Testing the Theory

The two- to five-day price trends and setups can be tested by reviewing a typical candlestick chart. Figure below (Wal-Mart (WMT)) is a good example.

This is a 30-day candlestick chart for Wal-Mart. The latest few days of this chart did not present a clear signal in either direction; but look at the activity from December 26 (the trading day after December 22) through January 4.

In these six trading days, there was a clear uptrend and sell signal. Five uptrend days ended with a peak in prices and exceptionally high volume. The following day was an NRD day, which is recognized by the virtual flat line in place of a more obvious trading range. This means that opening and closing prices were quite close together. A stronger signal would have involved the NRD and high volume in a single day. But if you had bought a call in late December, the development of this uptrend pattern ending on January 4 would have provided a clear sell signal.

[caption id="attachment_12598" align="aligncenter" width="560"](WMT) Wal-Mart (WMT).[/caption]

Smart Investor Tip

It is not any one signal that indicates time to take action, but a combination of an established short-term trend with a reversal signal. That is what swing traders depend on before making a move.

A clearer pattern emerged for Apple, the well-known computer company, during the period of December through early January. Figure below shows a one-month candlestick chart for the company.

[caption id="attachment_12599" align="aligncenter" width="535"](AAPL) Apple Inc. (AAPL).[/caption]

The range of trades marked off includes four days of declining price, followed by two uptrend days. There are five aspects to this pattern, all signaling an end to the downtrend:
  1. Consecutive downtrend days. The stock had fallen in value for four days in a row. This is the preliminary signal that, in fact, the short-term downtrend is probably coming to an end, and the most common pattern swing traders seek.
  2. A narrowing trading day. On December 26, a down day also showed a narrowing range, but it was not necessarily an NRD. You would expect an NRD to be quite thin (like the last day shown on the chart, for example).
  3. A reversal in direction with higher volume. December 27 was a day when price rose for the first time in five trading days, and volume picked up as well.
  4. A second narrowing trading day. December 28 was yet another up day and also with relatively narrow trading.
  5. A price gap. Chart watchers invariably point to a gap as significant. In the case of Apple, after the signals indicating that the downtrend had ended, the stock's price gapped between December 28 and 29. This is a strong indication that the stock will be rising in price, and it foreshadowed trading over the next seven to eight trading days.

In using options for swing trading, the signal that the downtrend had ended was clear by December 27 or 28. If you had bought a call on one of those days, especially one in the money and due to expire in the near future, you would have made a profit within eight trading days. For example, on December 27, when the stock opened under $79 per share, the January 80 call was selling for approximately 4 ($400). On January 11 (the last day on the chart and an NRD following a strong uptrend), the same call was worth 15.80, nearly 400 percent higher.

Of course, hindsight is always perfect in swing-trading situations being reviewed. At the time, the price decline followed news that Apple CEO Steve Jobs may have been awarded stock options without proper approval. The stock's price was reacting to the news, so the price decline caused a lot of fear among Apple investors. However, swing traders are supposed to ignore the news and just trade the price patterns and investor emotions. In this situation, the signals that the downtrend had ended were quite strong, and five separate indicators provided strong confirmation of that fact. Even so, using options the maximum risk in this situation would have been less than $500 for a single January call, far less than the purchase price of $7,900 for 100 shares. A comparison of the percentage return also bolsters the argument favoring the use of options over stock. A profit of $1,180 on 100 shares bought at $79 per share would be 15 percent, but the profit on a 4.50 option would be 262 percent. The option would have required less capital, involved less risk, and created a far higher return.

Smart Investor Tip

The more confirmation you have that an established short-term trend is on the verge of reversing, the better. But if you wait too long—even one day—you could also miss the opportunity.

This leverage feature is compelling. A swing trader faces the constant problem of capital limitation. With a finite amount of money, you can swing trade only a limited number of stocks if you are going to be buying shares. But slightly in-the-money, soon-to-expire options are quite cheap. In the example earlier in this article, when Wal-Mart stock was selling at about $48 per share, the closest in-the-money call was available for 2.37, or about 5 percent of the stock's price. The next-expiring in-the-money put was at 0.60, or about 1 percent of the stock price. So your capital is easily leveraged with options in place of stock. Rather than having to buy 100 shares for $4,800, you could put $237 into a call and have the same potential upside profit; or invest only $60 in a put for the same downside potential (not to mention avoiding the risk of selling shares short).
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 2020. Content published with author's permission.

Posted in ...