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.
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 TipThe 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.
[caption id="attachment_12595" align="aligncenter" width="500"] 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:
- Three or more days of clearly identified uptrend or downtrend movements. This is the clearest of all setup signals. A minimum of three days is required. An uptrend occurs when you see three or more trading days consisting of a series of higher highs, offset with higher lows in price. For example, a price range over three days of $23 to $26, $24 to $28, and $26 to $29 meets these criteria. A downtrend also occurs over three or more days, and consists of a series of lower highs and lower lows. For example, the price pattern of $29 to $26, $28 to $24, and $25 to $23 establishes a three-day downtrend.
The terminology is somewhat confusing, but once you see the series on a candlestick chart, the pattern becomes completely clear. The fact that uptrends consist of a series of white or clear boxes makes an uptrend jump right out and, of course, the black boxes in a downtrend are equally visible. As long as the size and shape of those boxes exceed the boxes of the previous day (so that both top and bottom are higher in an uptrend or lower in a downtrend), the pattern is clearly set. The three-day uptrend and downtrend are demonstrated in Figure below.
[caption id="attachment_12596" align="aligncenter" width="346"] Uptrend and downtrend candlestick patterns.[/caption]
- Look for the setup following the three-day pattern. The setup will usually consist of either a narrow-range day (NRD) or a day with exceptionally high volume. The NRD is easily recognized; the rectangle and shadows are quite small.