crucial signals to identify likelytrend reversals.
Hammer
Hangman
FIGURE 3.5 Reversal Patterns
This chart reveals trading in June in a narrow range with severalshort-term trends. The notation A shows a hammer at the end of a brief,three-day price decline. The price rises over the following three days,ending at notation B, which is a hangman. The price does fall immediately after this day. Another brief uptrend occurs over three days endingwith notation C, a second hangman, after which the price drops dramatically for four consecutive days.
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FIGURE 3.6 Hammer and Hangman Formations: Citigroup, Inc.
The hangman and hammer will not always appear at the end of an uptrend or downtrend, buthangmanwhen it does the indicator can be quite strong. Thea candlesticktypical swing trade strategy involves a multi-part sepattern occurringries, and not just any one formation. The first is aat the end of anuptrend. It conseries of three or more movements in one directionsists of a long(with each day’s closing higher than the opening inlower shadow anda small real bodyan uptrend, or lower than the opening in a downand signals atrend). Second is the narrow range day which inreversal andvolves a very small real body. Typical of thesethe start of adowntrend.formations are the hangman and the hammer.Third, and perhaps most important, is an initialtrading day moving in the opposite direction. So, at the end of a downtrend, the formations are evident but followed by a move upward; and atthe end of an uptrend, the narrow range day is followed by a move downward. Finally, the strongest possible signal is when the narrow range day isaccompanied by exceptionally high volume. This is not essential to thetiming of a swing trade, but it is certainly a strong form of confirmationthat the trend is ending and about to move in the opposite direction.
Patterns and Combinations
These indicators are not consistent and this iswhat makes all analysis interesting. You need to develop the experience to interpret these patternswith and without confirmation, and to becomewell versed in formation reading.Not every trend is going to look identical, either. There are times when trends change coursewithout a hangman or hammer, or even a narrowrange day. For example, one common pattern is theengulfing line. This occurs when the latest day’s candlestick main body extends both above and belowthe previous day’s, thus engulfing it. A bullish engulfing line has a white main body and a bearish engulfing line has a black main body.Figure 3.7 provides examples of both bullishand bearish engulfing lines. The bullish engulfingline anticipates a rising trend in coming tradingdays, and the bearish engulfing line is the opposite;it anticipates falling prices in the stock.To see the bullish engulfing line in an actualstock price history, refer to Figure 3.8. This is thecandlestick chart for Microsoft. The arrow points tothe bullish engulfing line, and over the course of thefollowing four days, the stock rises. The fact that noengulfing line appears at the top of this uptrendmakes an important point: The engulfing line formation is very revealing, but it does not always appear. In this case, a hanging man on the fourth dayanticipates an extended downtrend in the stock.
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engulfing linea candlestickpattern in whichthe main body ofa trading dayextends higherand lower thanthe main body ofthe previous trading day.
bullishengulfing linea candlestickengulfing line—one extendingabove and belowthe previous trading day’s mainbody—with awhite main body.
bearishengulfing linea candlestickengulfing line—one extendingabove and belowthe previous trading day’s mainbody—with ablack main body.
Key PointEngulfing lines occur often and may act as reliable signals ofchanging trend directions. While quite different than narrowrange days—the opposite, in fact—the signals they provide canbe given as much importance.
CANDLESTICK CHARTING FOR SWING TRADING
56Bullish
Bearish
FIGURE 3.7 Bullish and Bearish Engulfing Lines
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FIGURE 3.8 Candlestick Chart with Bullish Engulfing Line: Microsoft
Patterns and Combinations
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A bearish engulfing line is shown for Ford Motor Company in Figure 3.9. Note that two bearish engulfing lines are shown with arrows.Both anticipate a downtrend. The first one is followed by four days moving swiftly downward. The second one is followed by four days of uncertainty and then one significant downward-moving day. Note that on thefourth day after the bearish engulfing line, a narrow range day precedes alarge price drop. This may be thought of as a confirming signal. However, that day’s trading closes higher rather than lower; so it is a mixedsignal. You would expect the confirmation to point in the direction ofthe coming trend and in this case it does not. So with hindsight you maydecide that more weight should be given to the bearish engulfing linethan to the narrow range day; but without seeing the following day, thesesignals could also be confusing.The confusing and contradictory pattern—a bearish engulfing linefollowed by a narrow range day that is white instead of black—is typicalin periods of uncertainty. Buyers and sellers simply do not know whichdirection the price is going to move. Note that there are seven tradingdays of uncertainty in this example, preceded and followed by price declines. So the uncertainty merely interrupted the downtrend. This is theproblem with periods of uncertainty. It is difficult to read, and swing
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FIGURE 3.9 Candlestick Chart with Bearish Engulfing Lines: Ford MotorCompany
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CANDLESTICK CHARTING FOR SWING TRADINGKey PointSignals may be followed by several days of uncertainty. This iswhy swing traders need not only the reversal signals, but a second signal indicating the new trend has begun.
traders often have to wait out the uncertainty before they can fully trustthe charts. For example, once the uncertainty in this example ended, thestock declined dramatically, and then signaled a turn with a commondoji and began an uptrend the following day.The engulfing patterns demonstrate that the signals are very dependable, even when a brief period of uncertainty ensues. They do notalways appear to provide a consistent signal, however, so the uncertaintyitself is a type of signal telling you to wait. But when engulfing patternsdo appear, the indication is very strong that a direction of specific movement (bullish or bearish) will soon follow.Dozens of additional candlestick patterns can provide very good insights into stock movement. Combined with more traditional studies oftrading range, support and resistance, and well-known reversal signals,the candlestick pattern is a valuable tool for every swing trader.
Valuable ResourceTo find out more about candlestick patterns, check http://www.candlestickchart.com and link to both “bullish” and “bearish”patterns. This site provides visual descriptions as well as links forfurther explanation for more than 60 candlestick patterns. The sitealso provides cost-free candlestick charting services for thousandsof stocks.
Similarities Between Opposite Candlestick Patterns
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Similarities Between Opposite CandlestickPatternsAny study of trading patterns is going to require experience. Many patterns look similar to one another but can be interpreted in different ways.Candlestick patterns are no exception.For example, some bullish patterns might appear nearly the same as a bearish pattern, with entirely different outcomes. A bullish pattern calledconcealing baby swallow involves a series of blackreal bodies declining over several days. The first twodays have no upper or lower shadow, a conditioncalled marubozu in candlestick lingo. This patternindicates that after reaching a new low, the trendwill turn upward.But a bearish pattern is nearly identical toconcealing baby swallow. The three black crows pattern also consists of a series of black real bodies onthe decline. A subtle difference is that in this pattern the three or more black real body days do haveupper and lower shadows. The pattern implies thatthe market has been trading too high and is movingdownward. But lacking a reversal pattern (such as ahammer) the three black crows is viewed as a bearish signal.
concealingbaby swallowa bullish candlestick patternconsisting of aseries of fourblack real bodiesin a decliningtrend, anticipatinga reversal incoming trades.
marubozua candlestick witha real body but noupper or lowershadow; a daywhose tradingrange is confinedwithin openingand closingprices.
Key PointNot every signal is obvious. Even with candlesticks, a patterncan have a bullish or a bearish interpretation. You need confirmation before making decisions based on only one aspect ofprice movement.
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These two patterns are illustrated in Figure3.10.three blackThe similarities of formation in these patternscrowsmake the point: While candlesticks are visually efa bearish candlefective in chart interpretation, the similarities bestick patternconsisting oftween some bullish and bearish patterns can lead tothree or moreerrors in timing or even in misreading the comingblack real bodytrend direction. With this in mind, it is importantdays in a downtrend.to combine candlestick analysis with traditionaltechnical signals, and to seek the confirmation patterns indicating that reversals are about to occur. These include not onlythe apparent pattern as it develops, but also the narrow range day or engulfing line, and increased trading volume.Concealing Baby Swallow (bullish)
Three Black Crows (bearish)
FIGURE 3.10 Bullish and bearish candlesticks: Concealing Baby swallowand Three Black Crows
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Key PointIt is a mistake to use any one form of analysis exclusively. Combining different forms—like traditional and candlestick charting—improves the overall quality of information and provides moreconfirmation.
Similarities can be found between many candlestick patterns, not just the one above. For example, the three white soldiers is a bullish patterninvolving three long white days, each with a higherclose than the previous; when this occurs within abroader downtrend, it indicates a change and reversal. Another pattern called deliberation is bearish,although it looks very much like three white soldiers. In deliberation, a gap occurs between the twolatest days and this pattern occurs at the end of anuptrend, signaling the end and a coming reversal.So, even when patterns are very similar, their significance depends on what kind of trend is underwaybefore the formation; and on often subtle differences in the actual formation.These two candlestick patterns are summarized in Figure 3.11.The obvious similarities between many candlestick patterns only reinforce the importance ofmulti-level analysis and confirmation. It is too easyfor traders to misread signals, only to recognize theirerror in hindsight. This problem is not limited toswing traders; all technicians and chartists sufferfrom the same tendency to misread a signal.
three whitesoldiersa bullish candlestick occurring atthe end of adowntrend, consisting of three ormore consecutivewhite real bodiesclosing higher oneach day.
deliberationa bearish candlestick appearingwithin an uptrend,involving threeconsecutive whitereal bodies closing higher thanthe previous day,with the final dayopening with agap above theprevious close.
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Bullish and Bearish Candlesticks
Three White Soldiers (bullish)
Deliberation (bearish)
FIGURE 3.11 Bullish and Bearish Candlesticks: Three White Soldiers andDeliberation
You can never achieve 100 percent accuracy in the interpretation oftrends or in the timing of trades; but using confirmation and a variety oftechnical analytical tools you can improve your odds. A good rule ofthumb is that whenever a pattern is uncertain, it makes sense to not enterinto a transaction. The lack of a clear indicator should act as a warningsign. Even when you are confident that you are reading signals accurately, there are no guarantees. But the many tools available through traditional technical analysis and the use of candlestick charting canimprove the percentages in your favor.
Sources of Cost-Free Charts
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Key PointIf you find yourself misreading signals, you’re not alone. Everyone, even the most experienced chartists, never have foresightas good as their hindsight.
Sources of Cost-Free ChartsMany websites offer cost-free charting services. Normally, these servicesinclude the combination of OHLC pricing with 200-day moving averages or volume. You can find free charts on most sites by entering astock’s symbol and seeking a quote; the chart accompanies the quote. Forexample, the following services all provide free quotes and charts:BloombergCNNYahoo FinanceMSN MoneyForbes
www.bloomberg.commoney.cnn.comfinance.yahoo.commoneycentral.msn.comwww.forbes.com
All online brokerage services also provide free charting to theirclients. The most popular discount brokerage services include:Charles Schwabe*tradeScott TradeTD Ameritrade
www.schwab.comwww.etrade.comwww.scottrade.comwww.tdameritrade.com
For free candlestick charting with moving averages and volume,check the website http://stockcharts.com/index.html. This site is useful because of the combined information it provides.
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CANDLESTICK CHARTING FOR SWING TRADING
For a thorough explanation of charting, free charts, and visualsummaries of all chart patterns, the best free site is http://www.candlestickchart.com. The site’s free services include candlestick chartingwith volume for any stock as well as descriptions of bullish and bearishcandlestick patterns. Subscribers get advanced charting service and support. The highly visual, cost-free charting and tutorials make this a valuable tool for swing traders.The whole key to swing trading is recognition of the patterns asthey emerge. The candlestick chart is one of the best ways to study shortterm trends in price. Recognizing when price movement occurs as part ofa reaction cycle is equally important. This is the topic of the next chapter.
4Chapter
Reaction Swingsand the Reaction Cycle
ven though short-term price trends appear random, there aremethods for identifying turning points. That means finding thoseprice moments where the short-term cycle is likely to begin swinging in the opposite direction.The two- to five-day price trends swing traders use are part of ahighly chaotic system. Buyers and sellers trade off control over price—and only for those few days of cyclical change.When buyers are in control, prices rise. However,once the price becomes high enough—often onlyreactionswingsby points or fractions of points—selling pressureshort-termincreases and the sellers take over. These fast-movingchanges in priceand frequent turns are reaction swings, the times intrend resultingfrom the reactionshort-term price change when direction is reversed.of buyers to sellThese changes occur due to the immediate anders and vice versa.short-term exchange of control between buyers andsellers.Newton’s Third Law observes that each action has an equal and opposite reaction, and market pricing follows the same rule. When buying pressure forces prices upward, that results in selling pressure that takes over andpushes prices down. This continues in the swing trader’s two- to five-daycycle. Buyers and sellers operate in this situation as “action/reaction force
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REACTION SWINGS AND THE REACTION CYCLEKey PointJust as physics dictates how objects interact, the natural cyclesof price dictate action and reaction.
pairs,” which in physics describes what occurs when objects meet. For example, when a hammer strikes a nail, the nail goes into the wood, butsome offsetting bounce moves back into the hammer. This force pair is easily noticed by direct action. The interaction of buyers and sellers is moresubtle—and the more you study price charts, the more you actually beginto see the reaction cycle in action.The engulfing line and narrow range day patterns you see in candlesticks are symptoms of the interaction between buyer and seller. Theyrepresent the price equivalent of a nail moving through wood, the noisethe hammer makes on the nail, and the offsetting reverberation. In thecandlestick chart, the narrow range day indicates that the current trend isreaching its exhaustion point and that, once the price direction movesaway from that trend, the price cycle is about to move in the opposite direction—the force pair at work. An opposite version of the same idea isthe engulfing line, which involves an expanded trading range—but withopen or close in the opposite direction. In this reaction swing, the exhaustion is hidden within the two days’ candlesticks (the last day of theexisting trend and the day of the engulfing line); and the reversal of patterns is quickly established. So a downtrend (characterized by a series ofblack real-body days) ends with an engulfing line pattern and a white realbody, the beginning of an upward reversal swing; and an uptrend (characterized by a series of white real bodies) ends when an engulfing linepattern follows with a black real body.Both of these reversal patterns tell you the reaction swing is likely tobe underway. An important point to make here concerns the direction ofprice movement. The swing trader does not care whether prices move upor down. You know that the two- to five-day window is an opportunityto trade a stock and to make a short-term profit. Swing trading works inboth directions.
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Stock investors tend to be overly optimistic and are focused on upswings only. So the tendency is to look for the end of downswings, with theidea of buying at the low and then selling at the end of the upswing. This,however, is only one of two methods for getting in and out of the market.By emphasizing only the upswing, you would miss half of the swing tradingopportunities. Remember, reaction swings happen in both directions withconsistency. By recognizing that both up and down price movements areopportunities, you double your chances for swing trading profits.
Studying Action and Reaction of StocksAs a swing trader, you look for and identify specific patterns indicatingchange in direction. This swing occurs predictably, but it is not the sameas momentum. A reaction swing is just that: a reaction by sellers to buyers’ recent action, and on the other end of the swing, a reaction by buyersto sellers’ recent action. This is not the same as momentum, and recognizing the differences in the patterns help you to avoid making yourmove at the wrong time.Patterns emerge for both swings and momentum and they are notthe same. In a swing pattern, a few specific signs occur. These includethree primary signals:1. The swing trading cycle. This involves three or more days in whichspecific repetitive patterns emerge. In an uptrend, you expect tosee a series of higher highs, offset by a responsive series of higherlows. In a downtrend, you expect to see a series of lower lows offset by lower highs. The uptrend and downtrend patterns are illustrated in Figure 4.1 and Figure 4.2 respectively.
Key PointSwing in price is not the same a spice momentum. While swingmoves back and forth, momentum is a strong move in onedirection.
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REACTION SWINGS AND THE REACTION CYCLE
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FIGURE 4.1 Uptrend: Johnson and JohnsonSource: Candlestickchart.com.
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FIGURE 4.2 Downtrend: Pepsi ColaSource: Candlestickchart.com.
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Key PointRemember the specific swing trading definition of an uptrend: aseries of higher highs, offset by a series of higher lows.
Key PointSwing traders define a downtrend in a very specific manner: Itconsists of a series of lower lows offset by a series of lowerhighs.
The uptrend on Figure 4.1 for Johnson and Johnson appears in twoplaces. The beginning of these trends are marked 1 and 2. In both cases,there are a series of higher highs offset by a series of higher lows.The downtrend on Figure 4.2 for Pepsi Cola has six periods, an exceptionally long and sustained series of lower lows offset by lower highs;but this meets the criteria. Note that the series ends with a narrow rangeday and the immediate beginning of an uptrend.2. The narrow range day or engulfing line. The end of the uptrend ordowntrend is signaled in one of two ways. The narrow range dayhas two components. First is the narrow range itself, and secondis a movement in the opposite direction. On Figure 4.2, thestrong downtrend in Pepsi Cola stock extends over six days andends with a narrow range day with the stock moving higher instead of lower. This is a strong signal and subsequent tradingshowed that the signal was correct.Key PointThe narrow range day by itself is a strong cautionary signal thata trend may be ending; but it requires confirmation in the formof subsequent price movement in the opposite direction.
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REACTION SWINGS AND THE REACTION CYCLEKey PointThe engulfing line is an alternative signal that a trend may be reversing, especially when accompanied with high volume. But ifvolume is not high, the engulfing line may provide a false signal.
The engulfing line is equally as strong but often difficult to read. Attimes you will get a false signal by depending on the engulfing line alone,so it makes sense to wait for one additional trading day before makingyour move. For example, Figure 4.1 shows a large price gap and declinefollowing a bullish engulfing line. Two important points should be madeabout this false signal. First, it appears at the conclusion of five days ofuncertainty, so you really have no way to know how the stock is going tomove next. Second, the engulfing line is accompanied by exceptionallylow volume. In order to proceed with confidence at the end of a trend,you expect to see higher than average volume.3. High volume on a narrow range day. The narrow range day by itself is a promising indicator that the end is over. But when volume is also high, that is a very strong signal confirming the endof the trend. The combination of a narrow range day with highvolume is illustrated in Figure 4.3.In this example, Blockbuster demonstrated two end-of-trend combinations of a narrow range day and higher than average volume. Thesepoints are indicated as 1 and 2 on the figure. The first shows steam running out of an uptrend and is a large spinning top (large trading rangewith narrow real body); and it is followed by a downtrend. Volume forthe narrow range day was also exceptionally high.
Key PointWhen you see both a narrow range day and exceptionally highvolume, that is the strongest sign of all that the current trend isabout to turn. If, on the next trading day, the stock moves in theopposite direction, it is almost always enough confirmation.
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FIGURE 4.3 Narrow Range Day with High Volume: BlockbusterSource: Candlestickchart.com.
In the second example, the narrow range day was also accompaniedby high volume, but the other signals were not clear; the end of the downtrend actually came two days later, and was followed by a strong and sustained uptrend. In both examples, the high-volume days were key turningpoints even though the reversals were delayed by two trading periods.In comparison to the swing trading buy and sell signals, momentum is far different. It is characterized by sustained periods of movementin a single direction, lacking any patterns indicating the end of the trend.An example of a stock demonstrating first a downward momentum andthen upward momentum, is shown in Figure 4.4.In this example, Microsoft Corporation’s stock experienced downward momentum over 12 sessions followed immediately by upward momentum for seven sessions. The lack of any reversal signals during theseperiods demonstrates the difference between swing trading and momentum trading. The only reversal in this two-part pattern of momentumoccurred at the end of the downturn, where the classic three-day patternoccurred (three days of lower lows, offset with lower highs). Yet no confirming patterns (narrow range days or engulfing lines) occurred—another sign that these were periods of momentum and not swings.
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Key PointWhen you see continued trends without reversal signals, orweak reversal signs lacking confirmation, it probably means youare seeing momentum and not swing.
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FIGURE 4.4 Downward Momentum and Upward Momentum: MicrosoftCorporationSource: Candlestickchart.com.
The typical swing trade involves repetitive and easily identified patterns. Momentum trading disrupts this pattern and swing traders cannotaccurately judge the duration or extent of momentum. They can onlywait out the momentum period and look for a return to the more typicalswing trading cycles.Experience provides you with the ability to combine technicalcharting analysis with swing trading to (1) distinguish between swingsand momentum; (2) use both in combination to recognize developingpatterns; and (3) avoid making mistakes resulting from nonrecognition
Studying Action and Reaction of Stocks
of emerging longer-term trends. The direction andsize of the trading range are key technical indicators. Swing traders are interested in the short-termchanges in price, of course, but should also beaware of the longer-term trend within the tradingchannel of a stock.A channel may be flat, meaning that price doesnot move upward or downward over a period oftime, except for small swings within a confined trading range. In some respects, a flat channel can represent the best swing trading opportunity becauseshort-term price change occurs without a longerterm trend of more dynamic change. An ascendingchannel shows that, even given short-term priceswings, the longer-term trend of the stock is clearlyupward. An example is provided in Figure 4.5The example of the Charles Schwab Corporation shows that the channel moved upward for
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channelthe overall direction of a stock’sprice movement;the trend, whichmay be flat, upward, or downward over manymonths.
flat channela channel whosetrading rangeremains the sameover time, withneither rising orfalling price trendexhibited for aperiod of months.
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FIGURE 4.5 Ascending Channel: Charles Schwab CorporationSource: Candlestickchart.com.
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Key PointThe direction of the channel gives you a good idea of the longerterm trend. You will still experience swings within the overallchannel direction.
ascendingchannela channel with arising tradingrange over time.Short-term swingsin price occur, butthe longer-termprice trend isupward.
about one-third of the 120-day period shown inthis chart. This was followed by approximatelyequal-length uncertainty and then a downtrendingchannel.A descending channel is the opposite, a tradingrange with swings occurring within trading rangebut longer-term trend toward downward pricemovement. An example is provided in Figure 4.6.
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FIGURE 4.6 Descending Channel: Altria CorporationSource: Candlestickchart.com.
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The example of Altria Corporation’s 120-daychart showed a downtrend in the first portion.descendingHere the swings occurred within a declining tradchanneling range. The swing trader who is aware of thea trading rangelonger-term direction of the price channel will bemoving downward in price overbetter equipped to select stocks for swing tradinga period ofand to recognize when channel trading trends aremonths.coming to a close. The channel pattern is revealingbecause, when it ends, a period of long-term uncertainty is likely to follow. For the swing trader, this new period requirescaution while also presenting new swing trading opportunities.
Price and