There are some advantages to setup trading. Until you identify a setup, you’re out of the market, so you are at no risk. When you spot a setup, it’s a head start in getting in on a move, as it identifies the conditions that precede a move. And the start of a move is when you get the greatest profit, so if you get in straightaway, you stand to gain the most. This is in contrast to trend following, or momentum trading, where you jump on a move that’s already happening.
A setup pulls on various pieces of information – from candlesticks, patterns and indicators – and represents the psychology of the other traders, from which the expected actions are determined.
When you are looking at candlesticks for a setup, you can literally see the psychology of the other traders, otherwise known as the trader’s sentiment. With a bullish (white) candlestick, the length of the body indicates the demand – if there are a lot of buyers, and not many sellers, then the candle body goes higher and higher, pulling in sellers that are prepared to sell at a higher price. This implies that the traders who are eager to buy in do so because they think the price is going up. The same applies in reverse – a long bearish body suggests a lot of sellers, and not many wanting to buy.
When a stock is completing a move, the rate the price changes at slows, and this is called a consolidation. To be clear, a consolidation may be followed by a continuation in the same direction, or by a reversal – the consolidation is just the bulls and the bears ‘duking it out’, and the winners decide the next move direction.
In a previous section, I talked about the engulfing signals, both bullish and bearish. The bullish engulfing signal comes at the end of a bear run, when a large bullish (white) real body follows on a small bearish body, and its high is higher and low is lower than the previous bearish one. The bearish engulfing signal is similar, only opposite – a top reversal pattern.
There is also a thing called a harami, which is another two candlestick pattern, but the opposite of the engulfing, in that the following body is altogether inside the previous large body. The harami says that the previous trend is finished, and the bulls and bears are back at a balance. Often the second body is the opposite colour.
A special case of the harami is the harami cross – this is a harami (or should it be an harami?) which has doji for the second candlestick, and it’s an important reversal signal, especially if the previous candle body was long. Again, if you think about what the candles show, then you can see the market sentiment.
The RSI can also give you a signal to buy or sell, and the advantage of it is that it is faster to respond than a simple momentum indicator. However, because it’s based on the previous twenty days, in my charting setup, it can be funny and give false signals, depending what has happened previously. Its best use is a reference for confirming other signals. For instance, the appropriate overbought or oversold percentage will confirm the candlestick setups mentioned above. If the RSI hooks downwards from 70%, that is a good sign that the stock will come down – any divergence in direction is significant.
The way I use the moving averages gives a very clear signal, at a crossing, and to make sure of the trade, I will confirm with another indicator. Generally, when the stock passes the red moving average (the SMA20), we will be going long on the stock, and setting our trailing or moving stop at the green (SMA40). You can get some interesting things happen – for example, if your 20 is below the 40, and rises over it, that is a buy signal. Whenever a faster moving (less days) line rises above another, it’s a very bullish sign.
As I said earlier, the bar chart and the candlestick chart present exactly the same information; it’s just easier to understand the candlestick at a glance. In case you don’t agree, or don’t have access to a candlestick chart, I’ll just describe the bar chart, or OHLC chart as it’s sometimes called.
OHLC stand for Open High Low Close, and all these numbers are clearly represented on each individual bar. The bar can be in any length of time, and quite often represents one day’s trading. The way it works is that the top of the vertical line is the highest price that the security traded at, and the bottom is the lowest price. The price when the market opened for trading – the first transaction, if you will – is represented by the little horizontal line to the left of the bar, and the closing price is the horizontal line to the right.
The range is the difference between the highest and lowest prices traded. The buyers are said to have control, or be driving the market, if there are more buyers waiting to trade than sellers, and they push the price up. The sellers have control when the price is being forced down. You can usually tell who has control by looking at the position of the closing price in relation to the previous closing price, the range and the opening price. The larger the difference between opening and closing, the more the controlling hand wants to trade.
Compare this to the candlesticks – the body of the candlestick goes be-tween the open and close, so it corresponds to the little horizontal lines. The overall length is the same for bar or candlestick charts. And you can tell from the colour whether the open was higher or lower than the close, which makes it easier at a glance to see the trend.
Another indicator that I like to use is the Stochastic Oscillator, which is another refinement of the momentum, like the RSI. It is a powerful tool that became popular in the 1990s, and is, thankfully, calculated for you on most charts. Just to understand the principle, it compares the closing price with the range of prices that the stock has seen over time. This is the major line, which is referred to as %K. There’s also a second line, called %D, that is the three day (or three period) moving average of %K.
Strictly speaking, this is the “fast” Stochastic – there is another one, which smoothes thing down more, where the new %K is actually the %D I’ve described, and the new %D is a three day moving average of that. This is, of course, the “slow” Stochastic, and it is slower to signal but more reliable.
The (fast) Stochastic Oscillator can be used in a couple of ways to indicate trading points. Like the RSI, the values in theory go between 0 and 100%, but generally signal when they get to 20% and 80%, and don’t go much beyond those. Like the RSI, you should watch out for divergences – when the indicator goes the opposite way to the price, that’s a watch out situation, and probably means the price will change direction shortly, too.
Some traders use the actual crossing of the 20% and 80% lines as a signal to trade – for instance, if the stock is overbought, with the indicator above 80%, when it drops through the 80% going down, then that signals an opportunity to go short on the stock, which you expect to follow down.
An alternative method uses the two lines, the %K and the %D, and triggers when they cross. In this case, if the indicator lines are above 80% indicating a generally overbought condition, and the short term %K line crosses down through the %D line, then that is the signal to go short.
Of course both these methods can be used to signal a long trade, coming up from the 20% line in the opposite way. The stock is indicated oversold by the Stochastic being below 20%, and is expected to recover its price when the Stochastic rises through the 20%. The alternative crossing method is when the %K rises up through the %D from this oversold position.
You can use the slow Stochastic in exactly the same way. You should expect this to be a little slower getting you into the trade, but that the trade would be more reliable, that is, it would work out in your favour more often.
One more indicator that you may want to look at is called the moving average convergence/divergence. Now I’m not saying that you want to look at all these indicators all the time on any stock – you would rapidly get into information overload, and analysis-paralysis, and not get anywhere! I just think that you need to know about the ba-sic tools that can help you with your trading decisions. I would really advise you to have one, or at most two, indicators added to your chart, and get to know them. Then you can try a different one and see if it works any better for you. Just make sure, as I think I men-tioned somewhere above, that you’re not relying on indicators that are all based on the same thing, like momentum, or volume, because you just might find with being based on the same data that they all say the same, but it’s not right! Confirming indicators or factors need to look at a different aspect of the stock trading going on.
Enough of the lesson, back to moving average convergence/divergence, or MACD as you may have seen it called. This is based, not surprisingly, on the moving av-erages, and was invented by Gerald Appel. The basic idea is that moving averages are fine, but lag a little bit in telling you when to trade – because they’re based on historic numbers, the previous 20 days, say. So if you wait for them to cross, then you are missing being in the move at the start.
Before the lines cross, what do they do? That’s right, they converge! So if we can use convergence in some way, it may give us a signal earlier. If we just plot the convergence, all we will get is the crossing shown in a different form. Gerald Appel devised a way to show how much the convergence was varying, by using a moving average convergence/divergence line, which, plotted against the original line gives us crossings that provide signals. As with any indicator it again may be wrong, and is just an indicator, but it is considered a powerful tool.