Buy Weakness and Sell Strength
Buying weakness and selling strength is the art of buying pullbacks. Stocks that are in up trends will pull back offering a low risk buying opportunity and stocks that are in downtrends will rally offering a low risk shorting opportunity.
As a swing trader, you have to WAIT for these opportunities to happen because…
Doesn’t it make more sense to buy a stock after a wave of selling has occurred rather than getting caught in a sell-off?
Doesn’t it make more sense to short a stock after a wave of buying has occurred rather than getting caught in a rally?
Absolutely! If you are buying a stock then you want as many sellers out of the stock before you get in. On the other hand, if you are shorting a stock then you want as many buyers out of the stock before you get in. This gives you a low risk entry that you can manage effectively.
Buying Pullbacks And Shorting Rallies
Where do you buy a pullback and where do you short a rally? You buy them and short them in the Buffer Area for Traders (BAT). This is how you create the BAT:
BAT – The Trading Strategy
The Buffer Area for Traders (BAT) is a buy and sell zone on a chart that swing traders can use to identify possible reversals in a stock.
This is just simply “area” that we look at to see if a stock that is in a strong uptrend, after pulling back to this area, will likely reverse, and, vice versa for down trending stocks.
BAT is the area in between the 10 period moving average and 40 period moving average.. This is where you, as a swing trader look for reversals back to the upside when going long and reversals to the downside when shorting stocks.
For the 10 period, use the Triangular average, while for the 40 period use the Weighted average. But, the actual choice of moving average type is not very significant. It doesn’t matter whether you use sma’s or ema’s. There is little difference between different methods so don’t get caught up in the variations. We are just using these moving averages to create a zone that we will find our entries for long and short positions.
The area between the two moving averages is a buffer. We use the averages to identify the trend. If the 10 day is above the 40 day, the trend is UP. If the 10 day is below the 40 day, the trend is down.
When going long, wait for the decline into the BAT and when going short, wait for the rally into the BAT.
Swing Points
For a swing point low, the first candle makes a low, the second candle makes a lower low, and the third candle makes a higher low. This third candle tells us that the sellers have gotten weak and the stock will likely reverse.
For a swing point high, the first candle makes a high, the second candle makes a higher high, and the third candle makes a lower high. This third candle tells us that the buyers have gotten weak and the stock will likely reverse.
For our long entry strategy, we are trying to find stocks that have pulled back into the Buffer Area for Traders that have made a swing point low.
Now lets look at a stock on the short side. We are looking for a stock in a nice downtrend with the 10ma below the 30ma. Then we wait for a rally into the BAT that forms a swing point high.
A second setup: Consecutive Price Patterns
Many a time, you will notice that a pullback in an uptrend consists of three consecutive down days with lower highs and lower lows. (or two down days and one inside day).
That is what you want to look for in a pullback. You can buy the stock the first time it trades above the previous candle high. This will also complete the swing point low.
In a downtrend, you will see often that the stock has three consecutive up days with higher highs and higher lows (or two up days and one inside day). The fourth candle continues tol makes a higher high and a higher low. The fifth candle finally makes a lower high and a lower low – completing the swing point.
My point in explaining the pullback in a down trend was this : Pullbacks do not have to consist of exactly 3 consecutive up days (for short trades) or down days (for long trades.) Sometimes you will run your scans and find stocks that have more than that.
One final note: When you are looking for swing points to develop, you always want to look to the left of the chart to see if the stock is at a support or resistance area on the chart. That will improve the reliability of this entry strategy.
Ok, now that we know how to get into a trade, how do we get out? We need an exit strategy.
How To Take Profits And Control Your Losses
Your exit strategy consists of two parts: Where will you get out of the trade if the stock does not go in your favor? Where will you take profits if the stock does go in your favor? These are the two questions that make up your exit strategy. You have to be able to answer these questions before you can place the trade!
Part One – Your Stop Loss Order
First, lets put to rest the debate about where or not you should use a physical stop or use a mental stop. A physical stop loss is an order to sell (or buy if you are short) that you place with your broker. A mental stop is YOU clicking the sell (buy) button to get out of the trade. From a technical perspective, it does not matter which type you use.
Before you get into a trade you will have a plan that will determine when to get out of the trade if it does not go in your favor. You are a disciplined trader that always follows your plan (right?). What difference would it make whether or not you have an actual order placed with your broker or if you are going to pull the trigger yourself? There is no difference. In either case, you will get out of the stock when your plan (exit strategy) tells you to!
Personally, I always use physical stop loss orders placed with my broker. This is because I do not want to sit at my computer and look at a monitor all day long! Ok, maybe that’s a slight exaggeration, but you get the point!
Where is your stop going to be? First of all you need a stop that makes sense and you need it to be out of the “noise” of the current activity in the stock.
Look at the average true range of the stock over the past 10 days. If the average true range of the stock is, say, Rs 11, then your stop needs to be at least that far away from your entry price. It doesn’t make any sense to have your stop Rs 3 away from your entry price when the range is Rs 11. You will surely get stopped out prematurely!
For long positions, your stop should go under a support area and a swing point low.
For short positions, your stop should go above a resistance area and a swing point high.
Part Two – Taking Profits
Use trailing stops! This is an easy and unemotional way of exiting a trade. If this trade is going to be a typical swing trade with a holding time of 2-5 days, then you can trail your stops a few rupees under the two day low. (This is the low of the last two days). Once you have spent 2 or 2 days in the trade, tighten the stop to just the previous day’s low.
Note: Initially, on the day of entry, your stop should be based on your stop loss order. the trailing stops come in, on the day your trade becomes profitable.
If this is a first pullback scenario, then you may want to hold this for a longer time frame. Having some big winners every now and then will fatten up your trading account! In this case you can trail your stops under the swing lows (or highs for shorts) until stopped out.
In either case, you should always determine where your stop is going to be and how you are going to take profits before you get into the trade. Have a solid plan in place (write it down). This will take all of the emotion out of the trade. Then you can relax and trade the “map” that you have created. This will make your exit strategy easy to follow and it will put you on the path to success.
What is so special about this zone?
I have found that for swing trading, a lot of reversals happen in this area. So in order to create a focus in your trading strategy, it is helpful to narrow down your potential stock setups to one area on a chart. This zone provides a number of setups on a daily basis.
We are not really concerned with the moving averages themselves. When a stock pulls back into this zone, look to the left to identify support and resistance, trend lines, candlestick patterns, etc. You are looking for multiple signals all pointing in the same direction.
Will this strategy make me a profitable trader?
You may be surprised by my answer.
The answer is no. There isn’t ANY trading strategy that will make you a consistently profitable trader. Sorry to disappoint you. The only thing that will enable you to consistently pull money out of the markets is YOU.
YOU must have discipline. YOU must be able to take losses. YOU must be able to take your profits. YOU must eliminate fear. Put simply, you must be able to control the emotional and psychological problems that prevent success.
That will be your biggest challenge in learning how to trade stocks with any strategy.
