In Figure 2.4, start at the top swing high in August. That is our first swing high. It is then followed by a swing low and then a swing high. Note that I have drawn a horizontal line at the low of the first swing low. Our rule is to go short when the market breaks that horizontal line at the low of the first swing low. I’ve put an arrow pointing down on the day that we go short. We go short the moment the market drops below the low of the
first swing low. I don’t have to wait until the second swing low is in place to go short. Note that I am getting short before the second swing low is in place because I know that we will definitely be putting in a lower low in the future. I don’t know when, but it will happen. There is no possible way that we won’t put in a new lower swing low after we break that first low. In this case, the lower low that confirms that we are in a bear market actually occurs on the day the market breaks down through the first swing low.
In other words, I can put in a sell short order under the first swing low as soon as I have a confirmed lower high. At the second high, I have conformed half of the definition of a bear market: lower highs. Now all I
need to get short is to wait for a break of the first swing low to confirm that we will be making a lower low, again confirming a bear market. Once again, I don’t need to wait until the lower low occurs to get short. I just
need to know that it will be coming. And that knowledge comes as soon as I break the first swing low.
The stop on short positions is the most recent three-bar high. The protective stop on long positions is always the most recent significant swing low. I get to move the stop up whenever I am long and we make a new
higher low. I get to move the stop down whenever I am short and we make a new lower high.
So, in this case, we go short on a break of the first swing low and place a protective stop loss just above the most recent swing high, which, in this case, is the second high on the chart.
The market then sells off and we are off to a good start on our short position. However, the fourth swing low turns out to be a higher low as you can see in Figure 2.5. I’ve marked it as a higher low. Now, we didn’t know that low was a higher low until the close of the next day. We need to see that extra day to let us know that day was a swing low. So we now see at the end of the day after the swing low that the swing low was, indeed, a swing low! We look back at the two most recent highs and see that the market is still making lower highs but we are now making higher lows. That is one of the definitions of a neutral market and our rule is that we must be on the sidelines whenever there is a neutral market. We exit the position on the open the next day for a modest profit.
We are now flat on the open of the day after the day after the swing low.
We now look at the chart and notice that a break to below the most recent swing low would turn the market bearish. We put in a sell order to sell on a break of the most recent swing low. This move occurs later that day and is marked in the chart with a downward pointing arrow. We don’t know when we will make a new swing low but we do know that it is guaranteed to occur so we go short. Our protective stop on this trade is way above the current market at the most recent swing high, which is the second high on the chart and was also our protective stop on the first trade. Remember, we don’t need to actually see a lower low; we just have to know that one is guaranteed to come. And that guarantee comes when we break the most recent swing low.
We then make a lower swing low the following day and a lower swing high four days after getting short. We now get to lower our protective stop to just above the new lower swing high. Four days later, we make an even lower swing high so we lower our protective stop to just above that level.
The market then collapses, putting us into a nice profit position. Notice that we don’t lower our stop at all until we finally make a lower high in mid- October. We go over two weeks with the old stop. This is one of the interesting features that you will have to deal with as a trader. Remember that we want all stops to fulfill two conditions. First, we don’t get stopped out on some random move and, second, we don’t want to exit a position until after we know we are wrong. Trend analysis often gives the trader lots of room to work so that he or she is only stopped out when those two conditions are in place.
It can be psychologically difficult to watch a market drop dramatically, producing a big profit, yet the stop is not moved closer in the hopes that a bigger profit is to come. It is better to sometimes sit back and let the market run. Here’s what legendary trader Jesse Livermore said in Reminiscences of a Stock Operator (John Wiley & Sons, Inc., 1994):
And right here let me say one thing: After spending many years in Wall Street and after making and losing millions of dollars I want to tell you this: It never was my thinking that made the big money for me. It always was my sitting. Got that? My sitting tight! It is no trick at all to be right on the market. You always find lots of early bulls in bull markets and early bears in bear markets. I’ve known many men who were right at exactly the right time, and began buying and selling stocks when prices were at the very level which should show the greatest profit. And their experience invariably matched mine—that is, they made no real money out of it. Men who can both be right and sit tight are uncommon. I found it one of the hardest things to learn. But it is only after a stock operator has firmly grasped this that he can make big money. It is literally true that millions come easier to a trader after he knows how to trade than hundreds did in the days of his ignorance.
That’s right: Sitting is how he made his money. The point here is that traders should stick with positions that are making money. Don’t exit them prematurely. Going back to Figure 2.5, we see that the market continues to drop off a cliff to the circled swing low seen in late October. Two sharp up days create a new lower swing high and we get to lower our protective stop to that new swing high. We then get stopped out for a significant profit five days later.
This sequence of swing highs and lows and the resulting trades gives you a clear idea of how to trade the trend in the market. It is technical analysis stripped down to the absolute essentials. Let me repeat the rules. Go long the moment the market moves into a pattern of higher highs and higher lows. Note that all four points don’t have to exist to get long but three of them do have to exist and the fourth must be in the process of being formed. The reverse is true for bearish markets.
To find complete reading : How to Make a Living Trading Foreign Exchange: A Guaranteed Income for Life (Wiley Trading)
