Article Reviews, Trading

Underlying Principles of Swing Trading

I was reading this book “New Thinking in Technical Analysis: Trading Models from the Masters”, edited by Rick Bensignor. It contained a number of interesting articles contributed by various experts in their various area.

The first article contributed by Linda Raschke is particularly excellent. It is a great summary of swing trading, its key principles, methods, setups, etc. Highly recommended reading.

Swing Trading and Underlying Principles (Linda Bradford Raschke)

General Principles of Price Behavior

  1. A trend is more likely to continue than reverse.
    • The absence of any clearly defined swing or price pattern (e.g. sideways market) implies a continuation of the trend.
    • Never try to make a counter-trend trade in a slowly creeping market.
  2. Momentum precedes price
    • If momentum makes a new high or low, the price high or low is still likely yet to come. Momentum is one of the few “leading” indicators.
    • New momentum highs or lows can indicate a trend reversal or beginning of a corrective swing up when they follow a buying or selling climax.
    • A trader should look to establish new positions in the market on the first reaction following a new momentum high or low. Beware to distinguish between a momentum high vs. a buying/selling climax.
  3. Trends end in a climax
    • This tends to be marked by an increase in volatility, volume, and range.
    • Whipsaws and spikes create support and resistance levels, and it is at these levels where risk can be minimized.
    • Once support and resistance are defined, the market’s range will tend to contract as it begins its drawn-out process of consolidating toward an equilibrium point again.
  4. The market alternates between range expansion and range contraction
    • The range is either contracting in a consolidation mode, or it is expanding in a breakout or trending mode.
    • Once a market breaks out from a consolidation, there are high odds of continuation in the direction of the initial breakout.

Creating Swing Charts

  1. First method: Define a swing high / low based on the number of bars following the swing point that does not breach the level. E.g. an upswing beings only after 4 higher lows have followed a swing low.
    • Gann kept two swing charts concurrently
      1. First chart recorded moves that lasted 2 to 3 days. A bar that reached a low that was surrounded on either side by a higher low marked the bottom of a downswing, and vice versa for an upswing.
      2. Second chart was a swing chart of a longer time frame that marked the highs and lows on a weekly chart.
  2. Second method: Add a percentage to the most recent swing low (or subtract it from the most recent swing high). If the market trades above this level, a new wave has started in the opposite direction.
    • Arthur Merrill in his book Filtered Waves used a 5% swing function.
  3. Third method: A True Range function is added to the most recent swing low or subtracted from the most recent swing high to signal a new wave in the opposite direction (from Welles Wilder’s New Concepts in Technical Trading Systems).
    • It is best to use a moving average of True Range, and to multiply the moving average by a factor of 2 to 3, else the swings will be too sensitive.

Defining Uptrends and Downtrends

  • Uptrend = Two up waves with higher highs and higher lows
  • Downtrend = Two down waves with lower lows
  • Other conditions for identifying uptrend
    • Price is above a certain moving average
    • A shorter moving average is greater than a longer period moving average
    • The market is making new 4-week highs or some other channel function
    • An ADX has risen above a certain threshold
    • There has been a large standard deviation move
  • Nature of trends
    • Markets have a tendency to retrace deeper at the beginning of a trend.
    • As a trend progresses, the retracements become shallower as more people try to get on board.

Use Multiple Timeframes

  • Traders really gain an edge when they learn to use two time frames at once.
  • The longer time frame is used to identify the trend, and the lower time frame is used to look for short-term reversals in the direction of the trend.
  • If the weekly chart is in an uptrend, wait for a down wave on the daily charts to reverse itself and use this as a long entry.

Three Types of Trades

  1. Retracements
    • Quantifying a pullback
      • Use an oscillator
      • Subtract an ATR from the last swing high
      • Look for the price to retrace below a shorter period moving average (e.g. 5 period)
      • Look for the price to retrace a % of the previous swing (e.g. 50%)
    • Example setup #1
      • 20-period EMA > 40-period EMA (trend filter)
      • 5-period RSI pulls back below 40 (initial retracement)
      • Buy above the highest high of the previous 2 bars (trigger indicating trend is resuming)
      • Stop placed below the lowest low of the previous 2 days
      • Manage the trade by monitoring the price action as it approaches the most recent swing high. Is it picking up momentum, indicating a whole new leg up, or is it losing momentum indicating a potential failure test.
    • Example setup #2
      • Any time a market makes a new high, look to buy the first pullback.
      • Any time a market makes a new low, look to sell the first reaction up.
    • Example setup #3
      • Any time an oscillator (e.g. stochastic, RSI, MACD) makes a new high over the past 100 bars, look to buy the first pullback, and vice versa.
      • A trader should look to establish new positions on the first reaction following a new momentum high or low. The only exception is a momentum extreme that occurs at a buying or selling climax at the end of a long trend.
    • Trade-offs in oscillator period settings
      • The shorter the period used for the oscillator setting, the higher the number of potential trade setups, however the weaker the signals.
      • Cycle lows tend to coincide with a more deeply oversold reading. Trades established at cycle lows usually can be held for a longer period of time.
  2. Tests
    1. Failure test
      • Occurs at the end of a sustained trend, when the market fails to make a new leg up or down.
      • It is a loss of momentum, but does not indicate a trend change in and of itself.
    2. Box
      • Occurs in a trading range environment.
      • When the market penetrates one side of the consolidation range, but closes back inside the range, the odds are that it will test the other side of the range.
  3. Breakouts
    • Identifying when a breakout is approaching
      • Contraction in the True Range (use a period ranging from 1 – 30)
      • Low reading on a standard deviation indicator
      • Convergence of trend lines
      • Classic chart formations (e.g. triangle)
    • Method #1
      • Buy the breakout of the previous x-number bar’s high, sell the breakdown of the previous x-number bar’s low.
    • Method #2
      • Add or subtract an ATR to the previous bar’s close or current bar’s open and use that as the breakout level.

Trade Management

  • Don’t make trades when conditions are marginal, you need to protect your profits and not give them back.
  • Make trades as close as possible to initial support or resistance levels.
  • Stop management
    • Place stops at logical points (e.g. under support and above resistance) where your initial analysis would be considered wrong.
    • As soon as the trade shows enough of a profit, move the initial stop to break-even level.
    • As the market moves in your favour, move stops to lock in profits.
  • Exit at the first sign of danger or adverse movement against the position.
  • Reduce the size of the position when there is doubt or when it is not working.




2 thoughts on “Underlying Principles of Swing Trading

  1. i like the retracements set up ,its the best entery strategy among the three.The test strategy works well if you have strong fundamental insight on the asset.the breakout is the weakest among the three unless you use some other fundamental inputs with it.

    Retracments it he only entery strategy where you can rely purly on technicals.

    Posted by Mohammed Al-Alwan | March 24, 2013, 8:29 am
    • Yes, many people advocate entering on retracements. I used to think that entering on breakouts have a higher probability of failure, however recently I learnt from a systems trader that tested this and found negligible differences in entering on retracements vs. entering on breakouts.

      I am also thinking whether there could be differences due to the timeframe tested, e.g. perhaps breakouts have a higher probability of failure on a daily timeframe vs. an intraday timeframe, but have not tested this.

      Posted by whatheheckaboom | March 29, 2013, 2:49 am

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