This is an exclusive extract from Michael Thomsett’s new book, Options for Swing Trading. We’ll be running extracts from Michael’s book all throughout November and you can even win yourself a copy by entering our competition here, or read on below for details on how to claim 30% discount through Littlefish FX.
Part 3: Short-Term Price Cycles
Swing traders are visual analysts. They study charts looking for predictable price cycles and patterns. Some very clear and repetitive patterns can be found, and their meaning in terms of future price movement is a powerful tool for timing trades.
Among these patterns are the exceptionally strong candlestick short-term trend reversal indicators (notably the engulfing pattern, three white crows, and three black soldiers, all of which occur often), and in Western technical analysis, there are well-known patterns such as triangles and wedges, double tops and bottoms, and price gaps.
Because charting is widespread and instant charts are available online free of charge, more people today consider themselves “chartists” than ever before. With this free access, thanks to the power of the Internet, the world of technical analysis no longer belongs only to a small number of insiders of those willing to pay thousands to a charting service. This free access has vastly expanded the population of technicians.
Swing traders who also are serious students of technical analysis are aware, however, that this larger population of chart watchers does not have an increased level of expertise. It only increases the number of participants, including those whose knowledge and interpretive skills are as limited as they were before free access to charts. The truth is, many traders do not want to put in the time to learn charting skills; this population of chart watchers includes many who believe that solely because they have free charts, they understand how to interpret the signals on those charts.
Increased availability of charts might cheapen the perceived importance of study and acquisition of knowledge, and a broader population of chart watchers is less likely to be skilled than a smaller core of chartists. This is a great advantage for swing traders.
Just as swing traders exploit the emotional gut reactions of greed and panic, they may also exploit the tendency of a majority of technical analysts to misread the signs or to place too much weight on unconfirmed reversal signals.
One symptom of this is a widespread belief among technical investors in a skill set based solely on analysis of charts, but without any serious acquisition of analytical abilities. A truly skilled chartist knows that the first step in seeking reversal is to look for repetitive patterns that have proven reliable in the past. The less skilled technicians want a broader, more esoteric and complex series of signaling methods and ignore the possibility that the signals these produce might be far less reliable. In other words, finding a reversal signal does not mean action is demanded in response. Experience tells the skilled chartist that skill is required in recognizing false signals as well as reliable ones, in relying on trusted confirmation, and in avoiding self-fulfilling prophecies (if you think a stock’s price “should” rise because you own shares, you are likely to notice only bullish signals and fail to see bearish ones).
Price cycles do occur, according not only to the Dow Theory and its three trend types but also according to swing traders and their extremely short-term focus. Prices move through price cycles of varying duration, but those price cycles repeat. Beyond the cyclical realities of trading ranges, tops and bottoms, and sideways movement (congestion), swing traders can exploit great opportunities not so much by seeing these patterns but by seeing how a price departs from them due to the common overreactions based on greed and panic.
As prices rise, the greed reaction is a form of addiction, a thrill that traders experience as they acquire shares to take part in coming riches or continue to hold even in the face of reduced upward momentum. What many fail to realize, however, is that the downtrend causes just as much addictive behavior, just in the opposite direction. The uptrend prompts greed and the euphoria that goes with it, whereas the downtrend prompts panic and the dread it creates. Both of these reactions are irrational, and swing traders place themselves in a position to recognize that uptrends and downtrends of short duration are simply price cycles of the moment and not causes for greed/euphoria or panic/dread.
Traders subject to the emotional irrationality of the market make the mistake of not recognizing the role of price patterns. And so an uptrend and its promise of fast profits is interpreted as a reward for being a smart trader, and a downtrend is seen as a punishment, betrayal, or broken promise. None of these emotional responses are valid, of course, because the market does not have a consciousness. It simply moves in response to the underlying causes, and price patterns are the outcomes—impersonal, unintentional, unconscious, and natural in the auction marketplace.
Swing traders further realize that price cycles are not continuous. A sudden move above or below rational trading levels is an opportunity, not because it represents a price pattern, but because it is a departure from that pattern. Most of the time, prices are likely to move within a predictable pattern, and swing trading opportunities occur as exceptions. Most traders are impatient, addicted to the thrill of the trend, and unaware of their flaws in how they observe and react when prices do move. Swing traders tend to be those off to the side, observing price but, equally important, also observing the behavior of other traders.
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