realize it’s really quite simple. The best part about the Master Plan is that you don’t need to use judgment. The rules are mechanical. Two obstacles to successful trading are the human emotions of fear and greed. By following the Master Plan, these emotions will not influence your behavior, nor will they interfere with your success.

To keep it simple, we’ll first focus on the long trade. The rules for a short trade are simply the mirror image of the rules for a long trade. An example of a long swing opportunity is shown below. The price has declined (pulled back) and you are bullish on the stock.

Taking a Profit and Preserving Capital

An important aspect of the Master Plan is setting a profit target and preserving capital. The approach is fairly conservative – the profit target is approximately 7% with a potential loss capped at 4%. The actual profit is likely to be more than 7% while a loss is likely to be smaller than 4%. Here’s how it works.

• Once the target price is reached (7% above the entry price), half of the shares are sold, locking in a 7% profit. The other shares remain invested to benefit from any further increase in price.

• If the price moves against the trade, the maximum loss tolerated is 4%. This preserves capital for future trades.

• Typically, more trades will produce a profit than a loss. The net result is profit.

• The movement of the entire market is very powerful. When the market is moving with your trades, a very high percentage of your trades will be profitable.

• When the entire market is moving against your trade, a higher than expected percentage of your trades will lose. The stop loss protects you from excessive losses.

Profit is taken using a “sell limit" order – once the price is reached, the specified number of shares are sold.

Capital is protected using a “stop loss" order – when the stop price is reached, all the shares are sold.

• Buying AFTER the open is BETTER
• Wait a few moments to allow the market to breath normally

When to Enter the Trade

Using the Master Plan, swing trading opportunities are identified after the market closes. Trades are entered in the morning, usually within the first half hour of trading. When you enter the trade (and the decision rule you use) depends on whether or not the stock has gapped up or down from the previous day’s closing price. According to the Master Plan, a stock is considered to have gapped up when it opens 50 cents or more higher than the previous day’s close; it is considered to have gapped down when it opens 50 cents lower than the previous day’s close. Most frequently, the stock price will open within 50 cents of the previous day’s close, neither gapping up nor gapping down.

• The most common occurrence – the stock opens within 50 cents ($0.50) of the previous day’s close – the order can be placed a few minutes after the market opens.

• Occasionally a stock gaps up 50 cents or more compared to the previous day’s close – the order is placed at least 30 minutes after the market opens.

• Occasionally a stock gaps down 50 cents or more compared to the previous day’s close – the order is placed approximately 5 minutes after the market opens.

• To summarize, if the stock gaps in the same direction as the trade, wait 30 minutes, and if the stock gaps in the opposite direction of the trade, wait 5 minutes.

How to Enter the Trade

As with when to trade, how to enter depends on whether the stock gaps up/down or not. Typically, the stock price doesn’t gap up or down and the entry price is based on the previous day’s prices. When the stock gaps up or own, the entry price is not based on the previous day’s prices, but on the current day’s prices. Whether based on the previous day’s prices or the current day’s prices, the entry rules are the same.

• The most common occurrence – the stock opens within 50 cents ($0.50) of the previous day’s close – buy the stock the moment it trades 6 cents (1/16) above the previous day’s high. This can be accomplished by using a buy stop order. This increases the likelihood that the price is moving in the direction of the bullish (long) trade.

• Occasionally a stock gap up or down 50 cents or more – buy the stock the moment it trades 6 cents above the high of the new day. This would be 30 minutes after the market opens for a gap up or 5 minutes after the market opens for a gap down.