Pattern Recognition Criteria(19)

 

1     Pattern Recognition Criteria

While looking at a chart can often tell you whether a stock is appropriate for swing trading, it is very time consuming to look at charts, particularly if you look for opportunities every day. Another way to identify good stocks is to use software that can scan all of the listed stocks based on a series of algebraic equations that represent the characteristics of a good chart pattern. I use SwingTracker to accomplish this task.

Before discussing the specifics of pattern recognition criteria, we’ll briefly consider the measures used in the algebraic equations. Some of the measures are simple descriptive variables (e.g., the high price for the previous day or the average volume over the past 20 days). Other measures are based on technical analysis which is discussed in more detail in the Appendix. Technical analysis has many different indicators from a simple moving average to a complex oscillator. It is not necessary to have an in-depth understanding of technical analysis to be a successful swing trader, however, it is helpful to have a rudimentary understanding of how we approach swing trading pattern recognition.

1.1      Technical Analysis Measures used to Recognize Swing Trading Patterns

To begin with, we typically restrict our selections to stocks that are at least $12 in price, having an average (20 day) daily volume of at least 500,000 shares. Since market makers can more easily manipulate low price, low volume stocks, we stay away from them.

For long swings we are interested in identifying stocks that are in an uptrend. One of the indicators we use is a simple moving average (SMA). A moving average is simply the average closing price for a particular number of days. It’s called a moving average because on each new day, the current day’s price is added to the average while the oldest price is dropped. We typically focus on three moving averages, those based on 10 days, 20 days and 50 days. All moving averages smooth the price movement and make it easier to identify trends. It is also significant to know where today’s price is relative to the moving averages and whether the shorter time- frame moving average is above or below the longer time-frame moving average.

Two indicators that a stock is in an uptrend are:

·         Today’s closing price is above both the 10-day and 20-day moving averages

·         The 10-day moving average is above the 20-day moving average When looking for a long swing, we would like to identify stocks that are

experiencing a brief decline (pullback). We can identify a 3-day pullback as follows.

·         Today’s high price is lower than yesterday’s high

·         Yesterday’s high is lower than the high the day before

We also use a technical indicator developed by Dr. Alexander Elder called the Force Index. This index combines the magnitude of the price change with the direction of the change and the trading volume. In order to confirm the relative force behind an uptrend and a pullback, we use a 3-day moving average and a 13-day moving average of the Force Index. The following conditions demonstrate that the bears have been winning the short-term battle while bulls are dominating the longer frame:

·         The 3-day moving average of the Force Index is less than 0, and

·         The 13-day moving average of the Force Index is greater than 0

Another technical indicator we like to use is the Directional Movement Index (DMI) that was developed by J. Welles Wilder Jr. It is used to determine whether a stock is trending or not trending (i.e., moving sideways). In SwingTracker we provide the two components of this indicator – the Positive Directional Index (+DI) and the Negative Directional Index (-DI) – along with a 20-day moving average based on these two measures (ADX). An uptrend is confirmed if …

·         ADX is higher than 30

·     +DI is greater than –DI

Our most successful pattern recognition formulas are available to all visitors (free of charge) at www.mrswing.com in the SwingLab section of the web site. You can copy the formulas into SwingTracker and scan all listed stocks at any time.. These are the same formulas that provide the MasterSwings recommendations. The formulas will be built into the next version of SwingTracker.

2     The Master Plan – Entry and exit rules that insure successful swing trading

2.1      WHAT is the Master Plan

The Master Plan is a set of rules that determines when to enter and exit a trade. At first, it might seem a little complicated, but once you have place a few trades using the system, you’ll realize it’s really quite simple. The best part about the Master Plan is that you don’t need to use judgment. The rules are mechanical. Two obstacles to successful trading are the human emotions of fear and greed. By following the Master Plan, these emotions will not influence your behavior, nor will they interfere with your success.

1.1      Taking a Profit and Preserving Capital

An important aspect of the Master Plan is setting a profit target and preserving capital. The approach is fairly conservative – the profit target is approximately 7% with a potential loss capped at 4%. The actual profit is likely to be more than 7% while a loss is likely to be smaller than 4%. Here’s how it works.

 

·         Once the target price is reached (7% above the entry price), half of the shares are sold, locking in a 7% profit. The other shares remain invested to benefit from any further increase in price.

·         If the price moves against the trade, the maximum loss tolerated is 4%. This preserves capital for future trades.

 

·         Typically, more trades will produce a profit than a loss. The net result is profit.

 

·         The movement of the entire market is very powerful. When the market is moving with your trades, a very high percentage of your trades will be profitable.

 

·         When the entire market is moving against your trade, a higher than expected percentage of your trades will lose. The stop loss protects you from excessive losses.

 

1.1.1        Profit is taken using a “sell limit” order – once the price is reached, the specified number of shares are sold.

1.1.2        Capital is protected using a “stop loss” order – when the stop price is reached, all the shares are sold.