Volume SpikesIn the course of studying charts, you will notice thatspikeprice movement is rarely consistent or steady, evenan unusual pricein the middle of strong trends. At times you willmovement, abovealso see aberrations in price movement. These spikesor below established tradingmoving above or below the established pattern mayrange, and oftenoccur at any time and, lacking confirming indicafollowed by ators of big change, may not be important. However,return to thatrange.when a spike is accompanied by exceptionally highvolume, preceding price gaps, or external influences(such as pending mergers, earnings surprises, orchange in management, for example), it may not bepower spikean exception but a power spike.a price spikeabove or belowWhen spikes occur for no apparent reasontrading rangeand the trading range is immediately reestablished,accompanied byit can be ignored—assuming that nothing else inunusually highvolume or otherthe price pattern occurs—because it may not holdprice patterns andexceptional importance. When viewed as part of asignaling achange in thelonger-term trend, the spike may have no chartingchart pattern.importance. For the swing trader, a spike of thistype can be ignored. Remember, swing traders areinvolved with two- to five-day periods and not with longer-term trends.Of course, if those longer-term trends are going to affect the channel direction of the stock, then the spike cannot be ignored.An example of a stock with two spikes is shown in Figure 4.7.
REACTION SWINGS AND THE REACTION CYCLE
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Key PointA spike occurring by itself, followed by a return to the established trading range, may be ignored as having no permanentsignificance for swing trading.
In this 120-day chart, Hormel Foods had two spikes. The first,marked 1, was accompanied with exceptionally heavy volume. Note thatthe spike in this case was a shadow and not part of the real body of thecandlestick; the day’s price movement was downward. This is a classic example of an attempt on the part of buyers to take the price higher, butthat attempt failed. This power spike resulted in a three-week bearishtrend, ending with the second of the two spikes, marked on the chart as 2.Candlestickchart.com© 2006 The RediNews Network37.5036.90
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FIGURE 4.7 Stock with Two Spikes: Hormel FoodsSource: Candlestickchart.com.
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Key PointWhen a spike is accompanied with heavy volume on the sameday, it is probably a power spike. This anticipates price movement and trading range adjustments.
In the second spike, you can see several notable differences. First,the volume level is not different than surrounding days. Second, thedownward spike is part of a real body. Third, the day’s price closed up.This spike appears to hold no special characteristics like the first one did.The most compelling evidence of this is that price levels returned to theestablished range, which is marked and extends over four months.Candlestick chartists look for a relationship between price spikesand breakouts. This more typical power spike may signal a significantchange in trading range and for swing traders the signal also provides astrong signal to make a move. Some such moves may be quite dramatic.When you study the power spike in the context of a traditional swingtrading setup (three or more days in a trend, for example), the signal withthe power spike may be very strong, either on the side of entering or leaving the position.An example of a power spike is shown in Figure 4.8.In this chart, the price for Alberto-Culver spiked dramatically witha long upper shadow. This day also say extremely high volume. To theswing trader, the problem with such an unusual formation is that it doesnot give a clear signal. However, the high volume and the downwardmoving day offer a hint. The following three sessions do establish the traditional three-day downtrend pattern. This ends with a bullish engulfingline, which is followed by a sustained and very strong uptrend. In this example, the upper shadow spike is the first hint of a coming downtrend.Buyers were not successful in forcing the price higher on the spike day;and a following three-day downtrend ends up with a clear buy signal forthe swing trader.
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FIGURE 4.8 Power Spike: Alberto-CulverSource: Candlestickchart.com.
Power spikes may precede such movements and, in this instance, abrief downtrend was followed by a strong uptrend. The pattern involvestwo distinct signals working together. The spike itself was a power spikein the sense that volume was quite heavy. The fact that the spike occurredin the shadow only and not within the day’s opening and closing prices isnot as compelling as one with a real body, but it is a power spikenonetheless. The following sessions are a response to the unsuccessful attempt to push prices higher, but once that three-day downtrend ended, astrong uptrend followed. The end of the downtrend was the second ofthe two swing trade signals.
Managing the Reaction SwingThe typical swing occurs as part of the normal trading cycle, the interaction between buyers and sellers. It reflects the never-ending greed/fearemotional mindset that dominates short-term trading, and is a continualadjustment of price perception on both sides. Swing trading occurs naturally as part of this never-ending swing pattern.
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Key PointSwings are a natural occurrence, reflecting an interaction between buyers and sellers. Recognizing the action/reaction thatoccurs in all stocks is how swing traders earn profits.
This action/reaction (the reaction swing) occurs as a series of pricecorrections within a larger, longer-term trend. The various patterns technical analysts use in chart study—such as triangles, wedges, flags, andpennants—all are part of this correction trending. They help you to predict how and when direction of price is going to change. The trick is inthe timing.Swing trading and the prediction process must involve the count oftrading cycles. This is why emphasis is placed on the typical two- to fiveday period. This is where swing trades usually occur. In a continuation ofa strong trend, you can go along for the ride of a trend when the maximum five days are exceeded. Figure 4.8 provides an example of such anopportunity. Following a two-part signal (upper shadow spike with highvolume, and classic three-day downtrend ending with an engulfing line)the buy signal could not have been stronger. At the low point, the swingtrader knew it was time to buy. Yet instead of a two-to five-day cycle, theensuing uptrend extended at least eight days and possibly more. The interesting point in this pattern was that, lacking any reversal signal (inprice, volume spikes, or bearish price gaps), the swing trader would belikely to hold on through the entire upswing, no matter how long itwould last.
Key PointSome swing trading cycles extend beyond the five-day windowand, without a reaction change signal it is easy for swingtraders to move too quickly. This leads to missed opportunitiesand, possibly, to losses.
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The series of three periods occurs so frequently that swing traderscan find themselves making decisions on false signals prematurely. Figure4.8 contains a good example of this. If you look at the strong uptrendfollowing the spike and downtrend, after three uptrend days, the stockshowed one black real body. It was not an engulfing line, a narrow rangeday, or a high-volume day. Even so, it did follow three uptrend days, sosome swing traders would take profits at that point and sell. The problem with this is that there is not a sell signal. If a swing trader is going toreact to a three-day trend, then there are plenty of pitfalls along the day.It leads to poor timing. This is why the reaction swing requires a signal ofthe price moving in the opposite direction. So either the narrow rangeday or an engulfing line is essential to the timing of swing trades. Without one of these, you really cannot know whether the short-term trend isover or will continue.The problem swing traders face is distinguishing between the two-tofive-day trend and actual momentum. With momentum, you need towait out the exhaustion of the trend, even though it may move beyondthe two-to five-day window. Figure 4.8 demonstrates this in the stronguptrend at the conclusion of the chart. To its very end there exists no signal that momentum is over. In fact, the two price gaps in the trading periods four and five days prior to the chart’s end give strong evidence that thetrend will continue. This runaway gap moves the stock above the established trading range (not counting the spike) and continues the uptrend.Swing traders cannot rely on repetitive and consistent patterns, asthis example demonstrates. In fact, the power spike may precede momentum, even when that momentum runs in an opposite direction. Theuncertainty of how price moves after a power spike serves as a warning aswell as an opportunity. For example, given the failure of Alberto-Culverbuyers to move the stock into higher territory on the day of the spike, itwould be reasonable to conclude that the stock would move downward.It did, but only for three days. If momentum were to occur after thespike, it stands to reason that, failing the attempt to move price higher,that momentum would be downward. The typical swing trade pattern ofthree down days ending with a bullish engulfing line contradicted this,however, and the momentum move was up. In this case, the spike wasonly a first attempt; ultimately, buyers did prevail and the price did moveup beyond established trading range.
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Key PointA power spike can be interpreted in more than one way. A cautious trader may want to wait and see which direction priceswill move before entering a post-spike trade.
In managing the reaction swing, you may seek further types of signaling events. The obvious ones are clear: three or more days of specifictrends are always necessary (higher highs and higher lows indicating anuptrend, and lower lows with lower highs indicating a downtrend). Inaddition, you need to identify strongly confirming signals, of whichthere are three common types. These are the narrow range day, higherthan average volume, or the engulfing line. When higher than averagevolume accompanies either the narrow range day or the engulfing line, itis the strongest possible type of confirmation.There are additional confirming signals. Onthe upside, when a stock reaches a new high, for exnew highample, that may confirm the end of a recent upthe highest pricea stock hastrend as part of a swing trade timing strategy. Areached duringnew high is usually defined as a high price for thethe past 52weeks.past 52 weeks and, while such an occurrence is unlikely to show up frequently, it may be used as confirmation that a current swing trade is about to beexhausted.new lowA new low is the equivalent confirming signalthe lowest price aat the end of a swing trading downtrend. Once sellstock has reachedduring the pasters have driven prices down to a record one-year52 weeks.level, it is more likely than ever that a reactionswing will occur.However, because swing traders are less interested in long-termtrends and more intent on short-term price changes, confirmation doesnot need to take the form of a 52-week record. When a stock has beentrading in a narrowly defined trading range, and breakout above or below that level will establish immediate record high or low levels based on
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REACTION SWINGS AND THE REACTION CYCLEKey PointThe analysis of new high and new low prices does not have tobe based on 52 weeks. It may make more sense to study pricechanges based on the existing trading range rather than on atime constraint.
the established range. In fact, the breakout new high or new low may provide stronger immediate confirmation than a one-year record. If, for example, a stock has been hovering within a three-point range for ninemonths, and inches slightly above or below that narrow range, how significant is the change? For swing trading purposes, it may be more importantto observe a stock cycling within three points for a month, and suddenlyjumping above or below that shorter-term trading range—not for longterm investing purposes, for solely for swing trading confirmation.
The End of the Reaction SwingA lot of focus is placed on finding the beginning of the reaction swing,but the ending is equally important. Successful timing of your entry isonly half the equation; you also need to know when to get out.The end of a reaction swing is often the beginning of a new one. Somany swing traders will follow the closing of a transaction with an opposite buy (buy-sell followed by sell-buy; or the reverse sequence, sell-buyfollowed with a buy-sell).There is often a one- to two-day pause between swings, which maybe a brief period of uncertainty (or even a longer one), or the time youneed to verify and confirm the signal. The narrow range day with highvolume may be enough to prompt you to close out an existing swingtrade position. But you may not want to open a new one until you see afollowing day occurring in the opposite direction.You may also begin to recognize repetitive signals within your swingtrading cycles. Uptrends may end with a similar signal over and overand downtrends end with a different but recurring signal as shown inFigure 4.9.
The End of the Reaction Swing
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FIGURE 4.9 Repetitive Signals: Federal ExpressSource: Candlestickchart.com.
This is a 90-day chart for Federal Express. There are six points emphasized. Points 1, 3 and 5 are all bearish engulfing lines that signal theend of uptrends. Points 2, 4 and 6 are all narrow range days signaling theend of swing trading downtrends.You may also note a consistency in the duration of these uptrendsand downtrends, which is by no means assured. However, for as long asthe duration remains consistent, swing trading can be more accuratelytimed. Be aware, however, that no pattern or series of patterns lasts forever. All stock pricing trends alternate between periods of high action
Key PointSome recurring patterns can provide strong confirmation forswing trading. But remember, these are never permanent. Cycles are continually evolving and changing.
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and relative quiet. Swing traders emphasize the action/reaction with anawareness of the role played by greed, fear and uncertainty; and time decisions based on a study of the signals within the price pattern itself.The consistency in trading like that for Federal Express shown inFigure 4.9 lasted about two months. However, followed that trend, thestock broke from its cyclical pattern and began an uptrend for the subsequent two months. This is not at all unusual. A period of predictable upswing and downswing patterns complete with signals (bearish engulfinglines at the top and narrow range days at the bottom) led to an extendedperiod of upward price momentum. Here again, you will note the complete absence of a swing trading sell signal with confirmation after point6. This makes the point that nothing remains unchanged forever andalso that a period of predictable cycles may be followed by either a timeof flat price and uncertainty, or by a period of strong momentum in either direction.Because every reaction swing is likely to end differently, you need toset rules for yourself concerning the entry and exit of a trade. Three rulesare recommended for every swing trader:1. Enter trades only when the signals appear and are confirmed. Impatience may be called the fourth emotion of the market, and isworth resisting. You need confirmation to enter the trade. After athree-day or more period of specific trend, you should wait forthe narrow range day or the engulfing line.2. Exit trades based on a predetermined criterion. Your timing of exitis not quite as critical as timing for the entry. For example, youmay exit without confirmation as long as you want to take profitsand then go to the sidelines to await the next entry signal withconfirmation. However, you may also apply the same rule on exitas you use for entry, requiring confirmation of an exit signal.This assures that an extended trend may be ridden for many periods beyond the two- to five-day “normal” swing trading period.You may experience some losses because you didn’t take profitswhen you could have; but the decision should be based on yourexperiences and observations.
The End of the Reaction Swing
3. Use trailing stops to protect long position profits. If you want to lock in incremental profitswhile continuing to ride trends, use thetrailing stop. This is a type of order which establishes a percentage level below marketprice, which is adjusted as the price changes.This type of order automatically triggers asale if the stock’s price begins to fall.
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trailing stopa trading orderthat sets a percentage belowcurrent price. Ifand when thestock falls to thatprice or below, asale is generatedautomatically.
For short positions or to trigger an entry,swing traders can also use a buy stop order. Thisorder generates an automatic buy when the stockmoves up to a specified target price. This can eitherbuy stopopen a transaction or cut losses when your positiona type of orderthat generates anis short.automate buy ifAny swing trader knows that no pattern is goand when thestock moves to oring to repeat itself consistently. Even when repetiabove a specifiedtive cycles continue for several weeks or evenprice.months, the timing of the reaction cycle is nevercertain. Even those who try to depend on timingassumptions discover that the swing trade setup is the only dependableindicator to use. The two- to five-day period is common for most shortterm trades. Swing traders rely on a multiple-day trend, confirmed by anarrow range day or an engulfing line. And for very strong confirmation,exceptionally high volume is also an excellent indicator that the reactioncycle is about to move in the opposite direction.The next chapter explains a further restriction on swing trading: thebrokerage rules and requirements and regulations about high-activitytrading.
5Chapter
Brokerage Rulesand the PatternDay Tradervery online brokerage service imposes its own set of rules. Theserules are dictated by federal law and overseen by the Securities andExchange Commission (SEC) as well as by the industry’s selfregulatory body, the National Association of Securities Dealers (NASD)and the Federal Reserve Board.The rules governing actions of listed corporations, their executivesand boards, auditing firms, analysts, brokers and investors are complex.For swing traders, a handful of specific rules and the details of how orders get placed are of great importance. In fact, there may be a built-inconflict between any form of automatic order placement and the idealtiming of swing trades. An automatic order results in execution whenspecific circumstances are met (usually a specified price level). But it ispossible for price levels to be met without the swing trade setup or execution pattern.Specialized orders are useful to limit losses or to take profits at a predetermined level. When orders are placed using programmed limits orclosing criteria, you modify the swing trading system to cut losses, takeprofits, or to close out the swing trade when predetermined events unfold.
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BROKERAGE RULES AND THE PATTERN DAY TRADERValuable ResourceTo find out more about the regulatory agencies for the securitiesbusiness, go to the SEC website at http://www.sec.gov, the NASDhome page at http://www.nasd.com, and the Federal ReserveBoard website at http://www.federalreserve.gov.
Key PointAutomatically generated contingent orders are appealing formany reasons; but they may contradict the swing trading strategy as well.
Order Types for Swing Trading
market orderan order to buy orsell as quickly aspossible and atthe best availableprice. Execution isguaranteed, butprice is not.
limit ordera type of orderspecifying execution of a buy at orbelow a specifiedprice, or of a sellorder at or abovea specified price.
The market order is the most common orderplaced. With this order, you ask your broker tocomplete a buy or sell transaction as soon as possible and at the best available price. With a marketorder, you are guaranteed that the order will be executed, but the price depends on prevailing conditions, and on how quickly a stock’s price is trading.For swing traders, market orders are appropriatewhen you want to get a position traded as soon aspossible. When the setup is complete to make yourswing trade, for example, the market order is thefastest way to complete it.If you want a specific price rather than mereguarantee of execution, you may also place a limitorder. With this order, you get your price or better.For example, if you are buying, a limit order wouldget you a specified price or lower; and if you are selling, a limit order would get you a specified price orhigher. You can also place time restrictions on thelimit order, such as requiring the order be completedwithin one day or not at all. Opposite the market
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Key PointLimit orders are appealing because they lead to execution onlyif and when a specified price is met or passed. While swingtraders do not always apply such price-based rules, limit ordersprovide an alternative.
order, a limit order’s price or better is assured, butexecution is not, since your requirement might notbe met. For swing trading, a limit order is a usefultool. Some setup features require movement in thestock. For example, if the price has been falling andtoday appears to be a narrow range day, the buysignal would take place if and when the price ticksupward. So a limit order can be useful to automatically get your position opened as early as possible inthe reversal.A popular form of time restriction to an orderis the day order. This type specifies that if the order’s conditions are not met by the end of the trading day, it expires without completion. For swingtrading, this type of order can be used to limitlosses or to augment potential profits when youplan to cut short the trade. If you have made agood profit, for example, and you are concernedthat the price trend will reverse suddenly, you canplace a day order with price limits to close out aposition if and when conditions are met within theday’s trend.Another variation of the day order requiresimmediate action or, failing that, it will expire. Thefill or kill (FOK) order is a term attached to a limitorder telling your broker that the entire order mustbe executed right away or, if that is not possible, itis to be canceled. The instruction immediate or cancel allows the brokerage firm to fill part of your order under the same conditions. For swing trading,these are valuable tools to close out positions at theend of a two- to five-day trend if the end does end;
or betterin a limit order, theterms for completion of a transaction. In a buyorder, execution isto occur when aspecified price orlower has beenreached; and witha sell order, execution is to occurwhen a specifiedprice or higher hasbeen reached.
day ordera type of orderplaced with abroker specifyingthat if it is notexecuted by theend of the tradingday, it automatically expires.
fill or kill(FOK)a condition attached to a limitorder instructingyour broker tocomplete the orderimmediately or, ifthat is not possible, to cancel theorder right away.
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immediate orcancela condition allowing a broker to fillpart of an order ifthe entire ordercannot be completed; and on thestipulation thatthis be done rightaway and anyremaining portions canceled.
stop orderstypes of ordersthat generateexecution once astop price hasbeen met orpassed (below forbuy orders andabove for sellorders). Once thestop price hasbeen met orpassed, the tradeis executed.
do notreduce (DNR)instructions attached to an orderto keep a limitprice even whencash dividendsoccur. Without theDNR, the limitprice is automatically reduced fordividends earned.
or to continue riding profits if the timing is notright for the trend to stop. Some trends go beyondthe indicated time window, so the fill or kill canbe used in swing trading to maximize potentialprofits.In the last chapter, the trailing stop and buystop were described in the context of how swingtraders can take profits if and when a trend reverses. Both of these types of stop orders, which aremarket orders with a conditional requirement: thestock must trade at or below a specified price (forbuy orders) or at or above (for sell orders). Thisstop price is predetermined, but there is no assurance that execution will occur under those conditions. The stop generates the trade, even thoughthe price may continue to move or reverse directions after the generating event has occurred.Other kinds of instructions can also be attached to orders. For example, do not reduce (DNR)tells your broker to execute your trade at the specified limit price, and to not reduce that price whenex-dividend date occurs. Without a DNR, the limitprice is automatically taken down to match the effect of a declared dividend.Time limits can be placed on orders, althoughsome brokerage firms limit how long an unfilledorder can be left open. A good ’til canceled (GTC)instruction means just that: the order is to remainopen until it can be executed on the terms youspecify. Most brokerage firms will set a limit, afterwhich GTC orders will expire.The many special conditions, limits and contingencies attached to buy and sell orders may become an important aspect of a swing tradingstrategy. In picking an online brokerage service, theflexibility and range of conditional orders offeredmay be used as one of several criteria for selectingone company over another.
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Key PointA stop order is useful for assuring that paper profits are notlost, or for limiting exposure to risk.
Key PointYou can coordinate contingency ordering as part of a swingtrading strategy, but don’t allow the orders to offset the advantages of the setup and execution pattern.
Coordinating Orders withSwing Trading StrategiesUnder the guidelines for swing trading, you seek atrend’s setup and, when it appears, you go into action. So the combination of events creates the decision. These events include three trend days; anarrow range day or an engulfing line; and higherthan average volume. However, when you use special orders, you modify the swing trading strategy.Instead of acting when the setup occurs, you program in a specific trade based on a trigger event.This works on both sides of the transaction.You can place a contingent order to open a transaction as well as one to close. For example, you may
ex-dividendthe date of ownership for the purpose of payingdividends. Theowner of shareson the specifieddate is entitled tothe dividend, evenif shares are soldafter that date butbefore dividendpayment date(when shares aresaid to be tradingex-dividend). Theex-date is thedividing point.
Key PointUse the setup of the swing trade as your primary tool for identifying a decision point. The contingent order should be the exception rather than the rule.
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good ’tilcanceled (GTC)a condition attached to an orderto leave it openindefinitely until itcan be filled onthe terms theinvestor requires;brokerage firmswill let such orders expire after aspecified timeperiod.
contingentorderany order to buyor sell based onspecific pricelevels beingreached orpassed. This typeof order is used toprotect existingprofits or to avoidlarge losses in theevent of suddenprice movement.
long positionownership ofstock and othersecurities, entered by execution or trades inthe sequence buyhold-sell.
decide you want to enter a swing trade on a stockwith a long position, but only if and when thestock’s price falls to a specific price or below. Youmay also enter a short position in the same way,short selling the stock if and when the price meetsor exceeds a predetermined level.On the sell side, the contingent order can alsobe used to modify your swing trading strategy. Thisis a more popular use of contingent orders; you aremore likely to place a stop limit order, for example,to protect paper profits or to avoid the risk of largelosses.Before modifying your swing trading strategy,you need to decide how much use to make of thisalternative trading method. Swing trading, by definition, is a “hands-on” strategy requiring dailymonitoring of stock charts and price trends. Infact, swing traders tend to be trading enthusiastswho want to spend time each day tracking stockprices and moving money in and out of positions.For this type of person, programmed trading andcontingent order strategies are not appealing. Eventhe concept of using such orders to protect existingprofits may not be an obvious choice.A proposed modification of swing tradingstrategies protects your position and reduces riskwhile continuing to allow you to monitor pricesand make decisions directly. Some guidelines:1. Use contingent orders for only two reasons: protect profits and avoid large losses. The most appropriate use of contingent orders within aswing trading strategy is to take profits if andwhen price moves suddenly, or to minimizeyour losses. So long positions may developpaper profits, presenting swing traders with adilemma: Do you sell now and take yourprofits or, if the setup has not developed, doyou continue to hold the position until the
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Key PointOne of the most attractive features of swing trading is the directcontrol and timing of decisions. The contingent order is a usefuldevice, but most swing traders will prefer to time their decisions on chart patterns.
trend has run its course? The trailing stop isa valuable tool to protect profits if andshort positionwhen the stock’s price begins to fall withoutthe sale of stockthe swing trading signal in place. Short poand other securisitions become profitable when the stockties that is eventually closed with aprice falls; but the risk is that the price maypurchase transacrise. In this situation, contingent orderstion. In a shortposition, the seplace a ceiling on potential losses, in thequence of eventsevent that the swing trade setup fails andis sell-hold-buy.you do not close the position in time toavoid a loss.2. Do not place contingent orders that mightpaper profitscontradict the basic swing trading strategy.the profits inOne big problem in overusing contingentexisting stockpositions, whichorders is that they may contradict the basicbecome realizedswing trading ideal. Trading with continprofits only if andwhen those posigent orders is not always the same as swingtions are closed.trading. Contingent orders may, in fact,prevent you from maximizing profitswithin the swing trade. You may want to depend on setup patterns and signals rather than on the use of contingent orders; or
Key PointContingent orders are great for protecting paper profits or preventing large losses. Beyond that, they contradict your reasonsfor using swing trading to time your decisions.
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BROKERAGE RULES AND THE PATTERN DAY TRADERKey PointRemember, a contingent order could be detrimental to an effective swing trading strategy, if not properly controlled.
