Swing Trading: Creating Profitable Opportunities

Swing Trading: Creating Maximum Profit Opportunities

You can use chart patterns to time your entry and exit points. By analyzing consecutive high and low points and spotting SR test signals, you can invest as prices swing from one direction to the other. As a "swing trader," you combine well-known price patterns with gaps, volume analysis and confirmation signals, to anticipate which direction prices are going to take.

One popular swing trading method is based on a three-bar pattern demonstrating peaks with three higher highs, or dips with three lower lows.¹ For example, Figure 5-1 shows an upswing as the price bars achieve higher highs, but when the bars make three lower lows, the swing turns down. Once the swing turns direction, the highs or lows do not have to be consecutive. If the market traces out two higher highs and the next high is a lower high, and then prices rally to another new high, the swing is still up. A swing chart determines the trend by tracking the highs and lows. Whether consecutive or not, the pattern is established by

Figure 5-1

highs outpacing previous levels, or lows declining below previous levels.

Support and Resistance

On Figure 5-1, the support point is the swing bottom as prices moved from a downswing to an upswing. If movement were taking place in the opposite direction, the resistance point would be identified as the point where an upspring reversed into a downswing. As with all cases of patterns,

SR levels are established by unsuccessful attempts to break through, and these are usually followed by a reversal in price movement.

3-bar Swings versus 2-bar Swings

Some traders have observed significant differences between swings lasting over two bars and those

Figure 5-2

taking three bars. According to these traders, two figure 5-2 bar swings are preferable to three-bar swings because the likelihood of picking and timing the impending movement correctly is stronger with the shorter-term swing pattern.² Figure 5-2 shows a two-bar swing chart.

According to proponents of the preferred two-bar method, if and when a two-bar swing top is violated, the trend turns up. If a two-bar swing bottom is broken, then the trend turns down. Figure 5-2 shows an example within the box on the chart.

At point A, two consecutive higher highs precede an upturn of the swing. At point B, two consecutive lower lows precede a downturn of the swing line, and a swing top is established. At point C, the previous swing bottom is violated so the trend turns down and the swing line is dashed.

Reviews of charts show well-defined up trends as a series of rising support swing bottoms (support points). Downtrends consist of falling swing tops (resistance points). By applying the definition of the trend to the chart, the swing trader can time entry into long positions at the bottom of the channel, or right at support, or short positions at the top where resistance is established. On the closing side, the long position exit should be made when resistance appears to weaken, and short positions should be closed when support appears about to erode and give way.

Swing traders may advance this technique by using multiple time frames alone or in combination. For example, your current trading pattern could be set using daily bars, and the next time frame would be the weekly bars. By using a multiple time approach, you are able to differentiate between major and minor signals. Swing tops and bottoms would be interpreted as major SR on a weekly basis and minor support and resistance on a daily basis, for example.

Figure 5-3 (Microsoft) shows that the Weekly Gann Swing is up, but the trend is down (dashed lines) indicating that prices recently broke a weekly swing bottom. The Daily Swing Lines are solid and form a swing bottom. When prices broke the swing bottom, the Daily Swing Trend came into agreement with the indicators on the Weekly Swing Trend. With this information, breakouts of major SR levels would be more easily identified than minor SR probes, providing you with useful confirming signals.

Figure 5-3

Other Swing Trading Concepts

Many swing traders have further observed that up trending markets tend to move in patterns exhibiting swings of higher highs and higher lows.³ By using specific setups for entering into trades based on market direction, swing traders can employ the strategy of simply watching for consecutive lower highs or consecutive higher lows.

Once the price reaches a new high it may be followed by three to five consecutive lower highs. This downswing is due to late buyers coming in and buying at the short-term top. As the market moves lower, the same late buyers will be likely to exit their positions to cut their losses. The same strategy works on the downside. Once the price falls to a new low it may be followed by three to five consecutive higher lows. Similarly, following market action presents the short seller with timing opportunities.

This type of trading action is typical of the majority of market followers, who chronically buy after a price peak and sell only to cut losses. This presents the astute swing trader with an opportunity to take positions in the up trend by buying after this series of three to five consecutive lower highs or higher lows. This variation on swing trading is a chartist's version of contrarian investing—going against the action of the market. By timing long or short entry to consecutive lower highs or consecutive higher lows, the contrarian swing trader is able to take advantage of the common trading patterns of market reaction.

For example, Figure 5-4 is Affymetrix. This market had been making higher highs and higher lows.

The expectation is that this pattern represents a new support point in a general up trend. If the support point does not hold, the swing trader should exit with a small loss. Partial profits can be taken when the market returns to the old high, and a trailing stop order placed for the remainder of the position.

For stocks in a down trend consisting of a series of lower lows and lower highs, look for stocks that have rallied with three to five consecutive higher lows. Here, a stock may be advancing because buyers believe that the market has come down too far too fast and may be making a bottom—this is believed despite the fact the market is clearly in a down trend. For example, Figure 5-5 shows Yahoo

Figure 5-4

 (YHOO) in a downtrend with a short term rally consisting of four higher highs, after which the price rolled over again.

Traders who buy against the trend will likely sell out quickly if the trade does not work. This presents another opportunity. If the price trades below the low third or higher consecutive low, the contrarian swing trader may go short and remain at risk up to the high of the entry bar or the previous bar, whichever is higher. In this trade, the setup takes advantage of a potential resistance level just as it is forming. If the resistance level does form, then prices should fall to new lows typical of the down trend. Partial profits can then be taken near

Figure 5-5

the previous low, entering a trailing stop for the remainder of the position.

Summary

Swing trading takes maximum advantage of the tendency for prices to ebb and flow in the short term, to move in directions against the trend, and to reestablish that trend again. By waiting for the counter trends to occur and then trading in the direction of the trend, you create many more short term profit opportunities. Swing trading utilizes SR as points to enter stop losses for trades, as well as targets for profit-taking.

This is the essence of swing trading, and ultimately it defines your success in technical market trading. Beyond the short-term effectiveness of swing trading techniques, you can employ the same skills to forecast likely SR trends into the immediate future. The next chapter shows how to spot the signals for emerging SR trends.