Swing Traders: Find More Reliable Tops And Bottoms Using Bow Ties
Picking tops and bottoms can be costly, as markets are prone
to long-term continuation moves and false reversals. On the other hand, blindly
jumping on an established trend can also be costly, as these markets are prone to
correct. Below we will look at “Bow
Ties,†a swing trade setup which attempts to solve for the above by utilizing
multiple moving averages and a counter-trend correction.
size=2>Background
The pattern uses a 10-period simple moving average, which is
simply the sum of the last 10 closing prices divided by 10.
The pattern also uses a 20-period and 30-period exponential
moving average (EMA). An EMA weighs current periods higher than prior periods. The theory is
that recent price action is more relevant than older price action. It’s beyond
the scope of this article to cover the calculations of this average.style=”mso-spacerun: yes”> For details, see href=”https://tradingmarkets.com.site/stocks/education/tindicators/01112000-2748.cfm”>Moving
Averages: The Ins and Outs Of, or do as I do–forget about
the formula and have the computer do the work for you.
A simple moving average
(SMA) gives you a true picture of the
average price. EMAs, being front
weighted, tend to “catch up†to prices faster. One is not
necessarily better than the other. Both have their purpose and that is why I use both
in this pattern.
Why
These Averages?
I use a 10-period SMA because it gives a
true representation of the average price over the last two weeks (10
trading days). The 20- and 30-period
EMAs give a rough representation of performance over the
last month and six weeks, respectively. I like the exponential averages for these
longer periods as they are front weighted and catch up to prices faster.
These are my personal preferences, but feel free to use your own.
Proper
Order
Moving averages tend to follow price. The faster-moving
averages (shorter periods) tend to track closest to price, whereas the slower
moving averages (longer periods) tend to lag further behind. During
consolidations, prices tend to bounce above and below the moving averages.
During up trends, the faster moving averages remain above the slower moving
averages (and vise versa for downtrends).
Referring to the chart of Emulex
(
EMLX |
Quote |
Chart |
News |
PowerRating) below, notice
that during the consolidation, price bounces around the moving averages–and the
averages themselves are in no particular order.
However, once price begins to trend, the 10-day SMA climbs (and stays) above the 20-day
EMA and
the 20-day EMA climbs (and stays) above the 30-day EMA.style=”mso-spacerun: yes”> I refer to the 10-SMA > 20-EMA > 30-EMA
as uptrend “proper order.†Conversely,
for downtrends, I refer to the 10-SMA < 20-EMA < 30-EMA as downtrend
“proper order.â€
The Bow Tie
When a market makes a transition from an uptrend to a
downtrend (or a downtrend to an uptrend), the moving averages converge and then
spread out again–giving the appearance of a bow tie.style=”mso-spacerun: yes”> For this setup, ideally the convergence (the
middle of the bow tie) should be very tight (the moving averages are all close
in value) and the moving averages should spread out quickly.style=”mso-spacerun: yes”> In other words, it should look like a bow
tie.
In a perfect setup, the transition from proper downtrend
order to proper uptrend order (or vice versa for short sales) should take place
in a maximum of three to four days.
The
Setup
Here are the rules for the setup:
For buys (short sales are reversed).
Using a 10-period simple, 20-period exponential and a 30-period exponential moving average:
The
moving averages should converge and spread out again—