Lesson 4: How to identify the market direction - Part 1
It’s very interesting because everyone keeps coming up with the question: “Will the
market rise or fall?”. Using just a few technical tools – not indicators, just pure price
action – we can actually determine market direction.
Market direction is actually referred to in the technical world, as trends. A stock
moving upwards is in an uptrend; a stock moving downwards is in a downtrend.
Sometimes stocks reach a no-trade zone, or sideways zone. This happens because
when markets go up, it forces a situation of supply, and when markets fall down, they
force a situation of demand coming in.
When we use the concepts of supply and demand over very long periods of time,
you must realize that psychology exists on all time frames, except of course in tick
charts, where you have volume, markets will always move the same way if your
concept is technically sound. Let’s see how you can become your own amateur
financial analysis, determining whether the stock you’re stuck in or making a profit
with, might continue to go up or continue to move down.
The first thing we are going to learn is rally and decline.
Rallies and declines are seen on a per-bar basis, meaning we look only at one bar
and the next. Simply put, a rally is an upwards move, and a decline is a downwards
move.
Let’s look at a decline first. In the left part (black bars), notice how the next bar
always breaks the previous bar’s low. It also has a lower high. This means the
market is in decline mode. Remember that in a real market situation, it may not
happen consecutively, but a general move down is still considered a decline.
A rally is just the opposite. Look at the right part of the chart. The market going up
has every consecutive bar break the previous bar’s high. It also has a higher low.
The market is in rally mode.
If the market then goes in decline mode, and afterwards back in rally mode, the chart
will have the shape of a wave. Markets will always move in waves, they will never
plunge down or soar, unless on erratic days. Over general long periods of time,
markets will always move in waves, and this is very healthy.
Now that we’ve understood a rally and decline, let’s move on to swing highs and
swing lows.
Simply put, the meeting point of a rally and a consecutive decline – forming the
shape of a tent – is a swing high. The opposite, the meeting point of a decline and a
consecutive rally, is a swing low. Trends are made of swing highs and swing lows.
People use different names to call them, but all technical follow this because a swing
high is a natural place of resistance. It basically means that the market rallied, hit a
supply point, then either buying diminished or too much selling happened, and it fell.
The longer a swing high remains untouched, the stronger it gets.
Here is a real example of a chart. It’s basically a downtrend, but it’s full of swing
highs and swing lows. We’ve marked both on the chart. You should learn how to
recognize them.
How to trade swings
Swing trading has been described as a kind of fundamental trading in which
positions are held for longer than a single day. Most fundamentalists are actually
swing traders since changes in corporate fundamentals generally require several
days or even a week to cause sufficient price movement to renders a reasonable
profit.
But this description of swing trading is a simplification. In reality, swing trading sits in
the middle of the continuum between day trading to trend trading. A day trader will
hold a stock anywhere from a few seconds to a few hours but never more than a
day; a trend trader examines the long-term fundamental trends of a stock or index,
and may hold the stock for a few weeks or months. Swing traders hold a particular
stock for a period of time, generally a few days to two or three weeks, which is
between those extremes, and they will trade the stock on the basis of its intra-week
or intra-month oscillations between optimism and pessimism.
● The Right Stocks for Swing Trading
The first key to successful swing trading is picking the right stocks. The best
candidates are large-cap stocks, which are among the most actively traded stocks
on the major exchanges. In an active market, these stocks will swing between
broadly defined high and low extremes, and the swing trader will ride the wave in
one direction for a couple of days or weeks only to switch to the opposite side of the
trade when the stock reverses direction.
● The Right Market
In either of the two market extremes, the bear market environment or raging bull
market, swing trading proves to be a rather different challenge than in a market
between these two extremes. In these extremes, even the most active stocks will not
exhibit the same up-and-down oscillations as when indexes are relatively stable for a
few weeks or months. In a bear market or bull market, momentum will generally
carry stocks for a long period of time in one direction only, thereby confirming the
best strategy is to trade on the basis of the longer-term directional trend.
The swing trader, therefore, is best positioned when markets are going nowhere –
when indexes rise for a couple of days, then decline for the next few days, only to
repeat the same general pattern again and again. A couple of months might pass
with major stocks and indexes roughly at the same as their original levels, but the
swing trader has had many opportunities to catch the short-term movements up and
down (sometimes within a channel).
Of course, the problem with both swing trading and long-term trend trading is
success is based on correctly identifying what type of market is currently being
experienced. Trend trading would have been the ideal strategy for the bull market of
the last half of the 1990s, while swing trading probably would have been best for
2000 and 2001.
● Taking Profits
When it comes time to take profits, the swing trader will want to exit the trade as
close as possible to the upper or lower channel line without being overly precise,
which may cause the risk of missing the best opportunity. In a strong market when a
stock is exhibiting a strong directional trend, traders can wait for the channel line to
be reached before taking their profit, but in a weaker market they may take their
profits before the line is hit (in the event that the direction changes and the line does
not get hit on that particular swing).
● The Bottom Line
Swing trading is actually one of the best trading styles for the beginning trader to get
his or her feet wet, but it still offers significant profit potential for intermediate and
advanced traders. Swing traders receive sufficient feedback on their trades after a
couple of days to keep them motivated, but their long and short positions of several
days are of the duration that does not lead to distraction. By contrast, trend trading
offers greater profit potential if a trader is able to catch a major market trend of
weeks or months, but few are the traders with sufficient discipline to hold a position
that long without getting distracted. On the other hand, trading dozens of stocks per
day (day trading) may just prove too white-knuckle of a ride for some, making swing
trading the perfect medium between the extremes.