Swing traders specialize in using technical analysis to take advantage of short-term price moves. Successfully trading these swings requires the ability to accurately determine both trend direction and trend strength. This can be done through the use of chart patterns, oscillators, fractals, volume analysis and a variety of other methods. This article will focus on using oscillators and candlestick patterns as a quick and easy way to characterize a trend and successfully identify swing trades. (For more insight, see Introduction To Swing Charting, Introduction To Types Of Trading: Swing Traders and The Daily Routine Of A Swing Trader.)
The first step is to find the right conditions for a reversal, which can be done with either candlesticks or oscillators. Candlestick reversal indicators are characterized by indecision candles, while oscillator reversal indicators are characterized by divergence and convergence. Let's take a more in-depth look into these methods:
Candlestick charts are designed to enable traders to quickly and accurately interpret a stock's price movements. As we know, the body of the candle indicates the open and close, while the tails on either end represent the day's price movements. We also know that we can characterize indecision as "volatility without movement" - or long tails with a short body. Typically, indecision candles are seen as a time when the trend is about to change. (For related reading, check out The Art Of Candlestick Charting - Part 1, Part 2, Part 3 and Part 4.)
Convergence and Divergence
Convergence and divergence are simply times when a stock's price movement differs from momentum indicators. Think of it in physics terms - if you throw a ball up in the air, it loses momentum before it reverses direction. The same is true for stock prices: momentum slows before stock prices reverse. Convergence and divergence can show you when the momentum is slowing and a potential reversal is forthcoming. (To read more on this, see Introduction To Types Of Traders: Momentum Traders and Momentum Trading With Discipline.)
Pinpointing a Reversal
The next step is to define an exact (or as close a possible) point of reversal. This task is best accomplished using specific candlestick patterns. Although there are well over 60 different candlestick patterns, there are only a select few that give consistent points of reversal.
Bullish and bearish engulfings are some of the most popular candlestick patterns - and for a good reason! When properly identified, these candlestick patterns are among the most reliable. The key is in the length of the candlesticks. Ideally, the first candle should be short on low volume and the second one should be long on high volume. This indicates indecision in the last portion of a trend and then a decisive reversal in a different direction.
|Figure 1: Bearish engulfing|
The Harami cross pattern is another very common candlestick reversal pattern. The key to successfully reading this pattern is watching the volume. Here we are looking for strong volume on the trend leading up to the cross, and then low volume and very short tails on the Harami cross candle. This indicates a strong and sudden lack of confidence by traders in the prevailing trend, which is often followed by a reversal.
|Figure 2: Bearish harami cross|
Let's look at an example of each of these types to see how they can be applied to actual trading situations.
Here is a chart of Google (GOOG), in which we can see examples of indecision as well as a bearish engulfing. Notice that the indecision candles predicted a large reversal, while the bearish engulfing pinpointed an exact top. Although they may not always be this accurate, they do generally give a good indication of a pending reversal.
Notice here that the relative strength index and MACD are both declining while the stock price remains range-bound between $40 and $43. Soon after, Yahoo's stock price dropped from the mid-$40s to under $36. This reversal could be further confirmed by looking for reversal candlestick patterns during the time in which the stock was range-bound.
In general, candlesticks and oscillators provide traders with a quick and easy way to identify swing trades. Other methodologies like chart patterns, volume analysis and fractals can help build on the techniques seen here to increase accuracy and profits. To read more on these subjects, see Volume Oscillator Confirms Price Movements, Interpreting Volume for the Futures Market and Make The Fractal Your Friend.