How to Swing Trade Summary (C8): Indicator Tools

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There are many tools out there which you can use to help you make trading decisions.

In fact, that is a problem. There are too many.

After learning about some of them here, try them out and then choose a couple you are comfortable with and focus on only them.

Otherwise, you will probably go into paralysis analysis trying to get too many indicators to align.

The market tends to remember price levels.

Support is the lower limit of a price range where an asset continuously bounces back up.

Resistance is the upper limit of a price range where an asset continuously bounces back down.

When looking at a candlestick chart over a long period of time, the areas of support and resistance should become evident. You are looking for a connection by a horizontal line of several connecting tops (resistance) or bottoms (support). The more times the price bounces off the level, the more reliable it is.

Also, resistance can often turn into support once the price breaks through. The reverse is also true.

Major lines of support and resistance will be common on all time frames (4-hour, daily, weekly, etc) while minor ones may only be visible in shorter time frames. Major lines are more reliable so it is a good idea to look at several time frames for confirmation.

Trading on the support and resistance levels is simple but effective. Once you identify them you simply buy low (at support) and sell high (at resistance). Place your stop loss just below support and your take-profit limit at resistance.

Your risk is the difference between your entry price and your stop-loss. Your reward is the price difference between your entry and your take-profit limit. If your reward is at least double your risk, it is a good trade.

Here are some key factors to keep in mind when trading support and resistance levels:

• More recent levels are more relevant to present trades.
• The more ‘bounces’ the more likely the level will hold.
• Use candlestick patterns and other indicators to confirm reversals at the point of support or resistance.
• Round numbers in pricing are often levels of support or resistance, e.g., $5 is more likely to be a level then $4.39.
• The levels aren’t exact prices. It is more of an ‘area’ around the price level.
• If a stock flounders around an area of support or resistance it is possible it will break through and continue in the direction it was headed.
• Once a stock breaks through a resistance level, that level often becomes the new level of support. The reverse is also true (for downtrends.)

Long term trends move in waves and can often be marked on a chart using diagonal lines. They are more subjective than horizontal lines of support and resistance and therefore not as reliable.

When you have two trending diagonal lines they may form a channel. This channel can be used as support and resistance, but are probably better suited for longer term positions.

Moving averages are a simple tool you can use to help determine entry and exit points and also to keep you in longer term trends.

They are good to use in bullish or bearish trending markets as opposed to ones in consolidation (trending sideways sideways).

There are two primary types of moving averages. Simple (SMA) and exponential (EMA). Both can be calculated using different periods of time. The longer the time period used, the more the lag the moving average will have behind the real stock price.

If the stock price is constantly moving down, then the moving average will move downwards also. This shows you it is a bearish trend.

If the sentiment changes and stock price starts to move up, then eventually a shorter frame moving average, e.g., a 50 day, will cross above the longer time frame moving average, e.g., a 200 day. This is a signal that the trend is changing from bearish to bullish.

The SMA and the EMA are calculated differently. The main thing to know is that the EMA reacts more quickly to price changes, which may or may not be a good thing depending on what you are looking for.

Generally, the SMA is better in volatile markets because it moves slower and smooths out any volatile movements. If you were using an EMA it might give false signals.

Conversely, the EMA is better in less volatile markets because it reacts faster.

Likewise, a shorter time frame reacts faster and a longer one lags.

The most common time frames to use are the 20, 50, and 200-day. The 200-day moving average is especially highly regarded and often acts as a line of support or resistance in a trending market.

You can also use the percentage of stocks that are trading above the 200-day average to gauge the overall market. The more stocks over the 200-day moving average, the more bullish the market is.

During a down trend, when the 50-day moving average crosses from below to above the 200-day moving average it is a signal that the sentiment is changing from a bearish trend to a bullish one.

This is known as a golden cross (gold is positive).

The opposite is called a death cross, i.e., the 50-day moving average crosses from above to below the 200-day moving average.

There are a number of ways to trade the moving average.

If you see the 20-day SMA dropping below the stock price while the 50 and 200-day SMAs are still about, it is a reversal indicator.

You can also monitor the averages to help you decide whether to exit a trade completely or to scale out, i.e., take partial profits and let the rest ride if the trend is still moving in your favor).

The Relative Strength Index (RSI) can give you an indication of whether a stock is oversold or overbought.

Generally, if the RSI is under 30 it is considered oversold and may be a good time to buy. If it is over 70, it is overbought and considered a good time to sell.

You could also use 20% and 80% to be more conservative.

In an uptrend, the 45 level on the RSI will often act as support. In a downtrend, resistance will be around 55.

When the stock price action and the RSI are not in sync it is known as divergence. For example, if the price is making a new high but the RSI moves lower it indicates a possible bull to bear reversal and would be a good time to sell.

The RSI works best when used in conjunction with other indicators, as is true for almost all indicators.

The MACD (Moving Average Convergence Divergence) is primarily used to gauge the strength of a price movement. It works on the principle that changes in momentum will often precede changes in price.

It’s displayed as a line graph with one line representing the distance between two moving averages, most commonly the 12-day and the 26-day, and a signal line, commonly the 9-day moving average.

There is also a histogram (bar chart) representing the distance between the moving averages. The larger the bar, the further apart they are getting. The closer the lines are together, the more likely a reversal. If they are further apart, the more likely the trend (bullish or bearish) is to continue.

Note from Sam: This book does not talk about MACD divergence or crossovers, but I feel it is a good place to mention them.

MACD divergence occurs when the price of a stock and the MACD indicator are moving in opposite directions. For example, a bullish divergence is when the stock price makes a new low but the MACD line doesn't.

When the graph lines are below the histogram and the MACD line crosses above the signal line it is considered a buy signal. The further away the cross happens from the histogram the stronger the signal.

When both the MACD and the RSI give you the same signal (buy or sell) it is a good indicator.

The Average True Range (ATR) measures the volatility, i.e., how much a stock can swing in price over a certain time period.

For swing traders that want to take more risk, you may purposefully scan for stocks with higher ATR. And you can do the opposite too to filter out low volatility assets.

Another way to use the ATR is to see how much variation in price you can expect to see from day to day. This can prevent you from setting your stop losses too close, which means you won't exit the trade due to normal price swings.

A more advanced use of the ATR is as an exit indicator. If the stock price closes more than one ATR value away from its most recent close, it is a possible reversal signal.

Read the next chapter here.

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