Technical Indicators

Fibonacci Trading

Fibonacci ratios, when applied to trading stocks, correlate two trends; let's refer to them as primary and secondary.  The primary trend refers to a trending move in one direction while the secondary trend will refer to countertrend moves in the opposite direction.  The three most common fibonacci retracement levels are 38.2%, 50%, and 61.8% of the primary trend and most basic stock charting applications will use these as standard levels.  These fibonacci retracement levels act almost as magnets once the countertrend rally takes place.  These are very common, however, there are a few other fibonacci levels that can provide resistance.  These are the 75%, 78.6%, 87.5%, and 88.7% retracement levels.  The common rule of thumb is that when the 50% retracement level is taken out, the four levels I just mentioned become magnets to attract price.  Price action must be analyzed at those levels to understand if the countertrend move will cease or whether it will continue to fully retrace the primary move.

Fibonacci retracement levels are used by many floor traders and therefore become very relevant to your fibonacci trading activities.  These levels are so widely used now by traders, including systematic trading, that they almost become a self-fulfilling prophecy.   Some advanced traders will take it a step further and add fibonacci arcs and fibonacci fans to their trading arsenal, in search of an edge.

Defining the Primary Trend

Let's start with the characteristics of the primary trend of which we would want to play the countertrend.  I found that fibonacci retracement levels are most accurate after the primary trend has been a sharp move in price accompanied by heavy volume at the end of that move.  These types of moves typically exist in the story stocks of the day or the appear on the list of highest percentage gainers or losers list which complements my trading style as these are the only stocks that I will trade.

I am asked many times how to define the starting and ending points in order to calculate the length of the primary trend.  I see many traders make the mistake of using the highest point and lowest point of a trending move to define the starting and ending point of the primary trend.  While this may work in some cases, it is best to look for double tops or double bottoms when locating your starting and ending points.  This may or may not coincide with the highs or lows of the move. 

How to Use Fibonacci Levels

I do not use fibonacci levels as a primary trading technique, however, I found that it greatly improves my odds of generating a winning trade when fibonacci retracement levels start correlating with price objectives using other patterns, such as candlestick charting formations for example.  I use fibonacci levels in two ways:

1)  After identifying the primary trend, use price reversal pattern recognition (through candlesticks or any other trading technique that you employ) to coincide with a fibonacci retracement level to confirm that the countertrend move has ceased.  I then look for the stock to test the recent lows and double bottom or break through that level.  That is where I employ the usage of tape reading to determine whether I should play the double top/bottom or whether I should play a breakout in the direction of the primary trend.

2)  Many times, a stock will spike down on high volume and that will signal capitulation and put a floor in the market.  Usually, an automatic rally will ensue and fail when the dip buyers lose their buying pressure.  Oddly enough, this coincides with fibonacci retracement levels (usually 38.2% or 50%).  Once that rally kicks in, a retest of the recent lows will be attempted and a trading range can be created between the lows that were put in with spike volume and the highs of the automatic rally.  This trading range carries on for a bit of time before a breakout up through the range occurs.  This breakout can be bought with good tape action and then the tape action must be hawked as well as keeping an eye on fibonacci levels which could act as resistance.  If I see buying pressure fizzling out at one of the key fibonacci levels mentioned above, I get out of the trade immediately. 

As you can see, fibonacci trading is a secondary part of my game but a pivotal one.  You can really hit the sweet spot in trading if you can combine a few key trading elements together and design your own trading system where you put the odds in your favor.  The bottom line, you probably shouldn't leave fibonacci retracement levels out of that mix.

What is Swing Trading?

The typical textbook will define swing trading in terms of trade duration, somewhere between 1 day and a couple weeks.  We believe that the definition of swing trading is a time frame independent one.  Swing trading strategies revolve around a trader’s ability to recognize probable turning points in the market.  For this reason, swing trading and day trading are very similar and many of the strategies used for both can be interchangeable.  

Traders must understand that no single swing trading strategy is appropriate for every market.  Markets can either be directional or non-directional.  In fact, they spend about 80% of the time in a range bound configuration.  To be successful, swing traders need to have multiple strategies to take advantage of different market conditions.

Swing Trading Vs. Momentum Trading

The rules for swing trading stocks are almost the opposite of the rules used for momentum trading.  Momentum trading can become very difficult as greed starts to permeate through your decision making process.  There are very few that are actually successful at it. 

The talking heads on CNBC and other others syndication outlets can generate a fever or depression for a stock.  Many novice traders will jump on board, looking to score big profits with their newfound confidence in a stock which has just run up 10%.  Do you ever wonder why the stock always goes the opposite way after you buy it?  It probably means that you are chasing a move as it is coming to an end.  The market moves in waves and euphoric buying is almost always met with fierce selling which shakes the weak hands out of the market. 

Swing trading strategies work to take advantage of weaker traders.  In range bound markets, they sell resistance and buy support.  In thrusting markets, they sell important resistance levels and buy pullbacks off highs.  Swing trading takes advantage imbalances between buyers and sellers.

Rules for Swing Trading Stocks

We are going to cover a few swing trading strategies, but first, let’s cover some high level rules for trading stocks.  Firstly, a swing trading strategy can be applied on any timeframe chart; however, it is very important to understand that there are different traders who are trading different timeframes.  A day trader may see a bullish chart pattern while a trader looking at the daily charts may see a bearish one.  For this reason, it is recommended that you review different timeframes to uncover support and resistance areas that would otherwise be unknown to you. 

Second, if you enter a trade using the 60 minute charts, do not adjust your timeframe mid trade.  This is a recipe for disaster as your original reason for entry and money management rules will be thrown off.  Most traders who do this have their trade go against them and fail to execute risk management strategies which eventually has them sitting in a large drawdown.  Never go against your money management rules and always take a stop out if a trade goes against you. 

Finally, never feel as if you have to trade.  Overtrading will definitely cut your account size down.  Good traders wait for opportune times to strike, much like a lion does when she stalks her prey.

Identify the Trend

As we mentioned above, you must have a strategy which is conducive to the market environment you are trading within.  For example, a range bound strategy is not meant for a directional market and vice versa.  You must first identify the trend and then identify the major support and resistance areas.

Drawing trend lines, identifying previous price areas which provided support and resistance, noting volume spikes, and applying standard moving averages will help a trader identify the overall trend and understand what type of swing trading strategy to apply.  Trend lines should be drawn connecting 3 consecutive highs or 3 consecutive lows.  In a bullish uptrend, you will be connecting consecutive lows and visa versa in a downtrend.  Support is referred to as the demand line while resistance is the supply line.  In an uptrend, the supply line is drawn by placing a line parallel to the demand line at the swing high between the first and second points on the demand line.  This is your uptrend channel. 

I like to apply the 20, 50, and 200 period EMA to my charts when swing trading as it allows me to analyze the short term, intermediate term, and long term price structure as it relates to that timeframe. 

Swing trading is most effective when you put all the odds in your favor.  When we find moving averages converging near Fibonacci levels, we can assume that this area is going to be a strong area of price support or resistance. 

Be aware of huge volume expansions; this tends to end a move, up or down.  High volume highs and lows also tend to create range bound markets which test these areas a couple times before breaking out of the range.

Finally, support becomes resistance and resistance becomes support when broken through.  For example, if a stock was finding support at $25 a couple times and broke down through it, odds are that $25 will be resistance on the way back up.  This applies on all timeframes. 

Swing Trading Strategies

We have identified many trading strategies on mysmp, especially in our technical analysis and day trading centers.  However, the most common swing trading strategy is to buy low and sell high when trading within a range.  Typically, you will be able to draw 2 horizontal lines which contain price.  The ADX should be below 20 and volume should remain light.  Look for narrowing range bars to signal a reversal is at hand.  However, once price starts creeping above or below this range, it is time to switch hats and get out your momentum based strategies for swing trading.

During a trending market, we want to adjust our swing trading strategies to apply Fibonacci retracement levels, Fibonacci extension levels, and moving averages, in addition to price and volume analysis.  Remember, we never chase momentum; we just take advantage of the traders who do.  Off an initial thrust, look for a retracement of 40% to 50% with price remaining above all 3 moving averages and buy this move if the setup looks good.  We want to see high volume on the breakout and low volume on the pullback.  We want to see narrow range bars near this area to signal that there is no more selling pressure.  This strategy works best off the first major retracement which follows the initiation of trending move. 

A quick note on automated trading; there is a value of what you can discern with your eyes.  It becomes very difficult for a swing trading system to recognize trend changes and therefore, many of them will continue to fire off trades which should not be placed in light of the market condition.  Be careful when you allow a robot to trade your money, it could be substantially lower

We strongly urge you to visit our day trading center and technical analysis center to understand some of the trading strategies that are used by many professional traders.

Technical Analysis and the Credit Crisis of 2008

In the current market environment, many technicians are left wondering if technical analysis really works.  The reality of it is that a trader must first know what type of technical indicator or chart pattern works in a specific market.  This level of awareness of the current market conditions can only be developed from years of technical analysis education on a host of topics.  The learning curve is steep and is not conquered by simply memorizing definitions and stock trading strategies.

Technical Indicators

Oscillators

Technical indicators are a powerful tool but left in the wrong hands, can prove disastrous to a trading account.  Oscillators move back and forth between overbought and oversold levels on stock charts.  This form of monitoring the market works well in sideways markets but are less reliable in strongly trending markets. 

During the credit crisis of 2008 the stock market began a steep sell off that lasted for months.  Traders that utilized oscillators for trading stocks received a number of oversold signals as the market continued to trend lower.  Notice how in the below chart the Dow setup a number of false buy signals.  Everyone of these buy signals would have resulted in a loss.

Momentum Indicators

Momentum indicators can display oversold and overbought levels, but there are no limits on the values of the indicator.  Hence, if a market is trending hard in one direction, the indicator will go as far as the market is willing to take it.  Notice how in the above example, someone using technical analysis would have chalked it up to nonsense.  But look below how using a momentum technical indicator did not provide another buy signal until the market began to stabilize somewhat.

Summary

In summary technical analysis like any other form of judging the market requires skill.  Many investors have used the recent sell off as a reason to denounce technical analysis altogether, but with the right mix of trading strategies.  Just think about the trader who used the MACD in the above chart example, this person hit the jackpot on their shorts.