The Setup Signal

Swing trading depends on the setup, a buy or sell signal based on at least three days' worth of indications. Setups occur as well in combinations. In other words, a short-term trend requires at least a three-day price and pattern movement in one direction, ending with a clear reversal signal. It also requires a combination of setup indicators.

Swing traders do well using candlestick charts to spot these setups. The candlestick chart is based on an ancient Japanese system originally used centuries ago to track rice prices.

Today, Internet-based services offer candlesticks on most listed stocks and save time by computing the indicators for you. The candlestick employs a relatively simple pattern that reveals the opening and closing prices, trading range, and direction of price movement for the trading day (or other period).

While the candlestick tracks the stock's market price, the setup signals you can derive from the candlestick can be employed to time buy and sell decisions using options. As long as you use minimally in-the-money options with a short time to go until expiration (meaning there will be little or no time value remaining), the use of options will track option price movement very closely.

Smart Investor Tip

The reason to use close-to-expiration options is to maximize the point-for-point price movement. If there is any time value remaining in the option, swing-trading models will not work.

Candlestick charts consist of a series of boxes (squares and rectangles) with single lines rising above and below. A white or blank box indicates the price rose on that day, and a black box occurs when the price direction is downward. The box borders the day's opening and closing prices. The lines extending above and below represent the trading range for the day and are named the upper shadow and the lower shadow. For example, if a stock opened at $23 per share and closed at $26, but had prices as high as $28 and as low as $21, the candlestick for that day would consist of a white box (because the price rose from opening to closing). The rectangle would be bordered between $23 and $26, the opening and closing prices. And the lines would extend below the box down to $21 and above the box up to $28. The attributes of candlesticks are summarized in Figure below.

[caption id="attachment_12595" align="aligncenter" width="500"]The candlestick. The candlestick.[/caption]

The buy or sell setup is found when a clearly established trend comes to an end. The setup anticipates price movement in the opposite direction and may be seen in the emergence of one or more patterns. Important patterns to know include:An NRD is considered a strong signal that the established trend may be ending. This is especially true when accompanied by a high-volume day. So when you see (1) a trend lasting three days or more, (2) an NRD, and (3) exceptionally high volume on the same day as the NRD, that combination gives you the strongest setup possible. On the upside, it is a sell signal; on the downside, it is a buy signal.

Smart Investor Tip

A narrow-range day signifies price consolidation at the end of a trend. When this occurs with unusually high volume, it is the clearest possible setup, indicating time to take action.

By Michael C. Thomsett
Michael Thomsett is a British-born American author who has written over 75 books covering investing, business and real estate topics.

Copyrighted 2016. Content published with author's permission.

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