The Market and the Swing Trading
Market Analysis and Market Modes
The Three Market Modes
As we all know, having a solid idea of the broad market’s behavior is highly beneficial to helping one find successful trades. By analyzing the market, we have a much higher probability of success.
So what are the market modes we need to be aware of? There are three main market modes: the Upward Trend, the Downward Trend and the Trading Range.
In an upward trending market, most traders will be looking to take long positions so that we are trading in the direction of the trend.
In a downward trending market, most traders look to take short positions.
In a trading range market, traders have the option to look for both long and short positions.
The Tools for Market Mode Analysis
There are various tools available to help us determine what mode the market is in, each with their own advantages and disadvantages. So let’s took a look at some of the most commonly used tools and discuss how they can help us determine the correct market mode.
The 200 and 50 Period SMA’s
The 200 period and 50 period Simple Moving Average (SMA’s) are two of the most, if not THE most, commonly used trend analysis tools. With these tools, you can compare price to the moving averages or compare the moving averages to one another. For example, some folks may think the market is in an upward or bullish trend if the 50 SMA is above the 200 SMA. Many folks also think if the 50 SMA is below the 200, the market is in a downward trend.
While many people (including myself) use these and other moving averages every day to gauge the market, there are some problems with them.
The main issue one runs into with moving averages is called Smoothing Data. What happens here is that the averages suffer from lag and are not as responsive as we would like them to be. This means that some fast moving moves aren’t confirmed for quite a while because the market is moving faster than the averages. This lag or data smoothing impacts the longer moving averages like the 200 SMA more so than the shorter SMA’s because of the length of time it is measuring.
Another problem one needs to be aware of when using SMA’s is the Moving Average Whipsaw. SMA’s (and all other moving averages for that matter) can be problematic if they are used in a trading range. Whether you are comparing the moving average to price or another moving average, Whipsaws occur as price moves up and down through the averages. When price is oscillating like this, moving averages are of little use.
So Why Do We Want to Use the Moving Averages?
So if there are problems with these indicators, why use them? Because the rest of the market is looking at these indicators! Price often reacts to these moving averages due to the fact that they are so incredibly common. Folks use these indicators to help them analyze trends as well as to make sure they aren’t about to trade themselves into a hole.
The Relative Strength Index
The Relative Strength Index (RSI) is a very popular momentum indicator that is used to see if an instrument is overbought or oversold. If a stock has a high RSI reading (say in the 70 zone) it is considered overbought and is likely headed for a pullback. On the flip side, if a stock has a low RSI reading (in the 30 zone) it is said to be oversold and ready to bounce and increase in price.
While using the RSI in a trending market is very helpful, it can be tricky. While it is fantastic finding overbought and oversold levels in trading ranges, it can sometimes give off false reading in trending markets. The RSI comes in handy in trending markets when we use them to CONFIRM trades in the overall direction of the trend ONLY. So, if you were in a bullish trending market, you’d look for oversold reading on the RSI for higher low entries into long positions. The opposite is true for bearish trends. You’d look for new overbought readings around higher low entries into short positions.
Market Pivot Analysis
Many traders use the RSI in tandem with the SMA’s for market analysis, but there are also other methods folks use to determine market modes. Many traders use pivot analysis in order to detect the current market mode. Pivot analysis gives a better trend indication and removes many of the problems we observed with the moving averages and the RSI.
When using pivot analysis, you look for points on the chart when price pivots in different directions. Not only do you use certain points to determine trend direction, you also use these pivots to find potential entry opportunities. In an upward trending market, higher lows provide us with confirmation of a trend continuation as well as giving us a price improved entry spot for a long position. Higher highs show us that bullish sentiment is ongoing and pushing the market higher. In a perfect upward trend, higher lows are coupled with higher highs, giving us the ultimate confirmation for the upward trending market.
On the other side of the coin, lower highs provide bearish market confirmation as well as offering solid short entry opportunities. Markets that produce lower lows and that ignore support levels will increase selling pressure and most likely continue to decline. Lower lows along with lower highs provide us with the ultimate confirmation of the downward trend.
Trading Range Identification
A market that is not trending up or down is considered to be in a trading range. During this range, it is not making new highs OR new lows. Ranges can expand, contract and resemble a rectangle.
A Great Indicator!
So now that we have established how pivotal pivot analysis is (couldn’t resist), we have a fantastic tool to help you analyze every single pivot to help you determine the correct market mode. The indicator is called the WaveTrader Zig Zag Indicator. (WaveTrader is a proprietary trading add-on available for use in OmniTrader and VisualTrader. To learn more click here.) The WaveTrader Zig Zag Indicator looks to see how far price has moved away from the latest highest high and the latest lowest low value. Once the price moves a predetermined distance (in ATR’s) from the high or low, a pivot is plotted on the chart.
Detecting Reversals with Pivots
Pivots also provide an excellent way to determine if a trend is ready to reverse its direction or stall out. In a bullish trend, a lower high tells us that bullish pressure has decreased and that the bears are chomping at the bit to jump into the market. In a bearish market, the opposite is true. If a higher low is found in a downward trend market, it tells us that selling pressure is dissipating and that the bulls may come charging back into the market.
Another key concept to understand in swing trading is volatility. Volatility is directly related to instability in the market. Trading volatility, even for short positions, brings on more risk and it is wise to avoid trading into highly volatile markets. A good tool to utilize to gauge market volatility is the Wilder’s Volatility indicator. It will help you to identify an abnormal amount of volatility, saving you the headache of finding it yourself while you’re in a position.
Types of Market Modes and Trades
There are three types of market modes.
- Upward Trend
- Downward Trend
- Trading Range
If we determine that the indexes are in and upward trend, look for the following types of trades:
- Reversion to Mean Longs
- Breakout Longs
- Reversion to Mean Shorts in Trading Ranges
If we determine a downward trend is taking place in the indexes, look for the following:
- Reversion to Mean Shorts
- Breakout Shorts
- Reversion to Mean Longs in Trading Ranges
If we determine that a trading range is in gear, consider these types of trades:
- Reversion to Mean Longs in an uptrend or a range
- Reversion to Mean Shorts in a downtrend or a range
- Breakout longs in an uptrends or ranges
- And lastly, breakout shorts in downtrends or ranges
As we wrap up this post, let’s review what we’ve discussed:
- Swing trading is designed to capture quick profits on reversion to mean moves as well as momentum breakout opportunities.
- Moving averages and oscillators can be helpful in certain situations, but can lag and cause some false readings.
- Using pivot analysis determines the mode of the broad market as well as individual stocks.
- Volatility is a sign of fear entering the market and traders need to analyze charts carefully to avoid instability and increased amounts of risk.
- And lastly, based on the determined market mode, only consider certain types of trades.
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