As a swing trader you do not have to become an expert in all aspects of technical analysis—and some of it is quite complex. However, you do need to master the basic charting principles and these are relatively easy.
There are two general tiers to technical analysis. The largest and most complex is often overly theoretical and intensely mathematical.
This level tends to be taught to students, and is more academic than practical. By the time you complete your analysis on this level, the stock has moved onto its next phase and the information is out of date. On a more immediate and accessible level are a few important basics. This is where you can quickly gain the knowledge you need to improve your timing and your profits with swing trading.
The best-known signals are patterns called double top and double bottom and these are fairly simple indicators to spot and to interpret. A double top involves two tests of resistance, with a decline in price in be-tween. Because it is a double test, the double top is considered a bullish
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Common Gap
Resistance
Support
Breakout Gap
Exhaustion Gap Runaway Gap
Resistance
Support
FIGURE 2.3 Common Gap, Breakout Gap, Exhaustion Gap, and Runaway Gap
signal, and the stock price is expected to retreat.
The concept here is that there was not enough en-thusiasm among investors to push the price higher, so price retreats. The double bottom is the oppo-site, a test of support. Because support is strong enough to hold up under this two-part test, the price subsequently rises.
The double top and double bottom are illus-trated in Figure 2.4.
double top a price pattern in which resistance is tested twice with a pullback in between. As long as resistance holds up, price is expected to de-cline after the double top.
Double Top
Double Bottom Resistance
Support
Resistance
Support PricePrice
FIGURE 2.4 Double Top; Double Bottom
The head-and-shoulders pattern is an ex-tended variation of the double top or bottom pat-tern. This is characterized by three price peaks or declines, with the middle one extending further than the first and third (in a letter M shape). A head-and-shoulders top occurs at or near resistance;
the interim trading areas between the peaks is called the pattern’s neckline. Volume often is strong at the first “shoulder,” and relatively weak by the last phase of the pattern. The head-and-shoulders top is a test of resistance and because it does not break through, it anticipates a price decline.
The head-and-shoulders bottom tests support in the same way as the top tests resistance, but in the opposite pattern, in a letter W shape. Volume of the last of three head-and-shoulders extensions is likely to be lower than for the first shoulders and the inverse head, indicating a lack of enthusiasm among investors for a price decline. The head-and-shoulders bottom anticipates a rise in the stock’s price.
The two head-and-shoulders patterns each an-ticipate price movement in the direction opposite of the tests; and may also anticipate breakouts from the established trading range (below support after the top pattern, or above resistance after the bottom pattern). Both of these are illustrated in Figure 2.5.
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double bottom a price pattern testing support with a price in-crease in between. in the price level.
the price area in between the price extremes of the head-and-shoulders pattern.
The head and shoulders anticipates a reversal in price because it includes three separate tests of the limits, accompanied by weakening volume. The reduction in enthusiasm of investors is the real signal.
Key Point
While the double top or bottom and head-and-shoulders patterns provide visual signals antici-pating specific price trends, another important charting feature is the broadening formation. There is a tendency for price ranges to expand over time, often with accompanying expansion of daily vol-ume. Several specific types of broadening forma-tions are useful to swing traders to recognize patterns and to anticipate or confirm buy and sell signals.
head-and-shoulders bottom the inverse of a top, consisting of a head testing support with two shorter shoulders before and after, creating a letter W shape. The pat-tern anticipates a price increase.
Top
Bottom
Resistance
Support
Resistance
Support
FIGURE 2.5 Head-and-shoulders Patterns Top and Bottom
The broadening formation is illustrated in Figure 2-6.
A related pattern is the triangle. This is the op-posite of a broadening formation in which a trad-ing range becomes narrower than the precedtrad-ing pattern. This pattern implies uncertainty and what market watchers like to term “consolidation.” But while it precedes some future price movement, it is difficult to determine with any consistency the di-rection that price movement is going to take.
The triangle is illustrated in Figure 2.7.
The triangle has been given other names such as “flags,” “pennants,” and “wedges,” but the over-all observation is the same: Any change to an exist-ing tradexist-ing range anticipates a future price direction. A broadening formation reveals the like-lihood of stronger volatility in the future, and tri-angles imply momentary uncertainty.
No pattern can be reliably used to guarantee price movement. Even with the strongest of signals, short-term uncertainty dominates every stock’s price. But these patterns, when incorporated into
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broadening formations chart patterns showing widening trading range for a stock, develop-ing over time and providing specific signals for swing traders.
FIGURE 2.6 Broadening Formation
triangle a price pattern in which the trading range narrows, a sign of uncer-tainty about the stock’s price movement and a precursor of a coming upward or downward trend.
the more specific daily price analysis used by swing traders, can serve as powerful confirmation tools. When these are used along with the addi-tional information provided by candlestick charting analysis (discussed in Chapter 3), your arsenal of swing trading tools is vastly improved.