Saturday, December 19, 2009

Swing Trading With Transition Patterns

My recent post focused on making the transition from daytrading to trading larger time frames. Let's begin with the move from daytrading to swing trading, where swings are defined as moves lasting from two days to a week in duration.

The advantages of swing trading are that the time frame allows for nimble movement and a good degree of risk control, while still participating in overnight movement.

Two patterns that I like for swing trading are breakout patterns and what I call transition patterns. This post will deal with the latter.

Transition patterns mark a transition from a rising market to a falling one (or vice versa), often when trending markets have become range bound on a longer time frame.

The transition occurs in several phases: first, a momentum peak in which a great majority of stocks, sectors, and indexes are making new highs or lows; then a meaningful retracement from that peak; then tests of the momentum highs/lows that ultimately come on lower volume and with weaker participation of stocks and sectors. It is those secondary tests with poor participation that offer the best entry points. Once you see the test fail and selling/buying come into the market in enhanced size, you want to join that move on its first retracement.

In the chart above (click for detail), we can see two transition patterns. The first occurred with the momentum peak late on 12/13 and early 12/14, followed by the decline into 12/15 and then a secondary peak on 12/16. Some sectors made fresh highs on 12/16 (such as XLB, XLE), but many others did not. Once we could not sustain the highs around 1111 in the ES futures, we moved steadily lower into 12/17 and 12/18.

A second transition pattern was alluded to in my recent blog entry on reversals and continuation. The lows of 12/17 in the ES futures were followed by 12/18 lows in ES, but not in other indexes. Our momentum low was 12/17 and our unsuccessful test occurred on 12/18, leading to a reversal move back into the 12/17 range.

Note that these transition patterns, taken together, place us squarely in a trading range. The swing trader is trading that range--and eventually could trade a breakout from that range. Thus, for instance, I have a long position from the unsuccessful test at 12/18, with an initial target of 1100 (range midpoint) and a larger target of 1112 (range high). Because the trade moved in my favor late in the day, my stop is moved to breakeven. (My entry was based on a shift in NYSE TICK, Market Delta, and lead/lag sector behavior, based upon the italicized sentence above; the specific integration of those indicators is proprietary).

Transition patterns work by trapping longs and shorts that are counting on continuation of a directional move. Because they are forced out of their positions, the market reversals can be quick and quite profitable on a swing time frame.